In the healthcare mergers and acquisitions market, buyers and sellers have typically relied upon conventional seller indemnification obligations and an indemnity withhold from the purchase price to cover losses arising from breached representations and warranties. Strict laws and regulations and unforgiving penalties in the staunchly regulated healthcare industry present a degree of risk that insurers were generally hesitant to underwrite, making transaction risk insurance coverage for a seller’s representations and warranties an unlikely alternative to the traditional approach. Fortunately, the boom of the global mergers and acquisitions market carried over into healthcare and with it came the demand for transaction risk insurance, most notably in the form of R&W Insurance. Currently, the use of R&W Insurance in healthcare mergers and acquisitions is ever increasing as the new normal, whether used in conjunction with traditional seller indemnification or replacing the same in its entirety.
Overview of R&W Insurance
Used in transactions involving both private equity and corporate buyers,3 R&W Insurance provides coverage for breaches of the seller’s representations and warranties made in the purchase agreement. R&W Insurance policies can be structured as buy-side policies, under which the buyer looks directly to the insurer for coverage, and sell-side policies, which reimburse the seller for indemnification claims paid by the seller to the buyer, with the utilization of buy-side policies far outpacing sell-side policies.4
Customary duration and scope of coverage under a R&W Insurance policy is around three years for business representations and warranties and six years for fundamental representations and warranties.5 The policy will generally cover all breaches of the seller’s representations and warranties with the exception of certain exclusions, including known liabilities, such as pending litigation or self-disclosure proceedings; the seller’s covenants; adjustments to working capital; certain environmental matters, such as claims relating to asbestos; employee benefit funding; wage and hour disputes related to employee and independent contractor misclassification; collectability of accounts receivable; and any unique findings uncovered during due diligence. With respect to the policy limit, the policy may be structured to cover the full purchase price or a percentage of the purchase price, with excess losses typically borne by the buyer,6 but the nature of the underlying transaction will play a role in how the parties and insurer choose to proceed.
The most discernible benefit of a R&W Insurance policy is the transfer of risk to the insurer. From the buyer’s perspective, a R&W Insurance policy (1) helps to mitigate concerns regarding a seller’s ability to cover indemnified claims and post-closing collection efforts regarding the same, which is of particular concern in a distressed deal; (2) allows the buyer to avoid adversarial proceedings with the seller to enforce indemnification obligations; (3) presents the opportunity to obtain more favorable purchase agreement terms than it would have been able to negotiate under standard indemnity, such as a longer coverage period; (4) enables the exclusions and limitations to be more clearly established and set out in advance; and, as previously noted, (5) may allow the buyer to present the seller with a more competitive offer. For the seller, R&W Insurance limits indemnification risk, allows the seller to side-step the escrow of purchase price proceeds,7 and reduces its post-closing obligations so as to facilitate a relatively clean break. Materializing a clean break post-closing has been historically regarded as an elusive concept in mergers and acquisitions, but the surge of R&W Insurance has allowed sellers to adopt the “seller-flip” approach to pursue deals that achieve or come close to achieving this result. Under the “seller-flip” approach a seller will obtain a R&W Insurance quote to present to prospective buyers as part of their initial discussions, signaling that not only is there coverage for the transaction but the seller’s desire that the transaction not involve the traditional indemnify construct. This approach allows the seller to dictate the terms of R&W Insurance and, to a degree, indemnification and withhold amounts up front and avoid what is often a heavy-handed negotiation of its representations and warranties and indemnity obligations.
Overall, R&W Insurance is a valuable tool that offers advantages to both the buyer and the seller, but it is not without limitations. Most notably, in exchange for the benefit of transferring risk to the insurer, the parties, and the seller in particular, will be required to respond to extensive diligence requests and disclosures,8 which will require significant investment of time and resources. Should diligence be inadequate or uncover any known, or make known to the seller or the buyer, any contingencies of the acquired business, they will likely be excluded from coverage under the R&W Insurance policy, and in extreme cases may prompt the buyer to walk away from the deal. Parties should also be aware that the involvement of a third-party insurer that has access to diligence materials raises concerns regarding the loss of confidentiality, both the confidentiality of the transaction in general and the confidentiality of the seller’s business operations.
