P&C the April 2018 issue

When a Deal Goes South

You’ve done the deal and find all is not as it seemed. How could you have avoided this?
By James Grayer Posted on March 27, 2018

Reps and warranties insurance can help make a deal happen. It is used often to bridge the gap between a buyer and a seller for handling monetary obligations after closing. For anyone involved in negotiating a sales transaction, often the hardest issues to negotiate are those related to post-closing obligations and identifying breaches of the representations and warranties outlined in the transaction document. This includes whether money is going to be tied up, either through a holdback or escrow, to ensure funds are available to pay any future claim.

This specialty product covers the accuracy of representations and warranties made by a seller, subject to retentions, limits and exclusions. Policies are typically purchased by the buyer, but sellers buy them as well. Buyer policies tend to provide more coverage since they cover undisclosed issues at the time of the sale. Since sellers obviously know more about their own business, seller polices tend to cover less.

In a brokerage sale, there is typically one dominant document (the transaction document). Within document, the brokerage to be acquired makes certain statements that include such things as any current or pending litigation. It also attests that financial statements are in accordance with GAAP and the business complies with various legal requirements.

The seller may also agree to reimburse the buyer if the buyer is required to pay a tax liability the business acquired prior to the sale that is assessed after the deal is closed. The scope of these representations and warranties is negotiated. Then, the seller creates a set of disclosures, which set out issues that would otherwise violate reps or warranties if not disclosed to the buyer.

How does all of this come about? The reps and warranties insurance process begins with a broker’s request for a quote, which outlines the coverage needed. An underwriter provides a non-binding indication letter setting liability limits, retention, premium and areas excluded from coverage. It also outlines areas of significant concern, which are likely to be excluded, absent some due diligence.

Exclusions are based on known issues or issues that were not adequately investigated in the due diligence process. For example, there may be an exclusion for data security if the insured owns data centers. This is especially relevant if certain types of third-party testing were not done on the IT systems.

The client and its advisors will be heavily involved in the reps and warranties underwriting process, both in assisting the underwriter in understanding and getting comfortable with the risk and in the policy negotiation. As the broker, you will be in the middle of this process. In most cases, all communication flows through you from submission to final policy negotiations.

Unlike more traditional insurance products, the underwriting of reps and warranties insurance leverages the buyer’s due diligence. These are not cookie-cutter policies where the contours are essentially known at the outset. Legal counsel negotiates the text of the policy, including the exclusions, so no two policies are alike.

Reps and warranties insurance helps by limiting or—more and more—eliminating the need for funds to be held back or escrowed. And subject to the retention amount and the exclusions, it allows the seller to leave the transaction knowing that, for the cost of the premium, the remainder of the sale proceeds (those in excess of the retention) are not subject to clawback by the buyer in the event of a claim (other than fraud, which typically is not covered).

We are seeing more instances where reps and warranties insurance entirely replaces—absent fraud—a seller’s indemnity obligations. While “no
seller indemnity” deals have always been commonplace in public company transactions, reps and warranties underwriters are seeing more of these in private company deals, which creates a dramatic benefit for your clients.

As either the broker or insured, it’s key to be prepared. Make sure all due diligence is completed and communicate that to your underwriter.

James Grayer is EVP for underwriting at Concord Specialty Risk. james.grayer@concordspecialtyrisk.com

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