It is becoming increasingly important for tech companies considering a merger, acquisition, or other corporate transaction to understand the use of Representation & Warranty Insurance (“R&W Insurance”). R&W Insurance is a type of insurance policy purchased in connection with corporate transactions; it covers the indemnification for certain breaches of the representations and warranties in the transaction agreements. It is designed to provide additional flexibility in addressing these obligations by, for example, reducing or eliminating the need for an escrow by the Seller. 

The use of R&W Insurance is becoming more popular, and the volume of R&W Insurance sold has increased considerably in recent years. Recent estimates suggest it is now used in over 30% of North American transactions, with over 3,000 policies placed in North America in 2018.

R&W Insurance can be purchased as either Seller-Side or Buyer-Side coverage. Seller-Side coverage is a form of liability policy, covering the Seller’s liability for claims of breach of a representation or warranty. Buyer-Side coverage is a form of first-party coverage, directly compensating the Buyer for alleged breaches by the Seller. One common variation is a Buyer‑Side policy that also protects the Seller (by barring the insurance company, except in cases of fraud, from pursuing the Seller after the insurance company makes a payment to the Buyer for a breach). This variation is often used to reduce a Seller’s escrow or other exposure to representation and warranty claims, while still providing a source of recovery for the Buyer in the case of breach.

A key point in negotiating R&W Insurance is the amount of the limits and retentions. Limits are often set at 10% of enterprise value, with retentions typically 1% of enterprise value. Premiums generally range from 2% – 4% of limits, with one estimate placing the average premium at less than 3% of limits. The responsibility for the amount within the insurance policy’s retention is often split between the Buyer and the Seller, in the form of a deductible in the transaction agreement, but an increasing number of transactions have provided that the Buyer bear the entire retention amount, with recent estimates suggesting that between one-quarter and one-third of R&W Insurance transactions in 2018 included no seller indemnity.

There are several ways R&W Insurance can benefit a Buyer. In an auction situation, it can make a bid more attractive by reducing the Seller escrow, while still providing the Buyer with protection. The Buyer can purchase insurance to cover higher amounts than the cap the Seller is willing to accept, and with longer survival periods (generally three years for general representations and six years for fundamental and tax representations, although some policies are sold with a six-year policy period for all breaches). R&W Insurance can also provide a mechanism for recovery when pursuing the Seller or Sellers is expected to be difficult (for example, if there are numerous Sellers, or if the Seller is located in a foreign jurisdiction, may be insolvent, or has stayed on in the target’s management).

Buyers should be aware, however, that R&W Insurance does not provide as broad coverage as a Seller escrow of the same size, and so is not a perfect replacement. R&W Insurance does not cover breaches known to the policyholder (which must be disclosed), so if the Buyer, for example, has particular concerns about the way the Seller has been handling a tax issue, R&W Insurance coupled with a tax representation is not the solution. In addition, there are certain standard exclusions (including for forward-looking statements, working capital adjustments, asbestos or PCBs, and underfunded pension liability), and the insurance company will perform a detailed underwriting and may add deal-specific exclusions directed at high-risk areas for the target or its industry.

Indemnification from an escrow, by contrast, is not limited to breaches of representations and warranties, but can also include breaches of covenants and special indemnities; these would not be covered under an R&W Insurance policy. Thus, to the extent R&W Insurance is used to replace part of the Seller’s escrow, the recovery available to the Buyer will not be as broad. The insurance also involves payment of a premium and an upfront underwriting fee, and will have a retention that leaves some of the risk on the Buyer.

R&W Insurance is typically used to reduce or eliminate the need for an escrow from the Seller, allowing more of the proceeds to be distributed right away. It can provide a cleaner exit for the Seller, with fewer contingent liabilities. It may also be purchased to protect a passive or minority investor that was not in direct control.

The underwriting process to purchase R&W Insurance can be as short as seven days, though the initial phase of the effort can start much earlier. The first stage of the process involves working with an insurance broker to provide basic information and drafts of the transaction documents to one or more insurance companies. The insurance companies then provide non-binding indications of the coverage they would be willing to provide, with premium estimates. If the parties proceed, there is a non-refundable underwriting fee (usually between $25,000 and $60,000) for the insurance company to proceed with its diligence. After it has performed its diligence, the insurance company will provide a draft insurance policy, and this is often followed by some negotiation over the coverage.

A key issue for counsel representing that policyholder is coordinating the retentions, definitions of loss, and subrogation clauses in the R&W Insurance to match the purchase agreement, and the parties’ intent as to the risk borne by each party in different situations. Counsel also can assist in pushing back to seek to limit or eliminate the deal-specific exclusions the insurance company proposes after the diligence process. Counsel may be able to provide additional information enabling the insurance company to become comfortable enough with a particular issue to remove a proposed exclusion. Failing that, counsel should negotiate the precise language of each exclusion, so that its reach is no broader than the specific issue that was identified during diligence. Other features of the policy may be subject to negotiations, as well, and experienced counsel likely already has a set of negotiated enhancements to most insurance companies’ basic standard R&W Insurance forms that they have developed in previous deals.

R&W Insurance is not the only insurance relevant to M&A transactions. Certain types of transactions may benefit from other types of insurance, including environmental impairment liability policies, political risk policies, and policies that cover the failure to qualify for expected tax or regulatory treatment. In addition, an M&A transaction may affect the target’s existing or historic insurance program in various ways. An overview of other insurance issues in corporate transactions can be found here.