R&W insurers are shifting to an adversarial claims-handling process common to other insurance products, rather than advancing the commercial approach that made R&W insurance unique.
Over the past decade, representations and warranties (R&W) insurance has changed the U.S. merger and acquisition (M&A) market for the better. R&W insurance (RWI) eases negotiations between buyers and sellers over the scope of the R&Ws and the indemnification structure in acquisition agreements; it gives buyers a longer period of time to assert claims; it helps avoid confrontations with sellers or management who remain with the target post-closing; and it also avoids conflict among market participants—whether it be private equity firms or strategic buyers—when a breach is discovered.
Yet, all the benefits that RWI can bring to an M&A deal may not amount to much if the product does not work as designed when buyers most need it: to pay claims. Because R&W insurance is born out of the M&A market, which involves negotiations, commerciality, speed, and, ultimately, deal-making, those attributes carried over to RWI. Therefore, it is unlike other insurance products that are more commoditized, such as directors’ and officers’ liability, cyber insurance, or commercial general liability policies. With RWI, the buyer (policyholder) and the R&W insurer engage in underwriting and negotiate the terms of the policy and the scope of exclusions all through the lens of commerciality.
That sense of commerciality applied to the claim adjustment process too. In a survey of RWI market participants, conducted by Lowenstein Sandler LLP (LS) on the eve of the pandemic in 2020, 87 percent of respondents reported that, when claims exceeded the policy’s self-insured retention (SIR), a claim payment was negotiated—though there were hurdles along the way.
What a difference a few years—and a pandemic—make. Since then, R&W insurers have reported increases in both claim frequency and claim severity. And it appears that increased claims activity has translated into a more constricting claim resolution process. As we emerge from the COVID-19 pandemic and enter a brave new world, LS sought to determine if R&W insurers are still paying claims. Therefore, LS recently surveyed 154 RWI market participants (private equity firms, investment banks, strategic buyers, insurance brokers, and insurance companies). However, that refreshed survey revealed that only 60 percent of respondents were able to negotiate a claim payment (for claims above the SIR). This drop—from 87 percent two and a half years ago—raises the question of whether R&W insurers are shifting to an adversarial claims-handling process common to other insurance products, rather than advancing the commercial approach that made R&W insurance unique.
Data from R&W insurers and LS’s survey confirm that M&A buyers need the recourse that RWI can provide. For example, R&W insurers report that claims are made on about 20 percent of the policies they issue. And the claims are significant, with AIG reporting that 57 percent of its claims fall within the $1 million to $10 million or more range. Moreover, more claims are exceeding the retention than before. Seventy-one percent of respondents to LS’s 2020 survey experienced claims entirely within the SIR, but that percentage dropped to 61 percent today, leading to broader access to policy limits.
Claim severity is certainly one reason claims exceed the retention. But one buyer-friendly development is likely another factor: lower retentions. In Getting Paid, LS highlighted the RWI market imbalance if more than 70 percent of respondents reported claims within the retention. Since then, we have seen retentions fall. While an SIR of 1 percent of enterprise value remains standard for most deals, retentions of 0.75 to 0.9 percent of enterprise value are available and commonplace as R&W insurers compete for deals.
As buyers frequently call upon RWI and have increased access to policy limits, the importance of RWI to buyers as a risk-transfer solution is confirmed. Thus, RWI can provide value if a buyer experiences a breach. But that leads to the question: Does RWI provide that value?
RWI’s popularity is driven by the above-mentioned benefits, the seller’s requirement that RWI supplant the traditional indemnification structure in purchase agreements, and the buyer’s need for access to the policy in the event of claims. But demand for this insurance solution can be maintained only if R&W insurers pay claims when called upon to do so and if the claim process is a focused and commercial one.
The results from 2020 showed R&W insurers generally behaved as they should, with 87 percent of respondents reporting negotiated claim payments (when claims exceeded the SIR). Since then, the increase in claims and their severity may be leading to short-term thinking among R&W insurers on claim resolutions: R&W insurers have become more entrenched and the “let’s make a deal” mindset appears to be evaporating. Thus, only 60 percent of respondents reported a negotiated payment for claims exceeding the SIR. Further, the amount of the negotiated payments has declined. Of the negotiated claim payments, 60 percent of respondents reported claim payments above 50 percent of the claimed loss, which is a decline from 75 percent in 2020.
What does this mean? For M&A buyers, the first questions they need to ask when selecting an R&W insurer for their deal is “Does this R&W insurer pay claims? And what is their claim investigation and resolution process like?” A buyer can negotiate the strongest possible R&W policy, but that may not mean much if the selected R&W insurer will not partner with the buyer when there is a breach and resulting loss.
For R&W insurers, they should revert to the “old” normal of negotiating and paying claims. Rather than go down the path of treating RWI like a commoditized insurance product, with the concomitant entrenchment on claims handling, R&W insurers should reembrace what makes RWI a unique risk-transfer solution. Because RWI is part of the deal-making world, R&W insurers approached claims with a focus on commerciality and negotiated resolutions. That approach allows demand for RWI to remain strong, and it means that buyers can reflexively accept RWI as a natural part of M&A deals.
