Representations and warranties (R&W) insurance has become a mainstay in mergers and acquisitions—and that remains the case in a COVID-19 environment. With significant benefits to buyers and sellers in a transaction, R&W insurance allows parties to eliminate or greatly minimize the traditional seller indemnification in purchase agreements for breaches of seller and company representations and warranties. The popularity of this insurance product has also led to policyholder-friendly market developments—that make it unlike many other insurance products—and data show that it provides buyers with a meaningful ability to collect on claims that exceed the policy’s self-insured retention (SIR).
Why Buyers Obtain R&W Insurance
R&W insurance is intended to remove risks from companies’ balance sheets, but it can provide parties with other benefits as well. For instance, R&W insurance policies allow buyers to bring breach claims for a longer period than is often available through a traditional seller indemnity; the policy period for R&W insurance policies is typically three years for breaches of general representations and six years for fundamental and tax representation breaches. And unlike holders of most other types of insurance policies, buyers can negotiate the precise wording of R&W policies and exclusions in an effort to maximize coverage.
R&W insurance also alleviates pressure on relationships with management, who may remain post-closing: Buyers do not have to disrupt those relationships by accusing management of breaches and can instead recover through R&W insurance. Another benefit of R&W insurance is that it can solve a credit risk when the seller may not be able to stand behind an indemnity obligation. R&W insurance also brings practical solutions to the negotiation of the transaction. Two major issues of contention during deal negotiations—the scope of representations and the indemnification package—are greatly eased in deals with R&W insurance. Finally, while R&W insurance may have been a way for bidders in an auction process to distinguish themselves in the past, today R&W insurance is often a requirement to simply remain competitive in the auction.
Do R&W Insurers Pay Claims?
The increasing popularity of R&W insurance also raises the question of whether R&W insurers pay claims. A recent survey of 149 stakeholders (buyers, brokers, and insurers) in the R&W insurance market by Lowenstein Sandler’s Insurance Recovery Group found that when R&W insurance claims exceed the policy’s SIR, R&W insurers pay claims, but policyholders have to diligently pursue the claim and carefully manage the process. Specifically, 87 percent of respondents reported that at least a partial payment was negotiated for R&W claims that exceed the retention. Therefore, R&W insurance policies do bring value to policyholders when the policy is called upon in the event of a loss.
However, the Lowenstein Sandler survey also reports that a hurdle to recovery of a loss is the policy’s SIR. Essentially, the buyer (and possibly the seller, depending on how the deal is structured) is responsible for the amount of loss within the SIR, and the policy covers only the loss that exceeds the SIR. Several years ago, SIRs started at 2 percent of the target’s enterprise value, but SIRs have dropped significantly and today are commonly 1 percent of the target’s enterprise value in a transaction (though SIRs can be lower as a percentage on larger deals). Today, the SIR will typically drop to 0.5 percent of enterprise value 12 months after the deal’s closing.
However, despite the drop of SIRs to 1 percent of enterprise value, more than 70 percent of all respondents said that their R&W insurance claims still fell entirely within the SIR and, thus, there was no payment by the insurers to the policyholders. The amount of claims that remain within the SIR suggests that the SIRs being offered in the R&W insurance market should be recalibrated (i.e., lowered) to allow buyers to better benefit from the R&W insurance policy when coverage is needed.
What Do R&W Insurance Claims Look Like?
Claim frequency. With regard to the frequency of R&W insurance claims, some R&W insurers have reported a consistent percentage of claim notifications. In its report M&A: A Rising Tide of Large Claims, AIG states that a claim was brought on about 20 percent (i.e., 700 of 3,500) of its R&W policies from 2011 to 2018. However, AIG reports increased frequency overall on larger deals, with claim frequency of 24 percent of policies written on deals between $500 million and $1 billion. AIG attributes this to the success of R&W insurance: “The increased frequency for claims for the higher deal sizes is partly driven by the fact that R&W insurance is far more commonly used.”
