There have been a significant number of insurance company M&A transactions in the Canadian market in recent years, and this trend is expected to continue. In light of this, we have prepared and survey of the key provisions contained in and comments on trends based upon the acquisition agreements relating to these recent transactions.
The Canadian Insurance M&A Environment
A recent survey conducted by Towers Watson found that an overwhelming majority (86%) of North American insurance executives expect to see an increase in the volume of insurance company M&A transactions over the next one to three years.
The expectation of increased activity is supported by a general uptick in the level of insurance M&A activity in North America during the past few years as well as a number of underlying trends identified by various commentators, including:
- strengthening macroeconomic conditions;
- continued organic growth challenges;
- historic levels of excess capital and pressure to put that capital to work;
- emerging strategies to apply scale and analytics to improve the financial performance of potential target companies;
- increasing internet distribution, evolving consumer demands and higher service expectations are challenging insurers to consider broader transformation (including M&A transactions); and
- increased interest in insurance M&A from strategic players and private equity.
In addition to the broader trends, there are some additional factors in the Canadian market which support the expectation of increased insurance M&A activity, including
- the Canadian property and casualty insurance industry remains highly fragmented as the top 10 P&C insurers make up approximately 65% of the market;
- the ongoing pressures of relatively soft market conditions and low investment returns combined with the increasing costs of more stringent capital/regulatory requirements may create a more willing group of sellers (particularly among the small and mid-sized players) than has been the case in prior periods; and
- the potential demutualization of P&C mutual companies under regulations released by the Minister of Finance July 1, 2015 may promote additional M&A activity.
Survey Methodology and Transactions Reviewed
The survey is based on a review of the acquisition agreements publicly filed on SEDAR and EDGAR with respect to nine insurance company M&A transactions completed in Canada during the past five years.[i]
The transactions reviewed in the survey range in deal size from $150 million to $4 billion (with three of the transactions exceeding $1 billion) and include acquisitions by:
- Canadian insurers of the Canadian operations of global insurance companies that have decided to exit Canada;
- US insurers that have recovered from the financial crisis and are eager to deploy their capital for business growth in Canada;
- Canadian financial institutions seeking geographic and business diversification within Canada; and
- Canadian consolidators seeking to expand their product offerings through “bolt-on” and other acquisitions.
In each of the transactions, the target of the acquisition was a Canadian company or the Canadian operations of a foreign based parent company. All of the transactions were structured as share purchase transactions and the consideration was payable entirely in cash.
Of the nine transactions, seven involve the acquisition of a private company target, one involves the acquisition of a public company target and the final transaction is a hybrid transaction which involves the acquisition of a private company target but which contains deal terms more consistent with a public company acquisition. Accordingly, the survey terms reviewed below are predominantly consistent with private company M&A transactions.
When analyzing trends based on a review of selected acquisition agreements, it is important to note that the terms and conditions of any agreement are a reflection of “market” trends but also the respective leverage of the parties to the agreement (and ultimately the value ascribed to the transaction by the parties).
It should also be noted that, although Fasken Martineau played a role in connection with six of the nine transactions reviewed as part of the survey, our review and analysis below is based solely on a review of the acquisition agreements which have been publicly filed on SEDAR and EDGAR.
Trend Analysis and Survey
The trend analysis and survey reviews the following provisions of the acquisition agreements:
- Purchase Price and Post-Closing Adjustments
- Representations and Warranties About Target Company
- Indemnification of Buyer
- Closing Conditions
- Termination Provisions
Purchase Price and Post-Closing Adjustments
A key element of any acquisition agreement in respect of a private M&A transaction is the purchase price formulation and whether or not the purchase price is subject to adjustment. Of the seven private company transactions included in the survey, five adopted a closing balance sheet adjustment approach and two adopted a “locked box” approach.
Under a closing balance sheet adjustment approach, the purchase price is paid as an estimate at closing (determined in part based on the most recently prepared financial statements of the target company). The purchase price is then adjusted after closing based on the difference between working capital (or other movement in the value of all net assets or a subset of agreed net assets, not just working capital) of the business between the figure used in determining the estimated purchase price and the actual figure calculated from a special purpose closing balance sheet prepared after closing and as at the closing date. Under this approach, the acquisition agreement generally contains detailed provisions relating to the preparation of the closing balance sheet and dispute resolution and related matters. Each of the acquisition agreements which utilized this approach provided for an independent accounting firm to be appointed to resolve any disputes relating to the closing balance sheet and related matters.