A significant lag time remains in the claim investigation and resolution process. As an initial matter, the claim process starts with misaligned expectations. In R&W policies, insurers often promise to provide a coverage position letter within 45–60 days of notification of the claim. But over 50 percent of respondents reported that it takes over 6 months for insurers to provide their initial coverage position. To keep the claim process on track, the policy should still set deadlines for insurers’ coverage positions. But insurers should consider adjusting the one-size-fits-all time frame. Forty-five days may be sufficient (or even too long) for an insurer to acknowledge a defense obligation for a third-party claim. But it is probably not realistic for a financial statement breach and full-limit loss claim, given the complexities that usually accompany such a claim.
Once the claim process is under way, the time from claim submission to payment is one to three years, 51 percent of respondents reported, which is up slightly from 46 percent in 2020. R&W insurers are certainly entitled to conduct a reasonable investigation to confirm the merits of the claimed breach and loss. But buyers question the value of RWI when the claim investigation feels more like discovery in litigation (and takes as long) versus the deal-making mindset that encompassed the transaction and policy underwriting. During the deal, buyers are on the move, working to close the deal as soon as possible. And R&W insurers keep up with the deal pace; they need to, or they will not be in the market for long.
But that seems to end when the claims come in. Buyers question how they can negotiate, conduct diligence, and close a transaction valued in the tens or hundreds of millions of dollars in a matter of months, but getting paid on an R&W insurance claim takes years. The “need for speed” mindset from the time of the deal needs to carry over to the claim process. To that end, insurers should reconsider if it is really necessary to issue broad and far-reaching litigation-style information requests or if the requests can be “right-sized” to get R&W insurers precisely what they need for a reasonable and focused claim investigation.
As RWI claim payments constrict, new coverage defenses have emerged. To challenge a claim, R&W insurers are increasingly challenging the existence of a breach (reported by 40 percent of respondents) and whether there is a loss (reported by 47 percent of respondents), a significant jump from the 15 percent and 28 percent, respectively, reported by respondents in 2020. Further, respondents report that insurers are challenging the loss based on lack of information (49 percent); a dispute over the multiplied damages valuation (48 percent); valuation method (42 percent); or the failure to show “permanent impairment” to the target going forward (38 percent).
The insurers’ increased focus on the breach and loss likely contributes to the lengthy claims process and reduced claim payments: Insurers are challenging the ability of insureds’ to even access the policies’ coverage in the first instance.
Two other—preventable—coverage defenses are also on the rise. Thirty-three percent of respondents reported that R&W insurers asserted lack of consent to a settlement as a coverage defense, up from 18 percent in 2020. And 20 percent of respondents said R&W insurers still press late notice, up from 13 percent in 2020. Fortunately for buyers, R&W policies have favorable clauses that provide that consent to a settlement cannot be unreasonably withheld, conditioned, or delayed, and R&W insurers must show prejudice to prevail on a late notice defense. Thus, while these coverage defenses may not ultimately preclude coverage, buyers would do well to remember these policy requirements to remove the coverage defense from the conversation altogether.
For policies placed during the pandemic, R&W insurers added COVID-19 exclusions (of varying scope), and they have not hesitated to invoke them as claims were made. Twenty percent of respondents reported this coverage defense, and supply chain impacts and the failure to prevent COVID-transmission were the most prevalent reasons that insurers invoked the exclusion.
As companies show increased commitment to environmental, social, and governance (ESG) issues, conventional thinking may lead RWI stakeholders to believe that such companies have less risk. However, respondents reported that 49 percent of claims involved an ESG-driven or -focused company. Further, 32 percent of those respondents reported that those claims involved a representation and warranty related to ESG compliance, policies, or procedures. Thus, ESG companies do not appear immune from RWI claims.
In addition, 20 percent of respondents reported RWI claims resulting from special purpose acquisition company (SPAC) transactions, which is a healthy amount considering that SPACs make up only a subset of overall M&A activity. SPAC transactions are perceived as having a higher risk profile because of the possibility that the parties will circumvent more traditional planning and due diligence. Consequently, RWI was touted as a benefit for SPAC deals because of the increased diligence R&W insurers would require as part of their underwriting. However, this claim experience may show that SPAC transactions are difficult to underwrite—particularly with breaches falling outside of traditional legal diligence. Respondents reported breaches involving product issues and condition of assets, financial statements, and data security.
The fact that buyers increasingly need access to RWI—as demonstrated by insurers experiencing increased claim activity and losses exceeding the retention—is actually a good thing for the longevity of RWI: It solidifies RWI as a necessary risk-transfer solution for buyers. However, M&A buyers also expect results. If R&W insurance does not respond—and respond timely—when buyers need coverage, buyers will begin to question whether all the benefits of RWI in facilitating deals is worth it if the claim process is going to be lengthy and adversarial. The not-so-secret success of RWI is that it is not a commoditized product. Rather, its distinctiveness among insurance products because of its speed, commercial approach, and ability to negotiate terms should, again, inform the claim investigation and resolution process. Indeed, the last thing R&W insurers want is for buyers to question the value of including RWI in deals.
