Deal Insurance: Representation & Warranty Insurance in M&A Contracting
Parties to M&A transactions now commonly purchase insurance against breaches of the reps and warranties. In a forthcoming article, I study Representation and Warranty Insurance (“RWI”) in the U.S. market using two empirical methodologies. First, I survey nearly 100 market participants in the market—insurers, brokers, lawyers, and private equity managers. And second, I analyze the terms of over 500 merger agreements, comparing the terms of insured and uninsured deals. The full study is available here. These are the basics of what I found:
The use of RWI has surged dramatically in the U.S. since 2015. It is now extremely common in deals involving private targets, where lawyers estimate that it may now be used in half of all transactions. But it is rare in deals involving public targets, where it is almost never used.
Although RWI policies can be underwritten to cover either the seller or the buyer in the underlying transaction, the overwhelming majority of policies (over 95%) now cover the buyer. These are referred to in the industry as “buy side” policies.
In terms of coverage and cost: a typical RWI policy offers limits of 10-20% of deal value, a deductible of 1% of deal value, and premiums of 2-3% of limits.
RWI policies are designed to cover only risks that are unknown at the time of contracting and to exclude risks that are known by the transacting parties or their representatives.
Insurance frequently replaces the indemnity. Policies are often underwritten to cover deals in which there is no underlying seller indemnity. And when there is an indemnity, it is often linked to the retention amount.
RWI coverage implicitly covers “diminution in value” and “multiplied” damages—that is, damages measured not only by losses caused directly by the breach but also by the effect of the loss on the underlying valuation. For example, a buyer whose valuation was based on a 12X multiple of EBITDA might be entitled to damages of $120 million if the breach of a rep reduced the target’s EBITDA by $10 million.
In spite of the breadth of coverage, claims under RWI policies are neither frequent nor severe. Although underwriters report claims rates in the mid to high teens, my survey respondents emphasized that claims rarely “hit the policy.” Instead, the vast majority of claims are within the retention and are therefore resolved by the transacting parties, not the insurer.
These basic findings raise a number of interesting questions. But perhaps the central mystery of RWI is why parties buy it at all.
Why Buy RWI?
Some explain the proliferation of RWI by reference to the seller’s market in M&A. Sellers do not like bearing the liability risk inherent in indemnification provisions, and they especially hate putting proceeds into escrow to fund claims against the indemnity. So the parties buy RWI to substitute for the escrow account and, often, the seller’s indemnity as well. What’s puzzling about that?
But a seller’s market in M&A does explain the purchase of RWI. The bargaining power of sellers might lead buyers to accept indemnification without an escrow or, in the case of very strong buyers, take-it-or-leave-it deals, without indemnification. For buyers to purchase third-party insurance rather than simply bearing the risk themselves, through self-insurance, they must be getting something else from the policy.
Insurance, obviously, is not free. To stay in business and return profits to their owners, insurers charge premiums in excess of the actuarial probability of loss. As a result, the “something else” the buyer is getting must exceed the cost of the policy. Or, to put it slightly differently, if RWI does not increase aggregate transactional gains by more than its cost, it would be more efficient for one side or the other to bear the risk in exchange for a commensurate adjustment to the deal price. What are the parties getting from RWI to make it more efficient than self-insurance?
Not risk-spreading. Although risk averse parties often buy insurance to spread the risk of loss, RWI cannot be explained in this way because the parties to M&A transactions are essentially risk neutral. The buyer is either a corporation or a private equity fund, each of which has access to loss-spreading technologies that mimic those of insurance companies. Moreover, there is very often a private equity fund on the sell side of the transaction as well. As a result, one or both sides of the deal are risk neutral, meaning that risk aversion and the need to spread losses cannot explain RWI as it exists today.
In order for RWI to be more efficient than self-insurance, there must be an additional benefit to coverage. Candidates from the prior literature on corporate insurance include: loss prevention and loss mitigation advice, claims management expertise, and counterparty insistence. According to the participants I surveyed, however, none of these explanations applies to the purchase of RWI. But there are two other potential explanations: alternative corporate finance and agency costs.
Alternative Corporate Finance. Insurance may substitute for other sources of capital, such as debt or equity financing. But for this explanation to work, RWI must be cheaper than other available forms of finance. In the paper, I compare traditional finance arrangements to the cost of RWI, and RWI seems expensive. It is notable, for example, that RWI emerged during an extremely low interest rate environment. Moreover, if RWI were valuable primarily as an alternative source of finance, it would add value to public deals as well. Yet it RWI is used only in private deals. This suggests that alternative finance is not the explanation. Rather, the explanation must be related to unique characteristics of the private deal market.
Agency Costs of Private Equity. An alternative explanation is that RWI responds to the unique risk structure of private equity. Private equity investors can fully diversify against the risk of loss from portfolio company acquisitions, but private equity managers cannot. As a result, RWI may make sense for private equity managers even if it does not make sense for their investors. This can be seen either as an agency cost of private equity (managers imposing an inefficient cost on investors) or as a potentially efficient feature of PE compensation (investors willingly buying insurance to prevent managers from becoming risk averse).
In addition to the mystery of why transacting parties buy RWI, my paper explores the question of how RWI changes the underlying transaction.
How Does RWI Affect the Underlying M&A Transaction?
RWI would seem to create problems of credible commitment, moral hazard, and adverse selection. To see this, consider:
If sellers are no longer liable for inaccurate or incomplete disclosures, how can buyers have the same degree of trust in the information they receive? Insofar as the imposition of liability, through the reps, is the key to creating credible commitments in M&A, RWI would seem to inhibit efficient contracting.
Equally fundamentally, how can it enhance efficiency to allocate risk to a third-party insurer that plainly has less access to relevant information than the seller? The transacting parties’ superior access to information suggests adverse selection, which threatens the accuracy of risk-pooling and the stability of coverage.
Finally, does not the transfer of risk away from the transacting parties reduce their incentives to exchange information in the deal itself? RWI thus invokes the specter of moral hazard—the tendency of insured parties to reduce precautions—suggesting less careful reps, a less comprehensive diligence process, and greater risk embedded in the deal.
My paper uses survey data and participant issues to address each of these questions, ultimately concluding that RWI may indeed introduce frictions into M&A contracting. In particular, the introduction of RWI suggests greater potential for misinformation in M&A, leading to increased mispricing risk, which might induce buyers to discount or abandon otherwise wealth-enhancing transactions. RWI, in other words, threatens to recreate the very problem that the reps were designed to solve. As a result, I argue that RWI may not survive a downturn in either the deal market or the underwriting cycle.