Under a locked box approach, the purchase price is calculated and negotiated by reference to a recent historical set of financial statements dated prior to the execution of the acquisition agreement. As the amount of cash, debt and working capital are known by the parties at the time of signing the acquisition agreement, the agreed price of the target business is fixed and written into the definitive agreement. Consequently, the buyer will have no ability to adjust the purchase price after closing and will have to rely on contractual protections (through covenants, representations and warranties which are usually supported by an indemnity) to ensure that no value leaks from the locked box. Any purchase price adjustments and any permitted leakage from the locked box will have to be negotiated and settled prior to the execution of the definitive agreement. A key effect of this approach is that the economic exposure (benefit and risk) to the target effectively transfers to the buyer at the locked box date. A locked box approach may also be driven by the seller in competitive bid situations where relative certainty of closing proceeds may be an important consideration (to the parent company or its shareholders, as applicable). Interestingly, the two sellers in the surveyed transactions using the locked box approach were European companies (in recent years, the locked box approach has increasingly become a preferred route from a seller’s perspective in Europe).
Earn-outs and escrow or holdback provisions were not common features of the surveyed transactions.
In the context of insurance company transactions, it may be contemplated that an adjustment be made based on the favorable or unfavorable developments, after a certain period of time, of claims which were outstanding at closing (excluding however the claims which may be the object of a specific indemnification under the general indemnification provisions as discussed below). More precisely, this adjustment based on claims would consist of comparing the net actuarial liabilities related to the claims on closing (the “Closing Date Amount”) with all amounts paid post-closing related to such claims and the net actuarial liabilities related thereto after a certain period of time as determined by negotiations between the parties (the “Expiry Date Amount”). Should the Expiry Date Amount exceed a certain figure determined by the parties, the purchase price would be adjusted downward and should the Expiry Date Amount be lower than that certain figure, the purchase price would be adjusted upward.
Representations and Warranties About Target Company
The representations and warranties by the seller about the target company are statements of facts and assurances with respect to the target made by the seller to the buyer. These representations and warranties are typically the longest part of the acquisition agreement and often take a significant amount of time to negotiate.
The buyer’s goal is to get comprehensive representations and warranties to support the value inherent in the purchase price being paid by the buyer. Representations and warranties typically form the basis for the buyer’s right to indemnification and constitute part of the closing conditions; as such, they are key in the allocation of risk between the buyer and the seller.
In addition to the representations and warranties typically contained in private M&A transactions, the following additional representations and warranties were generally contained in the surveyed insurance company acquisition agreements:
- Policy Liabilities. The market standard has moved in the last number of years such that the seller will not typically make any representation as to the adequacy or sufficiency of the amounts recorded by the target company for liabilities arising from its policies of insurance. The market standard appears to be that the seller will make a representation to the effect that the policy liabilities reflected in the target company’s financial statements fairly present the results of the valuation by the appointed actuary of the target company and that the underlying calculations and methodology have been performed and carried out in accordance with accepted actuarial practice in Canada.
- Insurance Policies. The buyer will seek representations with respect to the target’s current insurance policies and related matters, including compliance with applicable laws and internal underwriting guidelines and maintenance in accordance with their terms and absence of default by target company under such policies.
- Capital Adequacy. The buyer will seek representations to confirm that it has received complete copies of all material reports submitted to the relevant governmental authorities with respect to the target company’s capital adequacy.
- Statutory Statements. The buyer will seek representations as to the fair presentation and preparation of the statutory statements required to be filed by the target company with relevant regulatory authorities (this is in addition to representations and warranties regarding financial statements).
- Reinsurance. The buyer will seek representations to confirm that it has received all of the target’s existing reinsurance contracts and that those contracts remain in effect and the target is not in default under any of those contracts.
- Investments. The buyer will seek representations with respect to the accuracy of the list of the target company’s current investments and compliance with the requirements of applicable Canadian laws relating to investments by insurance companies.
