As vaccines roll out and COVID-related restrictions are lifted across the country, it’s time to look at the impact the pandemic has had on the use of Representations & Warranty (R&W) insurance to cover M&A deals… and what to expect in the near term.
R&W insurance, of course, transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the policyholder, usually the Buyer, simply files a claim and gets paid damages.
The use of this specialized type of coverage had been steadily growing and becoming more widespread pre-pandemic. Even lower middle market deals were being covered.
Just as M&A deal-making contracted, there was a reduction in the number of R&W policies being written in the first three quarters of 2020. But by the fourth quarter, it had rebounded and even surpassed 2019 levels. That trend continued into the first quarter of 2021.
In fact, according to the BMS Group’s Private Equity, M&A and Tax 2021 Report:
“As the initial challenges of operating amidst a lockdown were managed, deal volume rebounded strongly in Q3 and Q4 was the busiest quarter ever in the M&A insurance market. As we go to press, early indications are that M&A activity has levelled up somewhat but nonetheless we expect 2021 to be a record year for M&A insurance.”
Thanks to a rush to get back to deal-making, as well as the previous pre-pandemic growth, I expect a rising trend to continue as more dealmakers – both Buyers and Sellers – realize the value of this coverage. I forecast that this rebound will continue into 2022.
That doesn’t mean there won’t be key changes.
First thing to mention – especially if you have been hesitant to use R&W insurance – you should know that it’s well established and popular.
The BMS Group report highlighted that:
- 90% of those who use it are either very satisfied or somewhat satisfied with their coverage.
- More than 2/3 have a favorable opinion of how claims are paid.
- 78% of respondents had used this type of insurance six or more times.
- Four out of 5 PE firms use R&W coverage on a majority of their deals.
Key Trends in R&W Insurance to Watch
The pandemic is going to impact how R&W policies are written, cost, and other factors. But some of this would have happened anyway – without COVID – simply due to the increasing popularity of this coverage.
The COVID Impact Is Limited
While it’s still early to make a final judgement, it appears COVID hasn’t had a catastrophic impact on the R&W market.
As it states in the BMS Group report: “Despite the increase in claims frequency and severity, premium pricing has remained relatively low whereas it has hardened across other lines of insurance.”
Going forward, COVID will have zero impact because it’s “known.” R&W insurance covers the unknown. Underwriters won’t necessarily issue blanket exclusions for COVID-related issues, but they will take it into consideration.
Limits on the Rise
Another trend to watch for: Expect buyers of R&W insurance policies to buy more limits. In the last couple of years, Buyers have been securing policies at 5% to 10% of transaction value, which is largely to just cover the escrow. Problem is if you have a $100M deal and a $10M policy, what happens if you have an $18M loss?
The eight million over the R&W policy is uninsured.
As a result, Buyers are seeking to transfer more risk. So, look for them to buy more Policy limits, or select “hybrid” Excess Policy Limits only or Fundamental Reps (the cost of which are a fraction of the R&W pricing). Because there’s no remedy for anything uninsured, as the Seller is off the hook.
In the event there is a breach, and the amount of loss is significantly higher than the amount covered by R&W insurance, Buyers are beginning to make claims of fraud or misrepresentation against the Seller… because they know the Seller has a D&O policy.
If there is a loss that exceeds the R&W policy, Buyers are looking to recoup some costs through the Seller’s D&O policy. So it’s no surprise there has been an increase in fraud lawsuits.
D&O policies don’t pay for fraud. However, that exclusion only happens if fraud has been proven in court. The defendant has to admit they knew of fraud in court, or there must be a final judicial finding that fraud existed.
Up until then, the insurance company pays defense costs. If they settle, which is often the most cost-effective option, the insurance company pays the settlement. As part of the settlement, Sellers don’t have to admit fraud was committed.
This is why Sellers are being required to secure a D&O tail policy (if they don’t already have D&O in place) – Buyers should insist on it – and why they also need a R&W policy.
Costs Are Going Up
As more R&W policies are purchased, the cost will go up.
The rate will go from high 2% to mid 3%. And it’s already beginning to happen. On a minimum premium deal like I do, it’s already at 3%. A $5M policy is $150,000 to $175,000. But on a $20M limit policy it’s going to be at $600,000 whereas last year it was closer to $500,000.
PE Firms
There was a serious contraction of M&A activity in 2020 and the early part of 2021 – no surprise there. PE firms were holding back – not willing to commit their money. Plus, it’s a natural result of meetings moving online, workplaces going virtual, and the like. Many industries slowed down over the last year and lost productivity.
