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Feb 27, 2020

Representation and warranty insurance: How it works - Part 2

Wednesday, February 26, 2020 | The Lawyer's Daily 

In M&A transactions, representation and warranty insurance (RWI) is an insurance policy designed to respond to and protect against losses suffered by an insured party as a result of a breach of a representation and warranty.

The prevalence of RWI in private M&A transactions has been increasing over the years, particularly in transactions involving private equity firms. Here’s part two of our primer on RWI.

Why is RWI expanding?

RWI is not new, but its use in Canadian private M&A has been steadily increasing because parties to these transactions are realizing that RWI allows them to efficiently close deals that may otherwise be bogged down in strenuous negotiations over risk allocation and costly due diligence.

Insurance companies have taken note of this, which has led to faster underwriting and a more competitive marketplace in terms of pricing. In some cases, coverage can be obtained in 10 to 15 days of contacting the insurer. Insurers, however, have seen an increase in the frequency and severity of claims, which may lead to higher rates.

According to the analysis of private transactions in 2018 by Practical Law Canada, 13 per cent of deals surveyed referred to the purchase of RWI. Of note, the premiums for the RWI was to be paid by the buyer in 50 per cent of the deals which referred to RWI.

Whether this arrangement becomes a trend remains to be seen; however, there is evidence both quantitatively and anecdotally that it is becoming more common for buyers to pay the premium.

What is RWI and how is it obtained?

RWI is a policy which may be purchased by either the buyer or seller in a M&A transaction in order to protect from the risk of loss for potential breach of misrepresentations and warranties.

Generally speaking, subject to the requirements and limits of the policy, when a loss is incurred by the insured as a result of a breach of a representation or warranty, the insured can claim against the policy. That is, the seller can utilize its policy to recover the costs of defending the claim; conversely, the buyer can claim against its policy to recover its losses if the holdback funds are insufficient or if there is no holdback at all.

Both buyer-side and seller-side RWI policies are available through a number of large insurance companies. When a quote is sought, the inquiring party will need to sign a confidentiality agreement. Thereafter, the insurer will require a number of items including the name of the parties, the amount of coverage needed, the details of the purchase agreement, access to the parties’ due diligence and the seller’s disclosure schedule.

If the inquiring party wishes to move forward with the RWI policy, the insurer will require an underwriting fee and only after the insurer completes its own due diligence will the terms of the policy be negotiated and fully determined.

Limits of an RWI policy

When investigating a RWI policy, it is important to be aware of the exclusions to coverage. Some of the exclusions will be particular to the given transaction, while others are applicable to RWI policies in general.

It is standard for RWI policies to exclude certain liabilities or breaches that are known to the parties, and other risks discovered during due diligence, from coverage. For example, the policy may not respond to losses that arise as a result of known breaches or existing liabilities such as ongoing litigation.

The policy may also exclude: certain tax liabilities, fines and penalties, adjustments to the purchase price related to working capital and forward-looking representations and warranties (i.e. financial projections). It is important for the insured to thoroughly review the terms of the policy with its advisers in order to fully understand the extent of the coverage.

Transactions for which RWI would be useful

Given its cost, the optimal transaction value for RWI is between $20 million and $1 billion. That being said, policy options are available for transactions of a lower value. Most commonly, the policy limit on a RWI policy is approximately 10 per cent of the transaction value. Generally, the premiums range from two per cent to 10 per cent of the policy limit and the deductible (also known as retention) is calculated as a percentage of the transaction value, typically between one per cent and three per cent.

That is, on a $20 million transaction, the deductible would be between $100,000 and $600,000. Minimum premiums, which are often between $100,000 and $200,000 may also apply and the insurer may require that the premium is paid in total upfront. The costs of preparing the policies would also typically include professional fees incurred by the potential insured in negotiating the policy and gathering the items required by the insurer.

All of these components would make the policy cost prohibitive for smaller transactions.

As well, practically speaking the utility of RWI will depend on the nature of the seller’s business and its structure. For example, where the seller is closely held and owner operated, the selling shareholders may have sufficient knowledge about the business and its liabilities to be comfortable accepting an indemnity knowing the potential exposure is minimal.

This is the second of a two-part series. Read part one: Representation and warranty insurance expanding in Canada.

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