Liberty Global Transaction Solutions also published a report, called 2020 Claims Study: Exclusive Insights Driven by 10 Years of Data, and stated that claim notifications were made on about 19 percent of the policies it bound in 2017. Liberty, though, qualified this statistic by adding that about one-quarter of notifications resulted in a request for payment. Ultimately, the relatively low claim frequency—and even lower claim payouts—supports reevaluating whether SIRs remain higher than the market and claims warrant.
Claim severity. R&W insurers generally classify claims as low-severity, medium-severity, or high-severity. Low-severity claims are those under $1 million; medium-severity claims are those between $1 million and $10 million; and high-severity claims are those above $10 million. According to the AIG report, in 2017, almost half of AIG’s claims were low-severity claims for an average claim amount of $340,000; almost half of AIG’s claims were medium-severity claims for an average claim amount of $4 million; and only 8 percent of AIG’s claims were high-severity claims for an average claim amount of $20 million. Liberty reported a similar percentage of high-severity claims, but its medium-severity claims were only 15 percent of its overall claims, and its low-severity claims accounted for 77 percent of all claims.
Claims by industries. By far, the financial services sector is the industry where most R&W insurance claims are made. In the Lowenstein Sandler survey, 72 percent of respondents identified a claim in this sector, followed by a lower and closer distribution among technology, health care, life sciences, manufacturing, and retail. The financial services sector is likely disproportionately high because it was an early adopter of R&W insurance, and it continues to include R&W insurance in many of its deals. The Liberty study also identifies financial services as the sector where R&W claims are most prevalent.
Claims by types of breaches. Financial statements breaches are the most common type of breaches among R&W insurance claims. In the Lowenstein Sandler survey, financial statement breaches were part of the claim 55 percent of the time, followed by employment (32 percent), employee benefits (31 percent), compliance with laws (28 percent), intellectual property (25 percent), tax (25 percent), and material contracts (23 percent), among others.
Financial statements breaches were also the most common in the AIG report, being the basis for the claim 20 percent of the time, followed by tax (18 percent), compliance with laws (16 percent), and material contracts (13 percent), among others. Interestingly, according to the AIG report, for claims of more than $1 million, financial statements breaches are even more frequent and are the basis of the claim almost one-third of the time, followed by material contracts claims almost one-fifth of the time.
The Liberty study follows a similar trend, with financial statements (26 percent) and tax (16 percent) breaches being the most common bases for paid claims. But unlike the Lowenstein Sandler survey or AIG Report, the Liberty study reported a meaningful amount of real estate claims (21 percent). Liberty’s financial statements breach claims are also the most expensive; when looking at aggregate payments, the financial statements breaches account for far more than half (63 percent) of Liberty’s paid dollars, followed by material contracts (14 percent) and real estate (10 percent), among others.
One reason why financial statements breaches often result in higher payments is because deals are often valued based on a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). Thus, when a buyer discovers a financial statement breach that causes EBITDA to be overstated, the buyer is able to assert a claim for the multiple of the overstated EBITDA, which can greatly increase the amount of loss sustained.
The R&W insurers’ claim experience also informs their underwriting while the transaction is negotiated and due diligence is performed. For example, the increased claims involving material customer and suppliers has resulted in R&W insurers underwriting buyers’ diligence more intensely: R&W insurers increasingly expect prospective buyers to conduct calls with material customers and suppliers, and the insurers devote additional time to probing the material contract and supplier diligence during underwriting calls and in follow-up questions.
