The capital markets seem to be in love with reinsurance. Capital from venture capitalists, private equity funds and hedge funds has been flowing into the reinsurance industry during the past several years. Many of these capital markets investors have focused on the property catastrophe reinsurance market. Others have focused on alternative reinsurance vehicles and sophisticated financial products to provide non-correlated investment opportunities as a hedge. Some just invest and others buy companies outright.
A key action item when considering a reinsurance investment is performing due diligence. This is nothing earth-shattering. No investor or acquirer would invest in or purchase a company without fully understanding the business and carefully examining the books and records of the target. When a reinsurance company is involved, the due diligence hits another level. Reinsurance companies do not make widgets. They don’t have inventory and they don’t have suppliers in the traditional sense. Reinsurance companies are financial services companies providing capital in exchange for insurance risk. The due diligence has to match the nature of the risk being acquired.
Because reinsurance companies assume risk from multiple reinsureds and because very often the risks assumed will not come home to roost for some time (except in short tail lines), understanding the risks assumed is critical to the due diligence. That requires an examination of the assumed reinsurance contracts, the target’s retrocessional protections and, perhaps most importantly, the assumed loss reserves. In other words, what are the ultimate expected losses that the reinsurer will have to pay to its reinsureds on a gross and net basis? Has the reinsurer accurately stated its reserves on its regulatory filings and in its books and records? Is the valuation of the company correct?
Failing to maintain adequate or accurate loss reserves means that the valuation of the reinsurer may be incorrect. Failing to detect under-reserving during the due diligence period is a near-guarantee that there will be a post-closing dispute over valuation once the under-reserving is detected.
An example of what can happen when purchasing a reinsurance company is found in WT Holdings Inc. v. Argonaut Group. Inc., No. 600925/09, 2015 N.Y. Misc. LEXIS 648 (N.Y. Sup. Ct. Mar. 3, 2015). Here, a purchaser of a reinsurance company sued for indemnification for alleged breaches of representations and warranties made by the target reinsurance company in a stock purchase agreement. The essence of the alleged breaches had to do with the claim that the reinsurer understated its case reserves. This recent decision follows a July 20, 2012 decision where the purchaser lost its argument seeking damages based on the difference between the value of the reinsurance company as warranted and the actual value of the reinsurance company. The court in 2012 held that the purchaser was entitled to damages only under the indemnification provision of the stock purchase agreement, which was the sole remedy permitted as the purchaser waived any right to a cause of action for damages for breach of contract measured by the benefit of its bargain. In the current decision, the purchaser tried to renew its motion arguing that it was entitled to a different measure of damages based on a purchase price theory, which seeks damages equal to the difference between the purchase price paid for the reinsurer and the price it would have paid but for the allegedly false representations and warranties. The court rejected this theory as new, denied the motion and held that the only measure of damages was for “loss” under the indemnification provision. “Loss,” of course was ambiguous and a trial is necessary to determine damages.
The point of this story is that this case has been around since 2009 and it still has not gone to trial. It also points out the need for careful drafting of stock purchase agreements in the reinsurance context especially where the measure of damages for breach of representations and warranties concerning reserves are concerned. The difference in the reserves made a huge difference in the valuation of the company and the purchase price. Careful due diligence and careful contract drafting helps to avoid these post-closing disputes. But as we all know, no amount of due diligence or careful contract drafting will help when there is buyer’s remorse.