What Is Representations And Warranties Insurance?

Representations and warranties insurance enhances the mergers and acquisitions process and increases the chances a deal will go through. 

As a breach of contract coverage, representations and warranties insurance is used in M&A transactions or public offerings via a special purpose acquisition company (SPAC). 

In exchange for a one-time premium, representations and warranties insurance transfers indemnification risk – away from the parties involved – to an insurance company, thereby reducing friction between the buyer and seller in the negotiation.

What Are Representations And Warranties?

Acquiring a company requires relying on certain statements (aka representations) made by the seller about the financial and operating condition of their business, as well as its market value.

The terms “representation” and “warranty” are often used together in practice… But what do these terms mean?

"A representation is an assertion as to a fact being true on the date the representation is made. It is given to induce another party to enter into a contract or take some other action.

If a representation is not true it is “inaccurate.”

"A warranty is a promise of indemnity if the assertion is false."

If a warranty is not true, it is “breached.” 

Representations and warranties have different meanings and different remedies under law. 

However, in the context of an acquisition, the consequences of an inaccurate representation or breach of warranty are provided for contractually in the purchase agreement.1

Representations and warranties insurance de-risks representations made by the seller of a company and may be preferable to a buyer holding back a portion of the purchase price in escrow…

representations and warranties insurance

Increased Use Of Representations And Warranties Insurance In M&A

Representations and warranties insurance is common in mergers and acquisitions over $50 million in value.

As low-cost debt and abundant capital has increased deal flow in the U.S.2 for private equity firms and businesses looking to grow through acquisition, R&W insurance helps buyers be more competitive in the market.

Buyers know a merger or acquisition may fail to perform as forecast if unexpected issues arise after a deal closes.

Post-close M&A issues may include, but not be limited to, unknown product liabilities, customers disappearing, intellectual property claims, human capital losses, employment contract issues, tax liabilities, etc.

What Does Representations And Warranties Insurance Cost?

Representations and warranties insurance cost includes two fees for underwriting and premium in policy binding, respectively.

Phase 1: Underwriting

An underwriting fee is paid by the client because of the amount of work that is required by both insurance and legal counsel to review M&A documentation, representations and warranties, up front… If coverage is purchased, fees may be waived.

What does representations and warranties insurance cost

Phase 2: Premium 

Representations and warranty insurance premiums start at around $150,000.

This is a minimum premium.

The premium for representations and warranty insurance is a percentage of the limit of coverage, usually 3-4%.

For example, if a M&A transaction is $100 million, the R&W insurance limit may be 10% – or $10 million. Therefore, the R&W insurance premium cost is 3-4% of the limit or $300,000-$400,000 for a $10,000,000 limit on a $100,000,000 transaction.

The amount of coverage is a percentage of the deal size, which varies based on the nature of the transaction.

R&W Insurance

Benefits Of Reps & Warranties Insurance

Representations and warranties insurance shifts liability for unintentional and unknown breaches of representations and warranties to an insurance company for a fixed cost.

Benefits of R&W insurance include:

  • Enhance or remove escrow requirement
  • Reduce friction/speed up transactions
  • Eliminate friction with new management team
  • 3rd party assistance in deal underwriting
  • Advantage for buyers in competitive M&A environment

As described below, a representations and warranties insurance policy may be “buy side” or “sell side”.  

This coverage may also include “general indemnities” beyond representations and warranties.

Buy Side vs. Sell Side Examples

Buy side R&W policies are more common than sell side policies… 

This is because of the perceived asymmetrical nature of risk in an M&A transaction (eg. the seller is more informed about the business than the buyer).

Buy side policies may be more expensive than sell side policies for this reason… 

A buyer in a M&A transaction is protected against unintentional breaches of the representations and warranties of the seller.

Buy Side R&W Example:

Company A agrees to purchase company B. Company B fails to disclose that the relationship between Company B and its largest client has been deteriorating for months for various reasons and that the large client indicated they were planning on canceling their contract with Company B. 

After the closing, Company B loses its largest client causing sales, and the company valuation, to fall precipitously.

Company A believes it overpaid for Company B. Company A files a R&W claim because Company B misrepresented the state of the relationship with its biggest client.

Sell Side R&W Example:

Mr. Big PE Fund is a real estate private equity firm disposing of commercial investment assets.

Mr. Big PE Fund receives a legitimate offer for a $250,000,000 Class A office building in downtown Manhattan.

The asset is located on a site that was once classified as a brownfield.3

The managing member and limited partners (LPs) want to accept the offer.

Mr. Big PE Fund buys a representations and warranties policy to cover the gap between the expectation of narrow indemnities by Mr. Big PE Fund’s LPs, and the expectation of broad indemnities desired by the buyer of the former brownfield site.

The sell side R&W insurance policy closes the gap between the narrow and wide indemnification, helping the deal go through at a profit.

R&W Insurance Summary

Representations and warranties insurance is an alternative – or backstop to – an escrow requirement that can improve the deal terms for a buyer and seller.

R&W insurance is one type of corporate management liability insurance that can help in mergers and acquisitions.

Deals of a certain size (typically greater than $25 million) are excellent candidates for representations and warranties insurance.4

One size does not fit all and reps and warranties coverage may be designed for either the “buy side” or the “sell side” of a deal. 

Your insurance broker should consider the representations and warranties policy and its relationship to any other insurance policies your business has in place.

Footnotes

  1. According to Thomson Reuters' Practical Law.
  2. A total of 18,433 M&A deals worth $3.15 trillion happened in 2017, according to MergermarketThe average size of an M&A deal in the U.S. is $352.9 million... M&A activity is strong across the U.S., representing just under half of global mergers and acquisitions transaction volume.
  3. A piece of real property that may be complicated by the presence or possible presence of a hazardous substance, pollutant, or contaminant. Former brownfields have undergone remediation according to EPA regulations.
  4. There is no exact standard... However, deals greater than $25 million in value are typical. According to a report by Practical Law, the majority (over 60%) of representations and warranties policies were placed for private transactions in excess of $100 million in deal size.
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