Getting the R&W Claim Paid
The underwriting stage. Maximizing coverage for R&W claims begins even before the deal closes, the breach is discovered, or the claim is made. Unlike holders of many other types of policies, R&W insurance policyholders are able to negotiate the specific terms and conditions of the policies as well as the deal-specific exclusions that insurers may propose. Thus, while the deal is being negotiated, buyers should work with coverage counsel who have experience negotiating R&W policies to try to secure “gold standard” terms and conditions that can help prevent insurers’ coverage defenses. For example, buyers can negotiate for (i) heightened burdens of proof for the insurers to establish that an exclusion applies; (ii) the right to select their chosen defense counsel (at their standard rates); (iii) a showing by the insurer that it suffered actual and material prejudice because of the insured’s noncompliance with a policy requirement before it can deny coverage; and (iv) the buyers’ preferred forums and choice of law.
Also critical, policyholders can and should push back on proposed deal-specific exclusions. R&W insurers often propose overbroad exclusions that can be narrowed through negotiation. For example, even though diligence may reveal a sales tax issue in a few states, R&W insurers often propose broad exclusion for “sales tax.” However, that exclusion can often be narrowed to just those few states where there is a known risk. R&W insurers also tend to seek broad COVID-19 exclusions to the extent COVID-19 affected any facet of the target. But buyers can sometimes negotiate that exclusion out or have it limited to apply only to claims involving transmission of the virus.
Coverage counsel can also help the adage “an ounce of prevention is worth a pound of cure” ring true. During the underwriting process, the R&W insurers and their counsel will host a telephone conference with the buyer and its advisors to investigate the buyer’s diligence in a number of key areas (such as financials, taxes, cyber, and employment) and any concerning findings. Coverage counsel can help buyers and their advisors avoid raising “false alarms” and deal-specific exclusions by being well prepared for those calls.
Providing notice of claim. Providing timely notice of a breach or third-party claim is, necessarily, a key step to recovering under R&W insurance policies. But buyers often delay reporting claims, to their detriment. For example, the Lowenstein Sandler survey reports that in 45 percent of claims, buyers often wait more than six months from discovery to make a claim under a policy. Given that the R&W insurance claim process often runs from 6 to 18 months, buyers only delay their recovery of payment under the policy by failing to provide early notice.
Further, while buyers have the ability to negotiate for protective policy provisions if a claim is delayed, that has not stopped insurers from asserting that coverage defense to try to avoid payments. In the Lowenstein Sandler survey, insurers reported that they assert “late notice” coverage defenses for nearly 1 out of every 5 claims, while policyholders reported that defense about 1 out of 10 times.
A policyholder might delay in providing timely notice because it (i) is laser-focused on the immediate needs of the business, (ii) assumes the breach will result in a loss within the SIR, (iii) is addressing seller indemnity issues first, or (iv) does not want to pay the costs of making and pursuing a claim. However, the better practice is to provide timely notice so that coverage is available if needed. Further, the R&W policy often affords buyers liberal opportunities to supplement the notice as the claim develops.
Getting to “yes.” After presenting a claim to R&W insurers, buyers will probably first hear “no”—but they can still get to “yes.” Even though 61 percent of respondents in the Lowenstein Sandler survey reported initially receiving a denial of a claim, those same respondents (including brokers and insurers) stated that almost 90 percent of the time after an initial denial, the policyholder was able to negotiate at least some payment for the claim. In fact, most claims in the survey resolved for more than 50 percent of the policyholder’s total loss.
However, getting to “yes” requires time and effort on the part of the buyer to negotiate and substantiate the claim. Buyers may have to build out their claim advocacy team—each with his or her own key role—consisting of coverage counsel (to advocate, investigate key facts, identify the legal basis, and present the case for recovery), the insurance broker (to provide the commercial/business relationship), deal counsel (to provide necessary background), and experts (to help prove the breach of the amount of loss). Indeed, a key reason for the buyer to have its own claim advocacy team is to level the playing field—because the insurer will surely have its own legal advisors and experts.
Oftentimes, buyer and insurer are able to resolve claims beginning with a comprehensive proof of loss that allows the parties to understand the case for coverage and meaningfully negotiate with the insurer without having to resort to full-blown litigation or arbitration. Informal negotiations or formal mediations are often successful means to recovering meaningful amounts. Nevertheless, about one-fifth of claims end up in litigation, according to the Lowenstein Sandler survey.