R&W Insurance Market Trends
Demand for R&W Insurance products in mergers and acquisitions has been tremendous over the course of the past few years, with the North American region leading all other regions in the use of R&W Insurance and other transactional risk insurance to facilitate deal closings. One global insurance broker estimates that in the 2019 North American market 48 percent of deals with an enterprise value between $25 million and $10 billion used R&W Insurance, an eight percent increase from the number of deals using such products in 2018.9 Comparing these numbers to 2016 and 2017, when estimates placed the use of R&W Insurance in similar transactions at 20 percent and 34 percent,10 respectively, shows the extent to which the mergers and acquisitions market has embraced the use of R&W Insurance as a fundamental component of deal-making. By the end of 2019, more than 20 insurers were offering one or more transactional R&W Insurance products11 compared to 2014 when a mere handful of carriers offered such products.
The increase in the number of insurers underwriting transaction risk insurance, coupled with low interest rates, a strong market, and demand for R&W Insurance, has contributed to a corresponding increase in coverage limits, and a decrease in policy premium and retention amounts, with one insurance broker reporting an 11 percent decrease in premium rates for primary R&W Insurance coverage from 2018 to 2019.12 In the current market it is not unreasonable for parties to expect a one-time premium equal to an amount that is between 2.5 percent and 3 percent of the policy coverage limit13 and a retention, or deductible, equal to 1 percent, or 0.75 percent for transactions in excess of $500 million, of the purchase price.14 In addition to these costs, the front end of obtaining a R&W Insurance policy will include an underwriting fee, which, depending on the value and nature of the deal, is likely to fall in the $25,000 to $50,000 range. The use of R&W Insurance has also been shown to impact other related deal terms, as one report found for all 2019 deals surveyed, both with and without R&W Insurance, a liability cap (meaning the maximum amount of recovery available to a buyer for indemnified claims) average of 13.2 percent of the purchase price, compared to a 14.3 percent liability cap average for deals without R&W Insurance.15 Unsurprisingly, the broker issuing this report also found that escrow and holdback amounts saw a similar drop, with all 2019 deals surveyed, both with and without R&W Insurance, demonstrating an average escrow amount of 8.9 percent of the transaction value compared to an escrow amount average of 12.5 percent of the transaction value for deals that did not include R&W Insurance coverage.16
The increased use of R&W Insurance is not limited to larger transactions. Insurance brokers are recognizing developments in opportunities for buyers and sellers in relatively small transactions to obtain R&W Insurance, with one broker identifying that 2019 represented a 46 percent increase in the use of R&W Insurance in transactions valued at $100 million or less when compared to 2018.17 Importantly, while enthusiasm for R&W Insurance in such transactions may be present, sellers in smaller deals are often less sophisticated than their large market counterparts and as such their ability to effectively respond to heightened due diligence requests may be limited. This limitation often makes it difficult for insurers to underwrite coverage, and has the potential to impact the feasibility and practicability of R&W Insurance for transactions with enterprise value below the $25 million to $50 million range.18 However, refinements in underwriting trend toward further expansion into mid-range transactions, particularly as the frequency of larger deals begins to wane and the market sees an uptick in midsized deals.19
Buyers are not obtaining R&W Insurance coverage merely to entice sellers. To the contrary, with the uptick in R&W Insurance policies written there has been a swell in the number of claims filed. Reporting on policies it helped place between 2013 and 2019, a global insurance broker identified that the number of claims filed on R&W Insurance policies in 2018 reflected more than a 400 percent increase in the number of claims reported in 2014.20 This report further noted that the occurrence of claim filing and amount of payout both vary with the enterprise value of the transaction. Larger deals accounted for more claims filed, while the frequency of payment generally trends higher for smaller arrangements despite an approximately 50.4 percent increase in the average payment above the retention from 2017 to 2019.21 Unsurprisingly, deals with a larger enterprise value resulted in greater average claim payouts than smaller transactions, despite a lower overall frequency of payout compared to the number of claims filed.22
Based on a sample of currently available data, on average the majority of claims under a R&W Insurance policy are filed within the first 12 months following closing of the transaction, with later claims accounting for matters arising primarily due to third-party complaints or tax liability.23 Claims for breaches of financial statement, compliance with laws and regulations, tax, employment and labor, and material contracts representations and warranties account for the majority of the claim types filed.24 Reporting for more recent years’ data will likely be subject to adjustment as policies’ terms approach their expiration and claims are uncovered during the buyer’s post-closing operation of the business, but drastic variation as to the timing and types of claims being filed as compared to current data is not expected.
