What Is Reps and Warranties Insurance?

The high-stakes world of mergers and acquisitions (M&A) often exposes buyers to risks of undisclosed liabilities and inaccuracies in a seller’s promises. Representations and Warranties Insurance (R&W insurance) serves as a safeguard, transforming potential deal-breakers into peace of mind. This insurance shields the buyer from financial loss if the seller’s assurances prove false, ensuring that the road to corporate expansion is not derailed by costly surprises. This article dissects the anatomy of a typical Reps and Warranties Insurance policy, shedding light on its role in M&A transactions.

What Is Reps and Warranties Insurance?

Representations and Warranties Insurance (R&W insurance) is a type of insurance policy used in mergers and acquisitions (M&A) to protect against financial losses due to breaches of representations and warranties made by the seller. It’s a contract between the buyer (or the seller) and an insurance company, where the insurer agrees to indemnify the buyer for losses resulting from such breaches. 

Representations and warranties in M&A are assurances by the seller about the company’s condition. They confirm the accuracy of information like financials and compliance with laws. If these assurances are false, the buyer may seek compensation for any resulting losses.

How Does Reps and Warranties Insurance Work?

R&W insurance acts as a safeguard in mergers and acquisitions (M&As), protecting the buyer against financial losses if the seller's assurances about the company's state are breached. Here's a more detailed look at how it functions:

During an M&A transaction, the buyer purchases an R&W insurance policy from an insurance company. This policy covers losses up to a specific limit and for a period post-closing, known as the survival period. If the buyer discovers a breach of the seller's representations and warranties after the deal closes, they can file a claim with the insurance company. The insurer then assesses the claim to verify the breach and determine the extent of the financial loss. If the claim is valid, the insurer indemnifies the buyer, compensating them for the loss up to the coverage limit.

Imagine a company, 'TechCorp,' is being sold to 'Allis Wellman LLC.' The seller, TechCorp, represents all its software products free from intellectual property disputes. The buyer, Allis Wellman LLC purchases R&W insurance from an insurance company to protect against potential breaches of these statements. After the acquisition, Allis Wellman LLC discovered that one of TechCorp's main software products is the subject of a patent infringement lawsuit, which was not disclosed during the M&A process. Allis Wellman LLC filed a claim with their R&W insurance provider. After assessment, the insurer agrees that this is a breach of the warranty. The insurer then compensates Allis Wellman LLC for the financial losses incurred, such as legal costs and any settlement or judgment amounts, within the limits of the R&W insurance policy.

Benefits and Drawbacks of R&W Insurance for the Sellers

R&W insurance offers several benefits to ensure smoother and more secure deal closure for sellers:

• Minimizes escrow requirements, freeing up funds for sellers.
• Sellers gain a cleaner exit with fewer contingent liabilities, allowing for a smoother transition.
• Shields passive or minority sellers from the risks of joint and several liabilities.

While R&W insurance has loads of benefits, sellers should beware of a few downsides:

• R&W insurance may lead to exclusions, which could involve complex negotiations and protection gaps.
• Premiums can reduce the seller’s net proceeds from the sale.
• Some buyers unfamiliar with R&W insurance may hesitate, affecting its perceived value.
• Underwriting might not begin until exclusivity (the seller’s commitment to only negotiate with the buyer) is agreed upon, potentially slowing the deal.

Benefits and Drawbacks of R&W Insurance for the Buyers

With R&W insurance, buyers enjoy enhanced deal security and efficiency, among other advantages:

• Buyers can accept lower seller indemnity packages without assuming all the associated risks.
• Makes buyers' bids more attractive in auctions.
• Covers defense costs and potential settlements against breaches.
• Enables buyers to rely on insurance rather than solely on seller indemnities, which fast-tracks deal closure.
• Preserves buyer-seller relationship, especially if the seller remains involved in the business.

Buyers considering R&W insurance should be mindful of its limitations:

• Coverage exclusions can cause protracted negotiations and potentially uncovered risks
• The significant cost implications which may be split or borne by the buyer will affect the deal’s financials
• Possible delays from the underwriting process.
• Post-closing discovery of issues not covered by the policy can expose the buyer to unforeseen liabilities.

