By Jonathan Gilbert, Crystal & Co
Over the past few years, dealmakers have discovered how much representation-and-warranty insurance policies can streamline negotiations and closing deals.
Under these policies, an insurance carrier promises to compensate the buyer of a company if there is an unanticipated breach of seller representations in the purchase agreement: for example, noncompliance with GAAP accounting principles, overstated inventory or loss of customer contracts. This helps avoid the often difficult discussion of putting some of the seller’s money in escrow for several years to cover potential misrepresentations.
Yet as the R&W insurance market has evolved, with more carriers and policy variations, strategic corporate companies and private equity firms are starting to wonder whether they’re getting the best coverage for the best price. Indeed, premiums can vary widely, typically 2% to 4% of the covered amount. At Crystal & Co we recently solicited bids from more than 12 carriers for one transaction and found a 20% difference between the highest and lowest premiums for policies with similar terms.
But while terms matter — along with underwriting experience, insurance carrier financial rating, claim experience and other factors — several strategies can be employed to pursue coverage that will help meet your pricing objectives while not compromising coverage. Here are eight areas of focus to reduce cost and maximize coverage:
Adjust the term and retention amount. As with most types of insurance, premiums for R&W are higher if the policy deductible or retention is lower. Retention rates have been standard at 1% to 2%, so if you’re comfortable at the higher rate, there’s money to be saved in the event of a loss due to lower retention. Additionally, if the retention is shared between buyer and seller, that reduces the potential cost exposure further for either party. Furthermore, the retention can be reduced to 0.5% or less after 12 or 18 months. While this may have a slight impact on premiums, the benefit in the event of a loss may be invaluable. Another option that can have a minimal effect on the premium is a shorter policy term. There is a slight premium credit for a carrier offering a three-year term for breaches of general representations vs. six years. Certain carriers are reluctant to offer a six-year term for breaches of general representations for a variety of reasons (e.g., reinsurance restrictions, general risk appetite, or need to hold reserves).
Explore using multiple carriers. If a company wants, say, $100 million in coverage, it sometimes can be less expensive to have four $25 million policies from different carriers than a single $100 million policy. These policies are arranged in a ladder, so one carrier is responsible for the first $25 million in claims, while the second covers claims that exceed that amount, and so on. The advantages of this are certainly cost as well as the potential aggregate payment any one insurance carrier may be responsible for in the event of loss. The disadvantage is differing carriers may have different views on risks or coverage, which can complicate the underwriting and claims processes.
Ensure the appropriate jurisdiction to minimize taxes. Most U.S. states collect taxes of 3% to 5% on insurance premiums for R&W policies. Other countries have tax-insurance premiums as high as 20%. For R&W insurance, it can be somewhat murky on which jurisdiction is entitled to the tax and the rules vary by state (i.e., is jurisdiction of the buyer entitled to tax, jurisdiction where target company is headquartered, where target company has substantial operations, etc.). But an adviser should be able to provide guidance on the applicable tax jurisdiction.
Get credit for other insurance policies that might cover a breach event. Sometimes, the seller may have already purchased insurance or the buyer could purchase a separate policy to cover situations that would first respond to loss involving a breach of the R&W in an acquisition agreement such as coverage against the cost of a product recall. In other cases, a buyer may take out a new policy on a specific area of concern, such as the environmental liabilities and potential tax liabilities of the seller. Either way, premiums for R&W insurance should be lower if other coverage is in place that would handle potential claims in the event that a material risk is excluded from R&W policies (e.g., environmental, sales and use tax, cyber risk).
Negotiate who pays the premium. That is, which party bears the cost of the policy becomes a negotiated point. The buyer could bear the cost, the seller could, or the cost can be shared. Be sure to incorporate these premiums as well as taxes and underwriting fees in the overall negotiation.
Push carrier to reduce exclusions. R&W policy underwriters have attempted to exclude coverage of certain areas in which they’ve had to pay significant claims (or risks that are known and higher than normal for particular industries). Some carriers are concerned about violations related to the immigration status of hourly employees: for example, wage-and hour matters, transfer pricing risks. So buyers and sellers should negotiate with carriers to make the exclusions as narrow as possible. Additionally, buyers should ensure that proper due diligence is being conducted on areas of heightened concern.
Push for the broadest representations, while staying within market standards. A buyer-friendly agreement may afford the purchaser the broadest protection in the event of a loss, but insurance carriers will push back to “market” for similar transactions. Given that insurers look at a plethora of deals, they have a good sense of what is “market,” and this is often a debatable point.
Insist on the latest policy form. As the market for R&W insurance has grown, carriers have steadily relaxed key policy terms, offering more coverage at lower prices. Of course, the insurance companies are not going to volunteer to you that they offered concessions to a different company last month. That’s where having experienced advisers comes in. If you’re working with insurance brokers, lawyers and investment bankers who regularly close similar deals, they can help alert you to the very latest policy provisions that are available.
None of this is meant to suggest that companies should strive to find the lowest premium available no matter what. The objective is to find the top value for coverage that meets your needs while considering contract terms, underwriting knowledge and claims experience. And like so much in business, it can be counterproductive to drive such a hard bargain with an insurance company that it sours the future relationship.
Nonetheless, R&W insurance is quite competitive, so with a little work you should manage to secure a policy that’s as competitive in price as it is comprehensive in coverage from a reputable carrier and an underwriter that can execute on your time frame.
Jon Gilbert leads the mergers and acquisitions practice at the New York-based insurance brokerage Crystal & Co. Reach him at Jonathan.Gilbert@crystalco.com or +1 212-504-5997.