R&W Insurance in Healthcare Mergers and Acquisitions
The vast majority of healthcare providers, from small physician group practices to national healthcare systems, receive payment from Medicare, Medicaid, and other governmental payors. Absent satisfying applicable exceptions or safe harbors, fraud and abuse laws and regulations impose criminal and civil liability for the solicitation, offer, payment, or receipt of remuneration to induce or reward items or services reimbursable by such programs, and the presentment or filing of false or fraudulent claims for payment or approval.25 Repayment obligations, penalties of up to $50,000 per kickback, penalties between $11,665 to $23,331 per false claim,26 treble damages, civil penalties under the Stark Law and the Civil Monetary Penalties Law, and potential exclusion from participation in governmental programs coupled with prosecutorial discretion in pursuing fraud and abuse actions creates the potential for liability that is both expensive yet difficult to estimate. Factor in cybersecurity and data privacy claims, malpractice claims, other avenues of potential liability, and the severity of potential exposure, and the challenges of underwriting coverage for healthcare transactions become quite clear.
R&W Insurance began to find its footing in the healthcare mergers and acquisitions market around 2018, a year in which the North American market saw an estimated 720 healthcare transactions worth approximately $120.2 billion.27 Insurance broker AON reported servicing 59 healthcare deals that utilized transaction insurance in 2018,28 a remarkable increase given that AON’s healthcare regulatory R&W Insurance policy was announced in 2014.29 Where insurers were in the past generally unwilling to entertain coverage if federal and state healthcare program reimbursement accounted for more than 20 percent of the revenue of the business to be acquired, policies are now being written for targets with revenue comprised entirely of reimbursement from governmental payors.30
A number of factors have facilitated the expansion of R&W Insurance in healthcare transactions, including an ever-growing demand for healthcare transaction R&W Insurance products; improvement in insurers’ ability to carry out more efficient and stringent regulatory due diligence; the relative financial stability of the healthcare industry, even in times of unpredictability or unprecedented disaster; consistently strong market growth; and exceptional returns. Seeing the promise of the product in markets where governmental regulation and oversight was less extreme, insurers gained comfort in expanding product offerings to healthcare transactions, and considering the share of healthcare transactions comprising global mergers and acquisitions, with private equity ever playing a more important role, it is arguable that insurers were left with little other option but to acquiesce to the changing tides. Importantly, despite the increased use of R&W Insurance in healthcare transactions and adoption of more sophisticated underwriting practices, the concerns insurers originally identified as the basis for their reluctance to cover the full gamut of healthcare representations and warranties continue to present a substantial degree of risk for buyers and insurers alike, with Medicare, Medicaid, and other governmental billing risk being a significant source of concern. To balance out these concerns it is not uncommon to find higher retention amounts on R&W Insurance policies where a significant portion of a target’s revenue is driven by reimbursement.