How to Get a Reps and Warranties Policy

Typically, buyers purchase most R&W insurance policies — about 93-97%, but either party can initiate the process. 

For Buyers:

• Engage a broker: Find an experienced insurance broker specializing in R&W insurance policies to solicit quotes from insurers.
• Submit information: The broker will gather essential information, including the coverage amount sought, financial records, the draft sale and purchase agreement and any seller's memorandum.
• Receive nonbinding indication of interest: Within a week, underwriters will provide initial indications on premium, retention and any areas of concern after reviewing the documents.
• Underwriting: The selected underwriter performs due diligence, which can take up to two weeks and requires an upfront payment of underwriting or due diligence fee. 
• Negotiate terms: Negotiate the policy terms, such as coverage limits and the survival period.
• Bind the policy: Once all terms are agreed upon, the policy is bound and the policy issued. 

For Sellers:

• Consideration: Decide whether to offer an R&W insurance policy as part of the deal to make it more attractive to potential buyers.
• Prepare documentation: Prepare all relevant documents that accurately represent the state of the business.
• Engage with buyer's broker: Work with the buyer's broker to provide any additional information needed for the underwriting process.
• Review policy terms: Although the buyer typically drives the R&W insurance policy, review the terms to understand the scope of coverage and any potential liabilities.

What Are the Limitations and Exclusions From R&W Insurance?

Representations and Warranties (R&W insurance) Insurance is designed to provide broad coverage in M&A transactions, but like all insurance policies, it has certain limitations and exclusions to manage risks that are not meant to be insured or are too unpredictable. Here’s a clearer look at some common limitations and exclusions:

• Forward-looking statements: Policies generally do not cover warranties based on future or forward-looking statements, such as sales projections.
• Known issues: R&W insurance policies do not cover known or expected issues, including those exposed or identified in the diligence stage or the disclosure schedule. 
• Purchase price adjustments: Disputes over purchase price tweaks after the deal closes are usually excluded.
• Tax credits and losses: Issues related to the availability or usability of net operating losses or R&D tax credits may not be covered.
• Special indemnities: Certain specialized representations, like those related to fines and penalties, may be excluded from coverage.
• Difficult areas of coverage: Some areas are particularly challenging to insure, such as violations of the Foreign Corrupt Practices Act (FCPA), union activity, underfunded pensions and wage and hour violations.

What Does a Typical R&W insurance Insurance Policy Look Like?

A standard Representations and Warranties (R&W insurance) Insurance Policy typically includes:

• Insured party: Specifies the name and address of the insured party, which can be either the buyer or the seller, although it's usually the buyer.
• Coverage details: Outlines the limit of liability, the deductible amount, and the specific representations and warranties from the acquisition agreement that are covered.
• Policy period: Defines the duration of the policy, typically negotiated to last between three to six years.
• Exclusions & conditions: Lists standard exclusions such as covenant breaches, purchase price adjustments and conditions applicable to the policy such as truthful information and premium payment.

How Much Does Reps and Warranties Insurance Cost?

The cost of R&W insurance varies depending on the transaction size, industry, and risks being insured. Typically, the total premium for R&W insurance — which includes the premium, taxes, underwriting fees, and broker compensation — ranges from 3.5% to 4% of the insured amount. Larger transactions often benefit from lower rates due to economies of scale. 

Also, there's usually a deductible (the amount the insured party is responsible for paying out-of-pocket before the insurance policy kicks in), generally 1% to 2% of the transaction value. This deductible may decrease after a certain period post-closing.

Find the Best Reps and Warranties Insurance From Benzinga’s Top Lenders

To find the best options for R&W insurance, Benzinga offers a comprehensive guide that can help you compare top lenders and policies.

Understanding R&W insurance Protection in M&A

Representations and warranty insurance is a powerful tool in M&A transactions, offering financial protection and deal facilitation for buyers and sellers. While it provides coverage against breaches and accelerates deal closure, parties must be aware of its costs, exclusions, and potential underwriting delays. Understanding the intricacies of R&W insurance ensures a more secure and efficient acquisition process.

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