Representations and warranty ("R&W") insurance has been available for a number of years but has only recently become widely used in M&A transactions, primarily because it has become significantly more affordable. Purchasing this insurance has become very common, almost the standard, in middle market private equity deals.
What Types of Policies Are Available?
R&W insurance is purchased either by the seller (“sell-side policy”) or the buyer (“buy-side policy”) and is typically used to backstop the seller’s liability for indemnification. The parties regularly negotiate who should bear the cost of buy-side policy, with the seller and the buyer frequently splitting the cost of the policy.
A buy-side policy can help the buyer make its bid more attractive because typically when such a policy is purchased, the buyer will offer lower escrow amounts and indemnification caps. It also provides the buyer with a source of recovery independent of the seller and its owners.
A sell-side policy provides the seller with protection against indemnification claims made against it. These policies can also be useful to address the concerns of sellers that are parties to the purchase agreement and liable for indemnification but are not actively involved in the business being sold. Having such a policy in place could allow the seller to distribute the sale proceeds more quickly.
How Does a Seller or Buyer Obtain Coverage?
A number of insurance companies and brokers now offer this coverage — Taft's private equity attorneys have relationships with many and are available to help in identifying insurers. With respect to process, it is important to involve the insurer as early as possible so it can complete its own due diligence and not become a gating item for closing. Pricing varies, of course, but currently costs are in the range of 3-4% of policy limits. There will also be self-insured retention amounts that will be accounted for in the purchase agreement indemnification “waterfall.”
How Does the Policy Work With the Purchase Agreement?
There are many ways to structure indemnities where R&W insurance is used. Most frequently, for the breach of general representations and warranties, the buyer is first subject to a deductible basket (roughly half of the policy’s retention) and the seller is liable for the excess losses, up to the amount of the retention (with an escrow traditionally securing this obligation). The seller is generally not liable for losses exceeding the escrow, thus creating a strong incentive to the seller to favor deals using insurance. However, it is common for breaches of fundamental representations and warranties to continue beyond the escrow, often to a purchase price cap.
Great care must be taken (from both the buyer’s and the seller’s perspectives) to ensure that the policy and the purchase agreement dovetail. The buyer will want to limit any “leakage” for policy exclusions and may seek to force the seller to provide special indemnity for any matters subject to a coverage exclusion. The seller will want to understand these exclusions from coverage and make sure the insurance company does not have the ability to subrogate against the seller, thereby completely eviscerating the benefits of the R&W insurance. Waivers of subrogation against the seller are common. While most of the provisions of the purchase agreement and the policy will match, there are certain provisions that will not. For example, buyers routinely obtain survival periods for most representations and warranties in the purchase agreement well beyond the survival period in the purchase agreement (frequently, three years for general representations and warranties and six years for fundamentals).