Healthcare sellers should pay particular attention to concerns regarding the loss of confidentiality that may result from sharing due diligence with insurers tasked with underwriting a R&W Insurance policy. Information shared pursuant to a confidentiality agreement between the seller and the buyer may not offer the seller protection in the event an insurer or its employees uses or discloses such information outside of underwriting purposes. Additionally, as the number of qui tam suits filed under the False Claims Act in healthcare remains relatively steady,31 sellers would be wise to consider the risks in sharing due diligence information as well as practical measures they can take to mitigate their exposure. Maintaining and enforcing comprehensive compliance policies and procedures, conducting routine compliance training, and actively monitoring and auditing operations for compliance concerns are part of a proactive approach to help reduce liability risks. Parties may also wish to consider whether common interest agreements are appropriate for the particular transaction, but should take care to review the laws of the jurisdiction(s) in which any communication or information is shared, as there may be nuances to the scope and use of the common interest doctrine across jurisdictions.32
The Impact of COVID-19 and Pandemics on R&W Insurance
Amid concerns surrounding political and economic uncertainty due to trade tensions, stressed international relationships, and other geopolitical factors such as Brexit, 2019 global mergers and acquisitions market figures lagged slightly behind 2018.33 Yet, 2019’s continued trend of aggregate value in excess of $3 trillion for global transactions in the mergers and acquisitions market34 helped to assuage fears over potential market volatility. Then in late 2019 and early 2020, the COVID-19 pandemic arrived and brought with it market uncertainty that looms even larger than the concerns for 2019. The COVID-19 pandemic impact on global mergers and acquisitions was almost immediate, and it ushered in myriad new considerations for the market. Financial uncertainty due to distressed supply chains, job loss and business closures, decreased consumer spending, and buyer self-assessment and self-preservation curtailed transactions as the first quarter of 2020 experienced a 30 percent decrease in activity compared to the fourth quarter of 2019.35 Despite these hits, transactions continued to close and showed that the market trend of the past few years remained. Preliminary reports for mergers and acquisitions in 2020 are encouraging, since they show a rebound in deal activity that began in the second quarter and carried over into the third quarter of 2020.36
Apparent market improvement notwithstanding, the lasting impacts of COVID-19, even in the relatively short amount of time since its devastating effects were first felt, will shape and crystalize deal activity across all industries for years to come. Parties can expect to negotiate new deal terms related to federal and state activities responding to pandemics, such as representations and warranties related to specific relief programs similar to the Paycheck Protection Program established under the Coronavirus Aid, Relief, and Economic Security Act.37 There also will likely be delays in obtaining consents and approvals, and third parties, government agencies, lenders, and internal leadership might more heavily scrutinize and require a degree of ongoing oversight of proposed transactions.
With respect to R&W Insurance, the industry has already begun to see COVID-19’s long-term effects. Uncertainty surrounding long-term financial stability and environmental and workforce health and safety concerns initially led R&W Insurance carriers to implement wholesale exclusions on coverage for any representation or warranty breach related to the pandemic.38 As the immediate reaction to COVID-19 began to wane and transactional risk insurers learned where to pinpoint exposure, there has been a gradual shift toward assessing transactions on a case-by-case basis rather than imposing wholesale exclusions, particularly given that blanket exclusions present the problem of overlap that might exclude coverage for matters that are incidental to the pandemic.
It is not unreasonable for buyers and sellers to anticipate that R&W Insurance policies’ exclusions will be narrowly tailored to address breaches of certain business, but not fundamental, representations and warranties. This is because pandemics are more likely to impact the seller’s representations and warranties related to its operations, including the conduct of the business; the condition of equipment, real property, and other assets; labor and employment relations; and environmental conditions. Fundamental representations and warranties, including organization, power and authority, ownership, and title, are unlikely to be affected by a pandemic. Looking forward, it is unlikely that COVID-19 and similar pandemic exclusions will be eliminated entirely from R&W Insurance policies, but the willingness of insurers to forego wholesale exclusions suggests that buyers and sellers can expect to see a more equitable approach to the allocation of risk.