- Market Conduct. The buyer will seek representations with respect to the compliance in all material respects of the target company with applicable laws in relation to current policies, policy forms, policy wording, business practices and related matters. The buyer will also seek representations with respect to the disclosure of all outstanding material market conduct claims.
The seller’s goal is to give as few representations and warranties as it can and limit the scope of the representations and warranties it has to give. Consistent with private M&A transactions in general, the sellers in the surveyed acquisition agreements negotiated limits to the scope of their representations:
- through the use of pervasive qualifiers (such as knowledge and the use of materiality and material adverse effect qualifiers); and
- by qualifying the representations by reference to disclosure contained in separate disclosure schedules or letters or making the representation as of a specified date or limited to materials identified in a data room.
In the surveyed acquisition agreements, knowledge of the seller was generally defined as the actual knowledge, after reasonable inquiry (or investigation), of certain listed senior officers of the target company and the seller and the approach taken to the definition “material adverse effect” was generally consistent with that used in private M&A transactions in general (see “Closing Conditions” below for a discussion of the approach taken with respect to the definition of “material adverse effect”).
An acquisition agreement will generally include interim covenants when the transaction does not simultaneously sign and close. As part of these covenants, the seller and target company will covenant to conduct the business of the target company as usual until closing. In most of the acquisition agreements this covenant was formulated as a covenant to conduct the business in the ordinary course (and, in most cases, consistent with past practices).
The interim operating covenant is generally supplemented by a list of certain things which the seller must do or not do before closing without the buyer’s consent. In addition to the list of items typically contained in private M&A transactions, the following additional interim covenants were contained in the surveyed insurance company acquisition agreements:
- no termination of and no material and adverse amendments to any material contracts with a distributor or reinsurer.
- no rate reductions or failure to implement actuarially based rate increases and no extensions or renewal accelerations of existing insurance policies other than in the ordinary course of business and consistent with past practices or as required under applicable law.
- no material changes in the standard forms of insurance policies, no new product introduction and no material changes to pricing practices.
- maintain reserves in respect of policy liabilities in a manner consistent with past practices.
- maintain investment portfolio.
- no material changes to underwriting criteria, asset liability matching policies, investment policies, reserving policies or principles or risk management policies (and no adoption of new or additional criteria or policies).
- use reasonable commercial efforts to maintain third party insurance distributors and the goodwill of such distributors.
The extent of the items listed may be impacted by the nature of the sales process (with competitive auction-driven processes sometimes resulting in shorter lists than other circumstances).
In addition to interim operating covenants, the parties will generally include covenants intended to facilitate the closing of the transaction, including:
- using best efforts to obtain regulatory approvals and third party consents;
- co-ordinating public announcements with respect to the transaction;
- completion of any pre-closing corporate reorganization of target or related parties necessary to facilitate the transaction;
- return (or destruction) of target confidential information provided to other bidders in the case of an auction process;
- co-operation with any financing to be conducted by buyer in connection with the acquisition (recognizing that completion of the transaction itself is not generally and, in none of the surveyed agreements was it, conditional on financing); and
- allowing the buyer continued access to the target’s employees and premises on agreed terms and subject to applicable law and any confidentiality restrictions applicable to target.
An acquisition agreement will typically include post-closing covenants intended to manage certain matters after the deal is done. The following post-closing covenants were generally contained in the surveyed acquisition agreements:
- The buyer tended to receive restrictive covenants from the seller not to compete with the target company or to hire its employees (these covenants generally ranged from 36 - 48 month after closing). The length of non-competition covenants that can be negotiated is limited not only by the respective leverage of the parties, but also by what courts will enforce.
- The buyer covenanted to provide director and officer insurance to outgoing directors or to change the name of the target company (if applicable).
Indemnification of Buyer
Indemnification arises in private M&A transactions to protect the buyer from losses generally resulting from breaches of representations and warranties or failure to perform covenants contained in the acquisition agreement and certain liabilities allocated to one party or the other (for example, a particular piece of litigation of the target company). Indemnification typically involves a payment from the seller to the buyer to compensate the buyer for losses incurred due to such breaches or failures.
The indemnification provisions contained in the surveyed agreements are summarized below.
