In this post, we summarize some of the highlights from AIG’s recently published Mergers and Acquisitions 2018 Claims Report, and include our own observations on the role that Representations and Warranties Insurance (R&W Insurance) is increasingly playing in M&A transactions.
Generally, R&W Insurance provides coverage for breaches of the representations and warranties made by a seller about its business and operations in the purchase agreement relating to a merger or acquisition.
There are two basic kinds of R&W Insurance: buy-side and sell-side. Buy-side policies remain the most popular form of R&W Insurance because under a buy-side R&W Insurance policy, the buyer in an M&A transaction recovers directly from an insurer for losses arising out of certain breaches of the seller’s representations and warranties in the acquisition agreement. By shifting the risk of such losses from the seller to an insurer, the buyer and seller can limit or even eliminate the seller’s liability for certain representation breaches, all without materially diminishing the buyer’s recovery opportunities.
As a result, over the past few years, R&W Insurance has become an increasingly important tool to bridge the gap between buyers and sellers in negotiating often-contentious provisions of a deal involving the scope of indemnities, as well as the security to be provided for such indemnities (usually in the form of an escrow) in M&A transactions. This is particularly true in deals consummated via an auction process where bidders have utilized R&W Insurance to make their bids more competitive or appealing to a seller looking to accelerate the receipt of proceeds from the transaction (which would have likely sat in an escrow for 12-18 months) and otherwise smoothing the path to a “clean” exit.
In the report (the company’s third annual report on R&W Insurance), AIG points out that the claims frequency during 2011-2016 for R&W policies issued by AIG is approximately 19.4%. According to AIG, a ratio of nearly one claim for every five R&W Insurance policies issued suggests that even a thorough due diligence process can fail to uncover material liabilities or obligations that may exist prior to the closing and not properly disclosed to the buyer during such process, or in response to the representations and warranties contained in the acquisition agreement.
The report notes that while there are still obvious incentives for buyers to conduct a thorough due diligence process, increased competition for target companies — along with demands from investors to deploy capital, have caused deal timetables to accelerate. As a result, buyers are often willing — or even required for deal competition reasons — to expedite and streamline the diligence process.
The report further notes that cross-border deals involving multiple jurisdictions are filled with complexity which could also explain the increase of claims for warranty breaches.
Additionally, according to AIG, the largest percentage of claims (approximately 24%) involved transactions with a deal size of over $1 billion, up from 23% the year before. The claims statistics also reflect that claims were up 21% for transactions valued between $500 million and $1 billion, an increase from 18% the prior year.
Some other notable points from the 2018 AIG report:
- For claim settlements in excess of $10 million, the average payout was $19 million for the most recent year, compared to $22 million the prior year. It will be interesting to see if this average payout decline is an aberration or reflects a trend.
- The majority of the material claims tracked by AIG fall in the mid-sized and lowest claims size band. For example, 46% of the claims noticed to AIG resulted in a settlement of $100,000 to $1 million (the lowest claim size band) with an average claim settlement of approximately $330,000. An equal amount of claims (46%) resulted in a settlement range of between $1 million and $10 million (the mid claim size band) with an average settlement of $4 million. On the other hand, only 8% of claims fall in the highest claim size band, which resulted in settlements in excess of $10 million.
- R&W Insurance claims are being submitted in a more timely fashion, with 33% of claims being made within the first six months following policy inception (i.e., at or shortly after the transaction closing date) for the most recent period. This represents an acceleration in quickly-reported claims from 27% a year ago, and may reflect the increased reliance on R&W Insurance due to truncated diligence processes.
- 45% of claims are still being submitted within the first 12 months following the commencement of a multi-year policy period, suggesting that about half of buyers are quickly concluding whether a breach occurred.
The report also provides an overview of the categories of breaches presented to AIG in 2018. On a global basis, the leading breaches reported fall within the following categories: Financial Statements (18%), Tax (16%), Compliance with Laws (15%), Material Contracts (14%) and Employee Related matters (9%). The next five breaches reported include Intellectual Property (7%), Operations related (7%), Litigation (5%), Fundamentals (4%) and Environmental (4%). However, these percentages vary depending on the market. For example, while the report notes that financial statements are the leading source of breach claims on a global basis, tax issues remain the biggest driver of breach claims in Europe, the Middle East and Africa.
In the Asia Pacific region, financial statements and material contracts are the bases for nearly half of all notifications. In the Americas, on the other hand, legal compliance, financial statements and material contracts remain the main drivers of reported incidents. As these are the areas that insurers will pay most attention to in underwriting R&W Insurance, buyers are well advised to focus on these representations (and the underlying diligence) in order to expedite the binding of a R&W Insurance policy for closing.
Some Additional Observations
- R&W Insurance continues to play an increasingly important role in mergers and acquisition transactions, and that importance should continue to increase at least through the end of the current business cycle.
- Sellers remain enthusiastic proponents of R&W Insurance, and buyers have become more comfortable working with R&W Insurance policies and the claims resolution process required under those policies to obtain timely payment from R&W insurers.
- While the availability of R&W Insurance certainly provides the grease to negotiate, investigate and close deals more quickly (a boon for buyers), the downside for insurers is that they may be increasingly shouldering the risk of due diligence short-cuts and faulty deal pricing, as well as the potential incentive for buyers to monetize R&W Insurance post-close to protect their margins on acquisition deals.
- Private equity buyers and their regular outside counsel constitute an outsized percentage of the R&W Insurance-buying marketplace. The good news is that this relatively small group of buyers is accelerating the evolution of R&W policies to provide maximum ease and economic benefit to buyers. On the other hand, R&W insurers that resist coverage-broadening and lower premiums risk being shut out of a substantial segment of R&W buyers if they don’t accede to buyers’ expanding coverage demands, and may lose control over the pricing and breadth of coverage being provided.
- The breach dispute resolution process now largely falls in the lap of R&W insurers, which have limited incentive to take hard coverage positions against repeat buyers and their outside counsel, for fear of being cut out of the pipeline for future R&W underwriting opportunities by those PE firms and their counsel.