Market trends for Representations and Warranties Insurance (RWI) have shifted significantly in the current M&A landscape. RWI costs, terms and processes are more favorable to policyholders today than they were in the past. Insurers are also more willing to offer coverage to transactions in the sub-$20 million marketspace, opening the RWI market to new deals.

This article contains a “Cheat Sheet” of what we have been seeing recently in transactions utilizing RWI, as well as further discussion on RWI and the market generally.

RWI Market Trends Cheat Sheet

Below is a summary of what we are seeing in the RWI market today. Click here to download a copy of the cheat sheet.

What Is Reps and Warranties Insurance? What Does RWI Cover?

Reps and Warranties Insurance is an insurance product covering breaches of representations and warranties, as well as stand-alone indemnification for pre-closing tax issues, in the purchase agreement in an M&A transaction. Rather than the seller indemnifying the buyer for breaches of representations or pre-closing tax issues, instead the RWI policy stands in the shoes of the seller. The insurance policy provides the buyer with indemnification protection for claims related to these items, up to the policy’s coverage limit. Typically, the buyer is the policyholder.

RWI does NOT cover known, material issues uncovered during diligence or issues of which the buyer’s deal team had actual knowledge, breaches of covenants in the purchase agreement (i.e., the requirement to pay off company indebtedness as of closing or the non-compete), purchase price adjustments and forward-looking representations and warranties. In a majority of transactions, the seller remains responsible for claims related to these items, as well as for the portion of a claim for breaches of fundamental representations that is greater than policy limits.

The potential benefits of RWI are it can eliminate most escrows, reduce claims against sellers who are part of management post-closing, and bridge negotiation gaps during letter of intent discussions. RWI is also the standard in middle-market transactions in most industries. But, RWI policies will generally require additional costs (for the policy and for legal counsel) and more precise due diligence compared to non-RWI transactions.

And as with any insurance policy, an RWI policy is only as good as when a claim is actually paid out.

Coverage Amounts

RWI coverage amounts typically range from 10 percent to 20 percent of the transaction’s total enterprise value (TEV) or purchase price.

Riders can be purchased for coverage up to the TEV for additional fees (often 20 percent or so of the premium for around 20 percent higher total coverage amount), which is particularly important for “no indemnity” deals.

Survival Periods

RWI policies will typically offer three years’ worth of coverage for breaches of garden variety reps (i.e., reps regarding financial statements, employment, litigation, etc.) and six years’ coverage for fundamental reps (stock ownership, authorization to enter into the transaction, taxes, no brokers, etc.). Riders can be purchased for longer survival periods for additional premium costs (around 10 percent or the premium).

Recently, we have been seeing insurers offer entire policies that survive for six years, rather than policies where general reps survive for a shorter period than fundamental reps do.

Exclusions

RWI policies exclude coverage for certain issues. Policy coverage exclusions range from standard exclusions across most transactions to deal-specific exclusions. Common exclusions are for liabilities related to:

• Underfunding of defined benefit plans;
• Asbestos or Polychlorinated Biphenyls;
• Arising under the CARES Act;
• Certain net operating losses or transfer taxes;
• Forward-looking representations and warranties;
• Areas of incomplete due diligence review; and
• Industry and deal-specific risks, often based on diligence findings.

Today, insurers are usually offering fewer exclusions than they have in the past. Whereas proposals from insurers have historically included long exclusion lists, in the current market exclusion lists are often shorter and less in-depth than they were 18 months ago.

What Does RWI Cost?

RWI policy costs include the premium, the underwriting fee and state taxes on the policy. In addition, RWI policies contain a retention (similar to a deductible) under which the policyholder is responsible for covered losses up to approximately 1 percent of the TEV. Brokerage fees are usually deducted from the premium rather than added as an additional policy cost. The buyer and the seller can negotiate who bears all of these costs, including the retention.

Premiums, fees and the retention have all generally come down over the last year or so.