- Survival. The seller risks post-closing liability for a breach of the representations and warranties or covenants in the acquisition agreement to the extent that, and for the time period during which, its representations and warranties or covenants survive the closing. In the surveyed acquisition agreements, the survival periods generally ranged from 18 to 24 months.
In most of the surveyed agreements, the buyer negotiated expanded survival periods for certain representations and warranties relating to:
- tax matters (for a period of 60 to 90 days following the expiration of applicable assessment, reassessment or similar periods);
- fundamental or “core” matters (e.g. title to shares, corporate existence and authority, tax residence, execution and binding obligation, no other options to purchase, etc.) and in some cases environmental matters (for periods ranging from five years to indefinitely); and
- in some cases employee benefit plans (for a period of 4 to 8 years following closing).
- Baskets. A basket limits indemnification obligations so that a seller is not liable for inaccuracies in or breaches of certain representations until losses exceed a specified minimum amount. Baskets usually only limit indemnification for breaches of representations and warranties, and do not cover breaches of covenants. Some of the agreements surveyed contained specific carve-outs from the minimum threshold with respect to breach of “core” representations and warranties.
Baskets are generally structured as:
- Thresholds (also known as dollar-one or tipping baskets) where the seller is liable for the total amount of losses once the minimum amount is exceeded. This type of basket is usually preferred by the buyer because it is made whole for the losses once the threshold has been met.
- Deductibles (also known as excess-liability or spilling baskets) where the seller is only liable for losses over the minimum amount. This type of basket is usually preferred by the seller and is generally more common.
Based on the surveyed insurance company acquisition agreements:
- Consistent with general market trends, buyers and sellers appear willing to forego an argument on the content of baskets and reserve their bargaining power to the amount of minimum thresholds and aggregate thresholds.
- The use of deductibles is generally the most common basket structure with the minimum amount above which the seller is liable generally ranging from 0.5% to 1% of the purchase price.
Some the surveyed agreements also used mini-baskets which require the losses from a particular claim to exceed a certain amount before the losses can be counted toward the basket.
- Aggregate Thresholds (Caps). One of the clearest trends in private M&A transactions in recent years is the lowering of the aggregate limit for which sellers will be responsible to buyers for breaches of representations and warranties.
The caps in the surveyed insurance company acquisition agreements generally ranged from 13% - 35% of the purchase price with the majority of the transactions in the 20% - 25% range. In a number of agreements, the cap did not apply to losses resulting from breach of “core” representations.
- Scraping. Numerous representations made by the seller are subject to materiality qualifications. In circumstances where indemnification is subject to a basket, there is a risk to the buyer of “double dipping” if representations also contain materiality qualifiers. In this circumstance and to prevent this double-dipping effect, the buyers in the surveyed agreements generally included a provision to “read-out” the materiality qualifiers from the representations for purposes of indemnification.
- Additional Indemnification Matters. In addition to indemnification for losses suffered as a result of breaches of representations and warranties or covenants contained in the acquisition agreement, some of the acquisition agreements contemplated indemnification for other specific matters (for example, in relation to tax liabilities that may arise prior to closing but which had not been otherwise disclosed to the seller or contemplated as part of the purchase price negotiation, material liabilities relating to any unrecorded liabilities which were not recorded on the most recent historical financial statements which the parties used in connection with their pricing negotiation or other transaction specific matters which may have arisen during the course of the buyer’s due diligence or the pricing negotiations which the parties agreed to deal with as an indemnification matter as opposed to a purchase price negotiation or re-negotiation, as applicable).
- Sandbagging. In connection with an acquisition transaction, a buyer typically conducts a substantial amount of due diligence on the target and its business. However, despite this investigation, a seller is required to make representations and warranties concerning the target and its business subject to certain exceptions and qualifications as set out in disclosure schedules or a disclosure letter. There may be facts, events or circumstances that although known to a buyer, are not set out in the disclosure schedules/letter and for which a buyer would be permitted to bring a claim for indemnification after the closing (on the basis that a representation or warranty of the seller would be inaccurate as a result of the existence of these facts, events or circumstances). This right of a buyer to bring an indemnity claim based on breaches known before closing is known as sandbagging.
