M&A Insurance, Reps & Warranties, and Due Diligence [PODCAST]

If you are purchasing a business, do you need representations and warranties (R&W) insurance? Well, according to AIG,  more than 20% of M&A transactions result in a claim. Joe Hellman recently sat down with Joe Housman, Vice President of Business Development at Brown and Brown Insurance in Minneapolis for an episode of The Transaction Abstract, to discuss reps and warranties insurance.

As a former CPA with extensive experience in M&A as well as business insurance, Joe knows first-hand how acquisition deals have changed over the years. Listen to this episode to hear his thoughts on the pros and cons of R&W insurance during due diligence and in the event of a claim as well as insurance due diligence considerations leading up to a transaction.

What Is R&W Insurance? 

Due diligence is core to any M&A transaction. The buyer is looking deep into financial and other key business data—history, current status, and performance forecasts, and they are making certain representations and warranties in pursuit of the deal. The seller is also making representations and warranties regarding the completeness and accuracy of the information they are providing.

Nonetheless, details may be misrepresented, overlooked or simply not uncovered for some reason. And the problems may not come to light until after the deal closes.

Buyers assume that liabilities may pop up despite due diligence. In the past, they established an escrow account—typically 10-20% of the deal price—as a hold-back. If no problems cropped up, the cash was released. Joe Housman says that in the last 7-10 years, the more popular option is to purchase representations and warranties insurance.

“It’s a broad policy,” he notes, “covering all the seller’s representations that they are putting forward in the sale. That way, if there is a breach of one of those reps, you are going to be dealing with an insurance company.” All the funds can flow through at closing because the insurance carrier will handle the claim.  

However, an R&W policy may not completely replace the escrow process. For example, a retention or deductible associated with the policy may be placed in escrow instead of the full potential liability. Even so, the amount that flows through at closing will be significantly larger than under the old escrow-only process.

While insurance is prevalent now, there are pros and cons to consider.

Cost vs. Benefits 

Every buyer has to know their own appetite for risk in the diligence process, says Housman. An insurance carrier adds eyes to the process. “I think that helps with the process,” he says, in terms of pressing the seller to provide needed information in a timelier manner.

For buyers, having an insurance company by your side can provide a functional and psychological boost if there is a claim, especially if there are complications such as management rollover involved. Choosing insurance improves liquidity for both the buyer and seller. More money is released at closing, and the buyer can free up funds that would have gone into escrow—-but not all, because there are costs involved.  

Insurance adds another process to one that is already complicated, and that can add delay, says Housman. Furthermore, “you are talking about a lot of dollars when it comes to the premium and underwriting fees.”

Costs Have Risen Dramatically in Recent Years

You might assume that the policy coverage should be the same as the 10-30% used for escrow, but Housman tells us 10-20% is more common. The premium will be around 4-5%. That is double (or more) compared to just a few years ago. A 5% premium on a $10 million policy is $500,000, a significant sum.

On top of the premium, underwriting fees can run $40-$50,000. The reality, says Housman,  a lot less practical to buy R&W insurance on valuations under $25 million because of the additional costs and process associated with it. It all depends on the buyer’s preference and the structure of the deal itself.

The bigger the enterprise value,, the more likely there will be a post-transaction claim. If one arises, there are no guarantees. After all, a claim is litigation. So it might pay out the full policy limit, or it may pay nothing at all, or could eventually settle, but the process could take years to resolve.

On a positive note, Housman says that although 5% premium price was common as of the end of 2021, recent analysis of middle market premiums indicates some softening to around 4% as of Q2 2022. It’s hard to predict whether that will continue, given current economic uncertainties.