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Representation and warranty insurance
(“RWI“) is a risk allocation tool
intended to protect the insured against losses arising from
unanticipated and unknown breaches of the seller’s
representations and warranties
(“R&Ws“) in a purchase and sale
agreement.

In essence, RWI is available to help protect both buyers and
sellers from losses suffered from inaccurate R&Ws, by shifting
the indemnity risk to the insurer. While most RWI policies are
issued for buyers (buyer-side policy), RWI policies can be obtained
for the seller (seller-side policy).

A buyer-side policy is a first party policy, the purpose of
which is to ultimately have the insurer indemnify the buyer for the
seller’s breach of R&Ws in the purchase and sale agreement.
A seller-side policy is a third party policy, where the buyer would
first need to pursue an indemnity claim against the seller under
the purchase and sale agreement in order to trigger a claim by the
seller for indemnification by the insurer under the RWI policy.

Reasons for Obtaining the RWI Policy

From a buyer’s perspective, RWI may be beneficial in a
variety of situations, including where:

  • the buyer is unable to obtain from
    the seller its desired level of indemnification or a sufficient
    duration for the survival period for indemnification;

  • the buyer has concerns over its
    ability to collect from the seller, whether it be as a result of
    transacting with a financially-distressed seller, a seller in an
    unfamiliar jurisdiction or multiple sellers located in multiple
    jurisdictions;

  • the buyer desires to provide
    protection over key relationships, for example, if the buyer values
    its pre-existing commercial relationship with the seller and wants
    to avoid having protracted negotiations with the seller regarding
    appropriate levels of indemnification and/or having to sue the
    seller in the event of a breach; and

  • the negotiation of R&Ws,
    indemnities and survival periods between the buyer and the seller
    have come to an impasse.

Additionally, a seller may find value in obtaining a RWI policy
in the following situations:

  • the seller desires to reduce its
    exposure to contingent liabilities associated with the sale;

  • the seller desires to either reduce
    or eliminate the seller’s customary indemnity for breach of
    R&Ws;

  • the seller desires to have a clean
    break from the sale with a resulting ability to distribute the sale
    proceeds earlier, whether it be by reducing the amount or the
    duration of the purchase price holdback;

  • for strategic considerations; for
    example, in an auction process, the seller may look to RWI to offer
    an indemnity or survival periods greater than the seller would
    otherwise be willing or able to provide to potential buyers on its
    own; and

  • to protect passive investors and
    shareholders.

Scope and Coverage and Duration

The scope of coverage provided for in a RWI policy is typically
customized to each transaction. It can be used as a replacement
for, or supplement to, the indemnity provisions in the purchase and
sale agreement. Coverage is available for both fundamental and
non-fundamental R&Ws, as well as for specific R&Ws when
appropriate.

For a seller-side policy, the term of coverage for the RWI
policy generally corresponds to the indemnity survival period in
the purchase and sale agreement. On the other hand, a buyer-side
policy can provide coverage in excess of the indemnity survival
period in the purchase and sale agreement, by protecting the buyer
against breaches of R&Ws that become apparent only after the
survival period in the purchase and sale agreement has expired.

Exclusions from the RWI Policy

As with any type of insurance product, the RWI policy will
contain exclusions from coverage. While the extent of the
exclusions will ultimately depend upon the insurer’s due
diligence on the underlying transaction and the negotiation of the
particular policy, some of the standard exclusions under a RWI
policy include:

  • actual knowledge of a breach;

  • projections or forward-looking
    statements;

  • adjustments to the purchase price
    pertaining to working capital;

  • fines and penalties;

  • liabilities related to pension funds;
    and

  • breaches that occur during the
    interim period between signing and closing of the purchase and sale
    agreement.

In addition, fraud will be excluded from coverage on a
seller-side policy (however, a buyer-side policy can include
coverage for seller fraud).

Costs to Obtain the RWI Policy

The costs generally associated with obtaining a RWI policy are
the underwriting fee, the premium and the retention amount;
although there may be additional costs, such as premium taxes and
an insurance broker fee, that are applicable to obtaining the
policy.

The underwriting fee charged by the insurer will typically fall
in the range of $30,000 to $50,000. The underwriting fee covers the
costs of the insurer and its outside counsel engaged to review the
due diligence process conducted by the parties to the transaction
and/or conduct further due diligence.

The premium charged by insurers for issuing the RWI policy is
typically a one-time fee that is paid up-front (at the time the
policy is issued) and generally falls between 2% to 4% of the
coverage limit, although it has been suggested that premiums for
RWI policies have been decreasing in recent years on account of
increased competition in the RWI underwriting market. To provide a
simple example, if the transaction value was $50 million with an
indemnity cap of $10 million, the premium on a RWI policy (with
coverage for $10 million) would be expected to fall in the range of
$200,000 to $400,000. The premium can be paid be either party,
regardless of whether the policy is a buyer-side policy or a
seller-side policy.

The cost of the RWI policy will also include a retention amount,
which functions like a deductible in that a specific amount of
losses must be incurred before the insurer’s obligation to
payout insurance proceeds is triggered. The retention amount is
typically a minimum of 1% of the transaction value, often landing
somewhere between 1% to 3% of the transaction value. For example,
in a purchase and sale agreement with a transaction value of $50
million, the retention amount would be expected to be between
$500,000-$1,500,000. However, depending on the policy, some
insurers are now offering a drop-down feature on the retention
amount, which effectively cuts the retention amount in half at the
12-month anniversary of the closing date of the transaction.

It should also be noted that most insurers will charge a minimum
premium between $100,000-$150,000, regardless of the coverage
limit. As a result, the use of RWI is generally viewed as less
suitable for transactions that carry an indemnity cap of less than
$3 million. That said, the attractiveness of RWI to buyers and
sellers in transactions that involve indemnity exposure below $3
million will remain, in part, dependent on the transaction value
and, by extension, the retention amount.

Recent Market Data regarding RWI Policies

While RWI products have been around since the 1990s, the use of
RWI in Canadian M&A transactions has started to gain traction
within the last decade. In terms of more current growth, Marsh JLT
Specialty recently issued its
2019 global M&A year-in-review
study (the
Marsh Report“), which provides that the
number of transactional risk insurance policies placed by Marsh in
North America in 2019 represented a 28% increase over 2018. The
increased demand for RWI policies has, in part, led to increased
market competition among RWI underwriters, resulting in more
favourable terms to insureds. By way of example, the Marsh Report
suggests that the market competition has resulted in a favourable
premium rate environment for insureds, with premiums in 2019
declining by 11% from 2018, and down 34% from 2015.

Additionally, a recent RWI
claim study
issued by AON (the “AON
Study
“) analyzed in excess of 2,450 RWI policies
placed by AON in North America between 2013 and 2019. The AON Study
notes a steady increase in claims made on RWI policies
year-over-year, resulting in an aggregate increase of more than
400% in total claims made on RWI policies in 2018 versus 2014. This
dramatic rise in claims is largely attributed to the increase in
the number of RWI policies issued during the same time period.

As RWI becomes more widely available and affordable, it is
becoming increasingly prudent for buyers and sellers to consider
using it to help facilitate transactions in the appropriate
circumstances.

Note: This article is of a general nature only and is not
exhaustive of all possible legal rights or remedies. In addition,
laws may change over time and should be interpreted only in the
context of particular circumstances such that these materials are
not intended to be relied upon or taken as legal advice or opinion.
Readers should consult a legal professional for specific advice in
any particular situation.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



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