The acquisition agreements in the survey adopted different approaches with respect to sandbagging. Some sellers attempted to restrict the buyer’s right to indemnification in certain circumstances (e.g. the buyer is made aware of a breach and expressly waives it prior to closing). Some buyers included express language to the effect that its rights to indemnification were unaffected by any investigation or waiver. In other cases, some of the agreements reflected a potential compromise by remaining silent on this issue.
- Types of Damages. The parties often negotiate what type of damages can be recovered in the definition “damages” or “liabilities” which are subject to claims for indemnification. It is also relatively customary to reduce the amount of any indemnification payment by any tax benefit realized or expected to be realized by the buyer.
- Exclusive Remedy. Subject to certain negotiated exceptions, the surveyed acquisition agreements generally contemplated that indemnification was the exclusive remedy after closing for breach of representations and warranties and covenants.
Although the indemnification provisions are generally consistent with those found in private M&A transactions, a key distinction between the insurance industry and other industries is that in the insurance industry, the number of insurance claims and litigations handled by the target company is important due to the nature of the target’s activities. In most insurance industry transactions, a specific indemnification related to the different claims or litigations directly related to the insurance activities of the insurer (the target) is not provided for. This, however, may be the case in transactions involving other industries where litigation is unusual and represents a direct risk for which relevant reserves may or may not be provided for in the financial statements of the target. In most instances in the insurance industry, which is highly regulated, the target’s reserves should be sufficient to cover litigation risks.
The buyer may, however, discover during its due diligence review that, according to its own assessment of the risks and based upon its own calculations, the amount of the reserves reflected in the books of the target company with respect to certain specific and important claims or litigations may not be sufficient to cover the risks related thereto. In such a situation, further to negotiations regarding the accuracy of the reserves, one option may be for the purchaser to request a specific indemnification for the amount that the target may have to pay to the insureds or incur in connection with the identified claim or claims above the amount of the reserve related thereto and already provided for in the books of the target with respect to such claim or claims. This compromise may be acceptable if the seller believes that the reserve is adequate and the buyer believes that it is not.
In addition, it would not be unusual in a situation whereby the seller agrees to indemnify the buyer for certain specific claims or litigation that the seller request to the buyer that all actions related to the handling of the claims fall under the seller’s control, even after the closing of the transaction. This allows the seller to be certain that the claims or litigation will be handled according to the same standards the target company was using prior to the closing of the transaction.
Another option available in such a situation, which would allow the target company to reflect a more favorable financial situation in its books, would be that the target company enter into a reinsurance agreement with the seller or a member of its group (if an insurer is among such group) in order to reinsure the risks related to the relevant claims and litigations. Since the seller and the buyer disagree on the accuracy of the reserve, the premium could be set at the amount of the reserve registered in the books of the target which according to the seller is sufficient to cover the risks related to the claim. Essentially, subject to the tax and accounting impacts of such a reinsurance agreement, this option would place the parties in the same situation as an indemnification provision would, considering that if the premium is not sufficient the seller will assume the additional financial exposure related to the claims under the reinsurance agreement.
An acquisition agreement will include conditions to closing when the transaction does not simultaneously sign and close. If the conditions in favour of a party are not met, the party will typically have the right to refuse to close the transactions.
The closing conditions contained in the surveyed agreements are generally consistent with those found in private M&A transactions and include:
- accuracy of representations and warranties at closing;
- obtaining necessary governmental approvals (typically insurance regulatory, competition and, in the case of non-Canadian buyers, Investment Canada);
- no injunction or other legal constraint on the transaction;
- performance and compliance with all covenants;
- a certificate of an officer of each party certifying the accuracy of representations and warranties and covenant performance;
- delivery of documents to effect resignation of target company directors concurrent with closing; and
- receipt of other required closing documents and instruments.
The closing condition relating to the bring-down of representations and warranties is often negotiated both in relation to the scope of representations and warranties to be included in the condition and the approach taken in the closing condition with respect to materiality qualifications (the buyer will be sensitive to potential double materiality qualification which may result with respect to representations and warranties in the acquisition agreement that are themselves qualified by reference to materiality or material adverse effect).
The surveyed agreements adopted different approaches in respect of this closing condition.