R&W Insurance in the Current Market
The sudden and traumatic arrival of the COVID-19 pandemic in the U.S. in March 2020 quickly diminished deal-making activity and threw markets into a state of uncertainty. Businesses decided to take a “wait and see” approach and hold on to their cash reserves. Moody’s Investors Service stated that the cash holdings of U.S. nonfinancial companies were a record-high $2.12 trillion in June 2020, which represented a 30 percent increase from the end of 2019.
However, deal flow resumed throughout the second half of 2020. In October 2020, Deloitte published a survey called M&A Trends Survey: The Future of M&A based on a poll in August 2020 of 1,000 executives at U.S. corporations and private equity firms. The Deloitte survey found that, in response to COVID-19, most organizations were taking an offensive stance. Sixty percent of organizations stated that they were more focused or significantly more focused on new deals since March 2020, and that number jumped to 70 percent for private equity firms only.
Thus, the mergers and acquisitions market remains generally hungry for continued deal-making, and the R&W insurance market has been ready to respond. Of course, R&W insurers have become more acutely focused on certain areas of the deal. For example, R&W insurers are focused on inventory issues in retail and manufacturing deals and the impacts of COVID-19 on companies’ operations, supply chains, workforce safety, and distribution. In the material contracts landscape, insurers have probed customers’ and suppliers’ attempts to cancel contracts based on force majeure clauses. Cybersecurity is another key area of attention for R&W insurers when the target transitioned its workforce to a “work from home” environment.
These—and many other—COVID-19 concerns have, therefore, affected what R&W insurance policies look like. At the outset of the pandemic, broad COVID-19 exclusions—for impacts on operation, supply chains, customer relationships, distribution, and labor and employment, which touched on every aspect of the business—were prevalent. As the pandemic continues, however, R&W insurers have become more comfortable eliminating the COVID exclusion altogether or agreeing to a much narrower exclusion (e.g., limited to claims involving the transmission of the virus). At the proposal stage—before a carrier is selected—buyers should press the insurers on their position on the COVID-19 exclusion to avoid an unwelcome surprise during underwriting.
One area where R&W insurers have not yet become comfortable are companies that have obtained Paycheck Protection Program loans or other forms of CARES Act relief. Exclusions for such government benefits remain commonplace, and buyers who are looking to insure such risks need to look to other bespoke insurance products rather than R&W insurance.
Finally, during the pandemic, the pricing for R&W insurance policies has increased above its pre-pandemic levels. R&W insurers have attributed this to increased claim experience, in addition to concerns over the pandemic.
As deal flow continues to climb, R&W insurance will continue to play a critical role in mergers and acquisitions. While R&W insurers will be even more vigilant during the underwriting process as a result of COVID-19, policyholders must be vigilant in negotiating favorable terms. The efforts put into crafting an R&W insurance policy with favorable terms and conditions and with narrowed exclusions can pay dividends in the face of a breach. And if and when a claim does come, buyers who assemble a strong claim advocacy team and diligently pursue the claim can be well positioned to secure a meaningful recovery—because, as the Lowenstein Sandler survey confirms, R&W insurers generally do pay claims that exceed the policy SIR.
Eric Jesse is a partner at Lowenstein Sandler LLP and a member of the firm’s Insurance Recovery Group.
 Lynda A. Bennett & Eric Jesse, Lowenstein Sandler, Insurance Recovery Group, Getting Paid: A Look at Representations & Warranties Insurance.
 Liberty Global Transaction Solutions, 2020 Claims Study: Exclusive Insights Driven by 10 Years of Data (2020).
 Press Release, Moody’s Investor Service, Research Announcement: Moody’s: US companies’ cash holdings hit record high amid pandemic (Nov. 23, 2020).
Copyright © 2021, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).