Sales of representations and warranties insurance have been surging globally as more midsize businesses and investors discover its effectiveness in facilitating a clean exit for sellers and reducing post-closing liabilities for buyers involved in mergers and acquisitions.
The total policy limits for this and other forms of transactional risk insurance products purchased by clients of broker Marsh Inc. increased 41% over 2011 to $4 billion in 2012. The biggest increase in policy limits for transactional risk insurance was in North America, where it grew 86% during 2012, Marsh reported.
Marsh also reported that the vast majority — 60% — of transactional risk insurance policies placed worldwide last year were for corporate sellers or buyers, which are typically more cautious on the amount of warranty protection they require in a transaction than their private-equity counterparts.
“We have seen a pretty rapid increase in the use of that product in the past couple of years,” said Jay Rittberg, vice president for mergers and acquisitions insurance at New York-based American International Group Inc. “Reps and warranty represents the majority of our (transactional risk insurance) business,” he said. “There's more widespread acceptance of the product in the M&A world now. We've basically doubled the number of policies that we've written.”
The “sweet spot” for representations and warranties insurance purchases “is transactions that have purchase prices between $15 million and $1.5 billion,” said Craig Schioppo, Marsh's New York-based transactional risk practice leader. While “sellers purchase the policies when they're on the hook for a significant indemnity post-closing,” he said, “buyers are using it strategically in competitive scenarios so they can ask for lower indemnities from the seller to make their bids look more attractive.”
For example, “if we were each bidding $100 million on a company and asking for a $20 million indemnity, you might ask for $20 million while I could ask for just a $2 million indemnity and purchase $18 million in reps and warranties insurance, making my bid more attractive to the seller,” Mr. Schioppo said.
“Buyers also use it when there's friction in the sales agreement. It's a way to bridge the gap between buyers and sellers who can't agree” on the amount of indemnity needed to close a transaction, he said.
Jeremy S. Liss, a partner at law firm Kirkland & Ellis L.L.P. in Chicago, began recommending representations and warranties insurance to clients involved in M&A activity about three years ago after discovering that terms and pricing for the coverage have improved significantly.
“We looked at this a long time ago, maybe 12 years ago. The carriers were too reluctant to underwrite it, and no one had any experience. Then about three years ago, we took another look. There was more of a marketplace,” he said.
Today, at least half a dozen insurers write representations and warranties insurance policies, providing up to $300 million in capacity, Mr. Schioppo estimated.
Premiums for the coverage also have dropped precipitously from maybe 6 to 8 cents for each dollar of coverage 10 years ago to as little as 2 to 31/2 cents per dollar today, sources said.
“Today, you would pay between $200,000 and $400,000 for $10 million in coverage,” said Alex Jezerski, president of RT ProExec, a Bloomfield, Conn.-based insurance wholesaler, who said his firm has been receiving “between five and eight calls a week from brokers asking questions” about the coverage. He compared the nascent interest in the product to “what employment practices liability insurance was like in the early "90s.”
“If you think about how long you'd have to tie up that amount of money in escrow and the limited return on investment you'd get because you'd have to invest it conservatively,” representations and warranties insurance makes an attractive alternative, said Mr. Jezerski.
In some cases, “representations and warranties insurance can get a potentially stuck transaction unstuck,” he said. “We're seeing the most interest in buyer-side policies, which protects the buyer from breaches made by the seller. Say the seller doesn't want to agree to the amount of escrow requested by the buyer, or the length of the survival period. In a competitive bid situation, the seller could potentially walk away with more cash if the buyer gets a policy to reduce the amount of money placed in escrow.”
Peter Rosen, a partner at Latham & Watkins L.L.P. in Los Angeles, said “a fair amount” of his firm's corporate and finance clients “have found that transactional risk policies can be very beneficial in minimizing their risk, whether as a seller or a buyer. Let's say you're a private equity firm and you've made some representations and warranties and want to backstop them with a policy so that if there is a claim, you don't have to deal with it anymore from a financial standpoint. You've now passed the downside risk onto the carrier, and you can essentially close your books on that transaction.”
Alternatively, “say you're a family-owned company that's selling because the family owners are fighting with each other. They deposit funds into escrow, but they may not be enough to satisfy the various representations and warranties, and the buyer doesn't want to chase the family members,” Mr. Rosen said.