In three cases, all of the representations and warranties were included and potential double materiality issues were “scraped” such that representations and warranties already subject to materiality or material adverse effect qualifiers had to be true and correct in all respects and each of the representations and warranties not otherwise qualified had to be true and correct in all material respects. In two cases, the closing condition was limited to certain core representations (e.g. title to shares, corporate existence and authority, tax residence, execution and binding obligation, no other options to purchase, etc.) and subject to materiality qualifications. In another transaction, the closing condition applied to core representations and warranties (on the basis that each core representation had to be true and correct in all material respects) and the other representations and warranties contained in the acquisition agreement (on the basis that the condition of closing would be considered satisfied unless the failure of these representations and warranties to be true and correct has had or would reasonably be expected to have, individually or in the aggregate, a material adverse effect).
Other closing conditions found in the surveyed acquisition agreements included:
- Material Adverse Effect. Most of the acquisition agreements included a standalone condition that provided the buyer with the right to walk away from the transaction if there has been a target company material adverse effect between the date of signing and closing.
The approach taken to the definition “material adverse effect” was consistent with that used in private M&A transactions in general which includes:
- the exclusion of “prospects” from the definition of material adverse effect;
- the negotiation of carve-outs from the definition for certain macro-events (including conditions affecting financial and credit markets, acts or war, changes in law or accounting rules, conditions affecting the insurance industry in general, failure of the target to meet and other negotiated matters); and
- a qualification to the carve-outs which provides that, if certain of the carve-outs have a materially disproportionate effect on the target compared to comparable companies, they will not be excluded for purposes of determining whether a material adverse effect has occurred.
- Financial Condition. One of the surveyed agreements contained a closing condition that the target had to have a minimum capital adequacy ratio at closing. Another of the surveyed agreements contained a closing condition that the target had to have a minimum net asset value at closing.
A termination provision allows one or both parties to terminate the acquisition agreement under certain circumstances. The following termination provisions were contained in the surveyed acquisition agreements:
- Failure to obtain regulatory approvals or close transaction by a specified date (subject, in some cases, to extension to a later date in order to obtain regulatory approvals).
- Non-fulfilment of closing conditions (subject to a right of waiver).
- Material breach of the agreement by the other party (often subject to a cure period).
- Agreement by both parties to terminate.
Consistent with private M&A transactions, the surveyed agreements did not generally contain fiduciary outs (which allows the board of directors of a public company seller to terminate the agreement and negotiate and accept a competing proposal if unsolicited and necessary to fulfill the fiduciary duties of the directors). The three transactions that did contain fiduciary out provisions were exceptions to this rule and appear to have been driven by the specific facts of each case. As noted above, one of the transactions included in the survey involved the acquisition of a public company and in this circumstance a fiduciary out is a common feature. The other two transactions involved the sale of a significant subsidiary by a public company parent (in both circumstances, shareholder approval of the transaction was required under applicable corporate law or stock exchange requirements).
In financial groups, the handling of the reinsurance treaties usually covers all insurance entities of the group. Therefore the sale of an entity of the group may raise some concerns for the seller as well as for the purchaser since the reinsurance experience of one entity may financially impact the others. Post-closing, the purchaser’s objective will be to avoid being negatively affected by events that may involve members of the seller’s group and the seller will have the same objective with respect to the target. Therefore, the parties should agree to use commercially reasonable efforts to terminate the coverage of the reinsurance agreements of the seller group with respect to the target and include it under other reinsurance agreements entered into by the purchaser.
It is only in the situation where the purchaser and the seller will not be able to terminate the reinsurance coverage for the target and to enter into new reinsurance agreements at acceptable terms and conditions that the target will remain covered by the reinsurance agreements in place prior to closing. If this is the case, the target will remain bound by the terms and conditions of such reinsurance agreements. In this respect, the seller will likely require that the target undertake in favour of the seller to comply with the reinsurance agreements’ terms and conditions and to collaborate with the seller to provide it with the relevant information and data necessary to allow the seller to handle its obligations under the reinsurance agreements, including relating to the target’s experience. In addition, the agreement between the parties to the transaction will likely foresee that the target will assume its share of the relevant amounts due to the reinsurers under the reinsurance agreements which remain outstanding at the time of closing.