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Transactional risk insurance purchases for merger and acquisition agreements have taken off in the past five years as deal activity has accelerated and corporate investors and private equity firms have become increasingly comfortable with how the coverage works.
Soft pricing is driving some of the rising interest in representations and warranties insurance, but claims frequency and severity have been increasing as well, experts say.
Ten years ago, reps and warranties insurance was used as “a last-ditch effort to pull together a deal where the parties were at odds and an insurance product was available,” said Aaron Zeid, area vice president for Gallagher Specialty Products at Arthur J. Gallagher & Co. based in Chicago.
“Now, it’s become part of the M&A toolbox,” he said.
As insurers have become more experienced in writing the coverage and handling claims, prices have declined, said Mary Duffy, London-based global head of M&A insurance for American International Group Inc.
“The rates came down significantly — that was the single most influential factor in it taking off,” said Ms. Duffy.
Private equity and strategic investors took up transactional risk insurance at a record level in 2018, as the number of insured transactions outpaced global M&A activity, according to a report released by Marsh LLC in July.
The brokerage placed 35% more transactional risk insurance limits globally in 2018 than the previous year, and the number of insured deals was up 31%, while average deal size increased to $262.2 million from $224.8 million in 2017.
The value of global M&A activity increased 11.5% to almost $3.5 trillion in 2018, marking the fifth consecutive year with deal volumes in excess of $3 trillion and the largest value since 2015, Marsh said.
One in three M&A deals is covered by reps and warranties insurance, but the number is higher in the “sweet spot” of middle-market private deals between $50 million and $750 million, said Phil Norton, Chicago-based national managing director for the management liability practice at Gallagher.
“One of the reasons why R&W insurance is so popular is because the sellers want a true exit. They might have shareholders who want to be paid off quickly, and they don’t want to wait to see if an escrow clears or whether an indemnity agreement is going to be invoked,” Mr. Norton said.
Investors were hesitant a few years ago to use the coverage because they weren’t sure it would work, said Toria Lessman, Chicago-based senior vice president and head of transactional liability at QBE North America, a unit of QBE Insurance Group Ltd. in Sydney.
“What they’ve seen is that insurers are paying claims. The product is helping people with acquisitions, especially if they have relationships that are going to continue post-closing. In the event there’s an issue on a deal, you’d rather go to the insurer to work through the issues,” Ms. Lessman said.
Reps and warranties cover stands behind the representations made by sellers and the due diligence of buyers, enabling them to move forward “with more confidence,” said Ms. Duffy.
The private equity community is using the insurance in around 75% of their transactions, said Gary Blitz, New York-based co-CEO of Aon PLC’s M&A and transaction solutions business in the U.S.
In the past few years, there has also been “significant acceptance by the strategic buyer, and that continues to increase,” with 20% to 25% of corporate transactions insured, Mr. Blitz said.
One of the reasons why corporations are buying it is “they realized they were not competitive, because a competing buyer using insurance was giving the seller a better exit,” he said.
Insurance market capacity for M&A deals has also increased, said Rowan Bamford, London-based president of Liberty Global Transaction Solutions, a unit of U.S. insurer Liberty Mutual Insurance Co.
“Ten years ago, there was not enough insurance capacity in the market to make it viable … Now the largest single M&A policy put in place was north of $1.5 billion of limits, so there’s enough capacity out there to do most deals, whether midsized private equity deals or huge strategic corporate deals,” Mr. Bamford said.
The flood of market capacity is contributing to softening market conditions, but at the same time there has been an increase in claims frequency and severity, Ms. Duffy said.
More transactional risk products are being sold and more private equity firms and conglomerates are using them, so there are going to be more claims, said Seth Gillston, New York-based M&A and private equity practice leader at Chubb Ltd.
“There is nothing in the claims environment that we see to limit our interest in this area,” Mr. Gillston said.
Financial statements, tax, compliance with laws and material contracts are driving most claims notifications, and the proportion of material claims over $10 million have doubled to 15% from 8%, at an average cost of $19 million, according to a May report released by AIG.
Tax breaches accounted for 25% of claims notifications in Europe and a “significant” proportion of claims notices globally, AIG said.
“Many would say tax is the new representations and warranties coverage in the U.S.,” said Jeff Anderson, Atlanta-based director and co-founder of ASQ Underwriting, a managing general underwriter that is part of Alliant Insurance Services Inc.
In terms of insurers with expertise to underwrite it, tax insurance still lags reps and warranties insurance, he said.
But this is changing, and it will be a “vibrant market in the future,” Mr. Anderson said.
Risk managers at companies involved in mergers and acquisitions face challenges in consolidating insurance programs but can also help the transactions run smoothly and spot potential problems, if they are given a seat at the M&A table early, experts say.