This article was published on CFO.com on September 1, 2015. It is reprinted here with permission.

Shifting to an insurer the risk of breached representations and warrenties makes deals likelier to happen.

In today’s robust M&A market, buyers and sellers are both looking for ways to make transactions more attractive to sellers by ensuring that they retain most of the net proceeds after the deal closes. To accomplish this, both parties are increasingly shifting the risk associated with the transaction — either by allocating risk to the buyer or by transferring it to third-party insurers through representation and warranty insurance (R&W insurance).

This is especially true in transactions with private equity sellers or when companies are carving out divisions or business units. In light of this trend, deal minded-CFOs, both buyers and sellers, are advised to familiarize themselves with the basics of R&W insurance.

In many transactions, the seller’s risk, known as the “cap,” is often low compared to the overall purchase price — in some cases, as low as 5 percent to 10 percent. Yet parties have long used contractual terms, such as limitations of liability, to ensure the seller will retain more of the net proceeds from the sale. In recent years, however, R&W insurance — first introduced in the late 1990s — has become more widely used as a tool to shift risk away from the seller.

Benefits of R&W Insurance

When R&W insurance is part of a deal, a seller can avoid the contingent risk of a breach of a representation, which ordinarily might result in a buyer seeking to recapture some of the sale proceeds and a reduction of the seller’s net gain. Absent fraud or other knowing/intentional misrepresentation, the seller can, for the most part, leave the sold business behind after the deal closes because the buyer retains recourse for the breached representations from an insurance company.

While R&W insurance can ensure that a seller receives more of the sale proceeds, it can also protect the buyer in a sale. If any unknown liabilities arise from a seller’s breach that are discovered post-closing, such liabilities will be covered by the R&W insurance. Known risks, however, require special coverage apart from the R&W insurance policy (usually a seller-retained specific indemnity or buyer-accepted coverage). In some cases, such as regulatory, tax, and environmental risk, specialty coverage is available at a cost. Where the cost is prohibitive or where there is no market for such insurance, the parties may use special indemnities with escrows, caps, deductibles, and survival periods tailored to the risk.

R&W insurance can also be an effective tool when conducting transactions abroad. It can minimize the buyer’s risk and increase its chances of recovery in jurisdictions that do not have well-established court systems and legal principles, or where, due to currency and exchange controls, it is difficult or legally impossible to establish escrow accounts.

Incorporating R&W Insurance into Your Deal

If buyers and sellers agree to purchase R&W insurance, the cost of the policy is usually paid at closing and is a percentage (approximately 2-3 percent) of the sale price, based on the amount of coverage desired. Buyers and sellers typically negotiate who will pay the insurance premium, and at times the purchase price for the company may be reduced in exchange for closing with a higher cash amount and less or no escrow or holdback.

Generally, R&W insurance policy periods match the survival period of the non-fundamental representations in the purchase and sale agreement. However, the market provides for coverage that could be much longer than the contractually agreed-on survival term.

The underwriting process for the policy — which includes the insurance provider’s due diligence and disclosure review, access to the buyer’s adviser reports (e.g., legal due diligence memoranda, environmental and tax reports) and transaction correspondence — usually takes up to two weeks. Generally, the insurer also employs experienced M&A counsel to supplement the due diligence and ensure that the terms being insured are consistent with the market and the product of effective negotiation.

Complications and Considerations

Because R&W insurance only covers unknown risks, a buyer should rely on due diligence and the advice of counsel in determining exposure to both known and unknown risks. A seller should not conduct itself differently in transactions involving R&W insurance, but there may be differences when the buyer is seeking qualifications to the seller’s representations. For example, a seller may be willing to accept fewer qualifications in representations to provide greater certainty that the buyer will be covered under the R&W insurance policy.

On the seller’s side, the seller should require the buyer to represent that the draft R&W insurance policy has been provided to the seller prior to signing of the purchase and sale agreement. This is because the R&W insurance policy is not bound and issued, and the premium is not paid, until the transactions contemplated by the purchase and sale agreement are closed.

As such, the seller should seek consent rights to any amendments, waivers, or other changes to the draft R&W policy prior to closing. In particular, the seller should be consulted on any changes relating to the R&W insurance provider’s waivers of subrogation — which is the R&W insurance provider’s right to reclaim losses and damages from the seller — or other terms that would expand the seller’s risk beyond that which was agreed on in the purchase agreement.

Conclusion

Although the R&W insurance market has expanded significantly over the last few years, there has not been a material increase in claims. This suggests that parties are vigorously negotiating their deals and addressing problems prior to signing. However, as with any transaction, risk persists, and CFOs should familiarize themselves with R&W insurance to increase the likelihood of successful conclusions to deals.