Premiums

• Premiums are often lower today than they were in the past, and now typically range from 2.2 percent to 3.5 percent of the coverage amount, or around 0.22 percent to 0.35 percent of the TEV.
• While RWI coverage is now available to transactions between $10 million and $20 million in TEV, there is a minimum floor for premiums of around $100,000 to $150,000.
• No-indemnity deals or deals where there is an indemnity but the seller is not responsible for any of the retention will have higher premiums (up to 20 percent or so).

Retention

• Similar to a deductible in health insurance, the retention under RWI policies is the first dollars of coverage for which the policyholder is responsible. Currently, retention sizes range from approximately 0.5 percent to 1 percent of the TEV, although transactions in a handful of industries may include slightly higher retention amounts.
• The amount of the retention the seller is responsible for as part of negotiations is typically escrowed as a small indemnification escrow.
• The amount of the retention will often “drop down” to half of its original amount once the indemnity escrow is released or after around a year or so following closing.

Other Fees and Taxes

• Underwriter fees are typically a flat $35,000 to $50,000, which the policyholder pays.
• The policyholder is responsible for state taxes on the policy. In New York, for example, there is a four percent state tax on the premium amount. The location of the policyholder determines which state’s taxes apply.
• Broker fees are typically fifteen percent of the premiums, although this is usually deducted from the premiums rather than as an additional cost paid for by the policyholder.
• Note, as well, RWI transactions typically require additional legal fees compared to non-RWI transactions, because of heightened due diligence to enable the insurer’s counsel to be comfortable with the scope of diligence for underwriting. That being said, we are now seeing insurers at times provide less scrutiny to legal due diligence than they have historically, instead relying more on financial and tax diligence.

Buyer and Seller Allocation of RWI Costs

• Although each transaction is different, the most common formulation for allocation of RWI costs is the buyer and the seller split RWI costs evenly, including splitting the retention evenly.
• When the retention is split, it is common for the buyer to bear the first set of indemnifiable claims equal to 50 percent of the retention, similar to a deductible in a non-RWI transaction.
• A minority of deals include the buyer is entirely responsible for the retention, which usually requires premiums that are around 20 percent higher than transactions under which the seller is responsible for a portion of the retention. These include:
  • The buyer is entirely responsible for the retention, but the purchase agreement still features seller indemnification for exclusions under the policy (i.e., known issues, breaches of fundamental reps greater than policy limits, etc.).
  • Alternatively, a true “no-indemnity” or “sole recourse” deal is a transaction under which there is simply no indemnification provided by the seller and the RWI policy is the buyer’s sole recourse for breaches of representations and warranties. This formulation is most often utilized in a hot auction process.

Other Considerations

• Typically, breaches of representations and warranties as well as the pre-closing tax indemnity are covered even in the event the seller acted with fraudulent intent in failing to disclose information. However, in such case (but only in such a case), the insurer may seek to recover amounts paid from the seller. Insurers will require in the purchase agreement that the buyer not limit the insurer’s rights (and the insurer’s related subrogation rights) in the event of seller fraud.
• Consequential and special damages are typically included in RWI coverage, even if the purchase agreement is silent. Damages based on a multiple or claims for diminution in value may be included in an RWI policy, but policies are frequently silent on this.  Instead, the buyer will need to negotiate with the insurer on coverage.
• If the purchase agreement disregards materiality for purposes of determining a breach and calculating a loss, subject to the insurer’s understanding of the seller’s disclosure approach, all insurers will follow a double materiality scrape for purposes of the policy. In a no indemnity transaction, insurers will apply a synthetic double materiality scrape for purposes of the policy.
• Payment of a claim is perhaps the most important factor in choosing an RWI provider. There are many excellent insurers in the marketplace, but it is critical to understand the insurer’s reputation, particularly in relation to paying out claims. The lowest premium is not necessarily the most important factor.

So, Where Are Things Today?

The M&A market has seen a reduction in the number of deals utilizing RWI over the last twelve to eighteen months. As a result, insurers are competing over fewer deals and are offering more attractive terms. Policy costs, coverage and processes are the most favorable to policyholders we have seen.

Please consult with an M&A legal adviser and an insurance broker prior to proceeding with a transaction that may make use of RWI.

Andrew Hubert provided additional key support for this article.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.