What’s Behind the Rise in Reps & Warranties Insurance?

Representations and warranties insurance (RWI) has seen a huge jump in popularity over the past few years. Matt Unterlack is the Executive Director of SRS Acquiom’s Indemnifications Solutions business, where he heads up their transactional insurance brokerage business. We talked to Matt about why reps and warranties insurance is so popular right now, what kind of deals it is most often used in, and how he foresees a possible economic downturn affecting the insurance product’s use in M&A deals.

MMR: Can you give us an overview of reps and warranties insurance?

Matt: Reps and warranties insurance is basically an insurance tool that M&A parties can use to protect against losses that result from certain inaccurate statements made by the sellers in the purchase agreement. So the insurance helps the parties shift certain post-closing risks to the insurer. It’s a very flexible insurance product that can be used by buyers or sellers, and can be combined with other indemnification tools such as escrows to serve as the insurance deductible.

MMR: You’ve worked with reps and warranties insurance for a while, including as an in-house lawyer, an insurance underwriter, and now as an insurance broker. What have you seen over the years in terms of the rising popularity of RWI?

About twenty years ago when the product was relatively new in the U.S., I was at a law firm explaining the insurance. A few sentences in, one of the corporate M&A partners stood up and literally walked to the back of the room and said, “I don’t know why I’m here. I would never use this.” He just got up and walked out.

Today, it’s not uncommon for me to receive phone calls from law firms, PE firms, and strategic acquirers saying,  “Can you come in and tell us about that reps and warranties insurance stuff?” They may have heard of it or been involved in a deal that used it, but they really want to understand how to use it strategically. Or they know their competitors are using it, and they don’t want to lose out on a bid to a competitor who knew how to structure the deal with insurance.

MMR: What accounts for the rise in popularity?

The very busy and competitive M&A market over the last few years has certainly contributed. At the same time more insurance companies have entered the space and insurance companies have become pretty capable at hiring M&A professionals into underwriter roles. The people underwriting this insurance coverage and drafting these insurance policies really understand what an M&A deal looks like, what due diligence looks like, what a purchase agreement should look like.

Also, in a seller’s market, sellers are able to say, “I think insurance can play a part in this transaction so that we can transfer part of our exposure to the insurance company.” When you pair the insurance with an escrow, the buyer is happy that it has the right level of protection, some from escrow and some from insurance. The sellers are happy that they get more of their purchase proceeds up front and that they’ve shifted some of their risk to the insurance company. And the insurance company is happy that both parties are still taking risk in the deal, which helps prove to the insurance company that the deal parties have skin in the game.

MMR: What sizes deals do you most typically see RWI used for?

It’s very popular for deals ranging from around $40 or $50 million in size, up to even several billion in size — with the sweet spot being more that $50 million to several hundred million range.

But as more parties are becoming familiar with the insurance and have used it, that starts to expand the uses of the insurance. So we’re starting to see the insurance now able to be used for much larger transactions then it used to be available for, because you can stack certain companies’ insurance coverage amounts on top of each other to create a larger amount of insurance available for any one transaction.

MMR: Do you see it in smaller deals as well?

We are seeing the insurance become available for smaller transactions. Again, as more insurance companies enter the space, the availability of the coverage has expanded a bit.

The $50 million deal size has often been thought of or discussed in the industry as a rule of thumb minimum deal size for where the insurance is going to be used. But the context behind that is that when you get to a certain deal size, you tend to have well-respected advisors on the deal: law firms, bankers, accounting firms, etc. You tend to see audited financials, and you tend to see the parties and their advisors doing a respectable level of diligence. The underwriters take a lot of comfort in all of those factors.

For a long time deal size was sort of a proxy for whether or not that level of diligence was happening. I think it’s fair to say that there are lots of deals of varying sizes — $20 million deals, $30 million deals, $40-$50 million dollar deals, whether they’re in the biotech, life sciences, tech, manufacturing, or retail space — that get very good advisors doing very good standard diligence and drafting and negotiating.

The other factor is that a lot of insurance companies have a minimum premium level for any reps and warranties insurance policy they write. The premium in this space is paid one time upfront, usually at the signing or closing of the M&A deal. Fifty million dollar deal sizes often result in a coverage amount that allows for that minimum premium amount. But, with more insurance companies in the space, some of the insurance companies are willing to look at deals below $50 million, either because the deal will still warrant enough insurance coverage to allow for the minimum premium, or because the deal itself is solid enough that the insurance companies don’t want to turn down the business, merely over size.

MMR: Everyone’s talking about when the economy is going to turn. How will that impact the use of RWI?

Like any other part of the M&A world, it might ebb and flow to some level. But I think there’s enough awareness and comfort with the insurance product, and enough familiarity among a broad spectrum of M&A principals and lawyers that even in a different market, that insurance still has a place and use.

One thing to consider is that reps and warranties insurance can be sold to either the buyer or the seller. It’s more common, especially in the U.S., for the insurance to be sold to the buyer. With buy-side RWI, the insurance policy is written and sold to the buyer, and the buyer is the insured party. And the buyer is protected in case it suffers losses that result from breaches of the seller’s reps and warranties in the purchase agreement. With sell-side insurance, the insured party is the seller. The underlying risk is the same thing. Were the seller’s statements in the purchase agreement inaccurate?

The idea that the insurance can be sold to either party is important. In a seller’s market, it’s more common for the sellers to say, “We’ll leave a moderate escrow on the table to serve as the insurance deductible, but we want the buyers to get the rest of their protection from the insurance policy.” If the market shifts and buyers have more leverage to say, “Listen, it’s not as competitive an environment and we don’t want the insurance or we don’t want as much of the insurance,” then sellers might have an incentive to start purchasing sell-side insurance to protect against the risk that the buyer may pursue the sellers under the purchase agreement.