But now, PE firms, who’ve been sitting on all this cash for a year or more, are ready to start deal-making again. They – and their investors – are looking to start adding value to their portfolios again and rebuilding their balance sheets.
Since PE firms are so committed to R&W insurance, there was a natural dip in policies being written that mirrored the drop in M&A activity. But R&W has returned.
SPACs
Special purpose acquisition companies (SPACs) will also have a hand in this growth in R&W policies being written in the next year or more. There are more than 400 SPACs that must complete an acquisition by 2023 – at the farthest out. That’s deadline pressure.
SPACs mostly target middle market companies – those $100M or more. As these so-called “blank check companies” start doing deals again, expect to see a spike in R&W policies written.
The one purpose of a SPAC is to acquire or merge with an existing company – it makes going public easier, quicker, and cheaper than a traditional IPO. And R&W coverage is perfect for these deals because even in the best of times, SPAC founders face tremendous pressure to get deals done within a two-year window. Because R&W insurance hedges risk for both Buyer and Seller it facilitates fast mergers and acquisitions.
Insurers Scramble for Qualified Underwriters
A natural side effect of the increasing use of R&W insurance over the last few years is that insurers are seriously understaffed with experienced Underwriters compared to demand for their services.
There are only so many Underwriters out there with the “know how” to underwrite M&A transactions. And as more insurance companies have entered the growing market, we’ve actually seen them “poach” underwriting teams from other insurers.
Pressure on Underwriters
R&W insurance is a complex line of coverage. Even if Underwriters outsource due diligence to an outside law firm, they are seriously stretched for time due to the sheer volume of policies being requested.
Many policies are being delayed – even declined – due to an insurer’s lack of bandwidth.
What does this mean for Buyers and Sellers?
You can’t expect Underwriters to turnaround a policy to cover your deal in a week or even a couple of weeks. Insurtech has not reached the R&W world yet. Although it was possible in the past, waiting until the week before closing to begin the R&W process is as prudent as waiting until April 14th to call your CPA for tax assistance.
If you’re interested in having this coverage for your deal, you need to start the Underwriting process at least four weeks out so there are no surprises. Don’t come in last minute and expect miracles. Underwriters are people too.
You can’t push them to the brink without losing relationships. A good Underwriter wants to be your partner; they want to do it right and be as timely as possible. So, start the process sooner rather than later.
A note of caution: Some insurers advertise faster processing, but they are prone to delays. Best case scenario – you’ll find an insurer to cover your deal on schedule but at exorbitant costs (2-3X the normal underwriting fee) that result in extra expense.
What Underwriters Are Watching For
The ideal situation for an Underwriter is to put as few limitations as possible on deal. Their objective is to have as few exclusions as possible because exclusions create friction. But they still need a sustainable product. They must protect the insurance company they work for.
As a result, we’ll see Underwriters exercising more caution on wide open worded Reps. For example, if there is a Rep with the following wording “will continue to be” or “will continue” – which means post-closing – the Underwriter will read that out as if the wording doesn’t exist.
In this market dynamic, Underwriters are also watching out for the definition of “damages”. They don’t want to explicitly cover multiplied or consequential damages, which are very problematic.
But they have been known to strike a balance with policyholders. If, in the agreement the definition of damages is “silent” with regard to multiplied or consequential damages, the proposed policy will match the agreement with the intent that while the policy is not specifically covering consequential or multiplied damages, such damages are not specifically excluded either. This enables the parties to consider such damages in the event of a claim.
It’s essential for the insurance broker to make clear with the Underwriter that silent doesn’t mean excluded. In other words, if it’s not there it doesn’t mean it’s excluded, it means it’s agreed.
Where to Go From Here
As with many things, COVID has had an impact on M&A and the specialized type of insurance that covers these deals: Representations and Warranty. Yet, I expect the true value of this coverage to shine through, and for its popularity and widespread use to not just continue, but to grow and expand.
Here’s how they put it in the BMS Group report:
“We remain optimistic about the outlook for M&A insurance and expect it to continue to play a vital role in M&A, especially given how ingrained it has become in the deal process and the part it plays in unlocking both capital and negotiations which have reached an impasse on M&A transactions.”
In light of these trends, I wanted to offer you a free download of some best practices to consider going forward when it comes to incorporating Representations and Warranty insurance in your next M&A transaction.
If you have a deal coming up or one closing between now and the end of the year, and are open to having a conversation on how R&W can work for your particular deal, you can contact me Patrick Stroth, at pstroth@rubiconins.com.