Another component of the R&W Insurance process that has felt the effects of COVID-19 is heightened due diligence inquiries. With financial statement, tax, employee and labor matters, and material contracts representing the types of representations and warranties sellers allegedly breach most often,39 insurers have revised underwriting procedures to target corresponding areas for diligence, such as changes to business plans and supplier and customer relations, the financial condition of key customers, financial projections and other forward-looking data, disruptions to contract performance, disruptions to business performance and corresponding insurance coverage, employee and workplace safety policies and procedures, dealings with licensing or accrediting bodies and governmental agencies, and billing and collection of receivables.40 It is reasonable for sellers to prepare themselves to receive several supplemental requests for diligence, and to have their responses scrutinized. Areas of particular importance to the target business will also come under more intense scrutiny. In the healthcare setting this would include governmental payor reimbursement and fraud and abuse compliance. This increased focus on diligence likely will sacrifice a portion of the timing benefit typically afforded by R&W Insurance, with transactions that, pre-COVID-19, were prime for expedited closing experiencing delays related to intensified underwriting diligence efforts.
The COVID-19 pandemic is also expected to impact the frequency with which buyers and sellers use R&W Insurance. Before the outbreak of COVID-19, 79 percent of participants in a 2020 survey of global risk insurers indicated that they anticipate there will be a continued increase in the use of R&W Insurance in the mergers and acquisitions market.41 Sellers and buyers encountering pandemic-related uncertainties, such as whether future spikes will lead to further lockdowns, supply chain slowdowns, declined consumer spending, or other factors lending toward market stagnation, and buyers experiencing increased difficulty in forecasting long-term business durability, will look to shift risk to the other side. This desire to shift risk will present additional demand and opportunity for R&W Insurance. Furthermore, business hardships stemming from a possible resurgence of the pandemic will likely lead to an increase in distressed business sales, which naturally provide for the utilization of R&W Insurance. Funds for distressed sales – wherein sellers experiencing prolonged business losses or possible bankruptcy are motivated to sell and buyers have the opportunity to purchase assets at a reduced price – are generally earmarked to maximize the seller’s use thereof, whether as a means of paying off indebtedness, securing the viability of other business lines, or affording certain sellers the opportunity to walk away from a business gone awry. Because sellers are often unable or unwilling to commit to a traditional indemnification and escrow structure in a distressed deal, the situation is primed for the use of R&W Insurance as it provides both the buyer and the seller with post-closing security.42
Whether the COVID-19 pandemic triggers a shift toward increased premiums and retention amounts for R&W Insurance policies remains to be seen. The same survey that found that insurers anticipated an increase in R&W Insurance activity also found that the vast majority of participants neither felt pressure from the broader insurance market to change their approach to policy pricing or to change their approach to underwriting,43 suggesting that for the time being underwriting remains relatively flexible with the operations and business of a particular target being a significant driver of the terms of R&W Insurance policies.
Expectations for Healthcare Mergers and Acquisitions
Generally, because of the healthcare market’s historic resilience and stability the overall impact of COVID-19 on healthcare mergers and acquisitions is expected to be less severe than other sectors.44 But this healthcare market trend is not the only factor leading to this expectation. Additional consideration must be given to the acknowledgment among providers of the significant risks associated with going at it alone in modern healthcare.
The concern regarding long-term security applies across the entire healthcare spectrum; from small physician practice groups to stand-alone community hospitals, providers are seeing the swift ramifications from a sudden decline in patient visits. In a matter of weeks, small physician practices and other providers came face to face with the reality of the volatility of their business as patient visits all but evaporated due to wariness of patients over potential exposure to a deadly virus and government-mandated stays on the provision of non-emergent elective services. In response to this development, larger health systems and physician organizations that have the infrastructure to better weather global events like COVID-19 have noticed an opportunity to acquire hospitals and physician groups, whether distressed or otherwise, looking for security and protection.
The use of R&W Insurance has become a fundamental component of mergers and acquisitions. Demand from both buyers and sellers opened the door for R&W Insurance in healthcare mergers and acquisitions. As activity within the healthcare mergers and acquisitions market increases, so too will the use of R&W Insurance as an invaluable tool for buyers and sellers alike in the deal-making process.