More and more buyers are using representation and warranty insurance (RWI) to supplement or replace indemnities from a seller in the sale of a business in Canada. While some of our clients, particularly private equity funds, use RWI regularly, other clients find themselves having to quickly familiarize themselves with how it works, sometimes in the middle of a complex mergers and acquisitions (M&A) transaction. Whether you are a RWI expert or not, two recent market reports from AON and Marsh JLT Specialty provide helpful information about market trends, claims experience, typical breaches and claims settlement.
The two reports noted above, the AON Report and the Marsh Report, confirm predictions that greater awareness of the strategic value of RWI and heightened sensitivity to risk would lead to increased use of RWI in transactions. See our prior reports on the increasing use of RWI, the strategic application of RWI and the fundamentals of RWI.
The Marsh Report provides global insight into RWI trends and the AON Report provides a North American perspective.
Fundamentals of RWI
RWI, sometimes referred to as transaction insurance, protects against unanticipated and unknown breaches of representations and warranties and other matters that may otherwise require an indemnity from a seller. RWI can supplant or supplement indemnity provisions and survival periods in a purchase and sale agreement. Coverage is available for both "fundamental" and non-fundamental representations and warranties and can be provided for specific representations and warranties when appropriate. RWI can also be used to overcome fundamental differences between a buyer and seller on the assessment of risk ("how significant is this risk?") and allocation ("who will bear this risk?"), and get to a signed agreement.
2019/2020 Global Market Trends—Marsh Report
Increased awareness of the benefits of RWI and demand for RWI has correspondingly led to increased competition among insurers, resulting in downward pressure on pricing and expanded coverage. The Marsh Report indicates that:
- Deductibles have held steady at approximately 1 percent of enterprise value for transactions below $500,000,000 and 0.75 percent of enterprise value for transactions above $500,000,000, in both instances whether or not there is a seller indemnity in the purchase agreement.
- Deals without a seller indemnity in the purchase agreement (sometimes referred to as "public style" transactions) increased from 30 percent in 2018 to 41 percent in 2019.
- The enterprise value of target companies in insured transactions has also decreased from an average of $402,000,000 and a median value of $135,000,000 in 2018 to an average of $343,900,000 and a median value of $130,000,000 in 2019.
- In 2019, buyer side policies accounted for the vast majority (99.6 percent) of issued policies, of which, 51 percent were held by private equity firms and 49 percent by corporate and strategic buyers.
The Marsh Report also indicates a dramatic increase in the use of tax insurance primarily related to M&A activity and tax credits.
Unsurprisingly, given reduced deal flow in the first half of 2020, there is anecdotal evidence of a decrease in both RWI submissions and binding over the same time period and a reduction in premiums charged. Some carriers have also been including broad exclusions around COVID-19, the impact of COVID-19 and related government programs, such as exclusions for:
- claims arising out of or increased by COVID-19, mandatory or advisory restrictions issued, ordered or threatened, by public authorities and regulatory bodies;
- the failure of the target company to take sufficient steps to protect its employees, contractors and other third parties from the spread of COVID-19 or to collect accounts receivables; or
- generally, the effects of COVID-19 on the target company.
While the existence of COVID-19 is known, its full extent and implications are not. Careful attention must be paid to these exclusions to ensure that they are appropriate in scope and not overly broad, while also being mindful that the fundamental purpose of RWI is to protect against unanticipated and unknown breaches of representations and warranties, and not to fully insure the impact of COVID-19.
Claim Trends in North America—AON Report
The AON Report provides some interesting insight on its claims experience with RWI policies in North America, which is particularly helpful for those considering how useful or reliable RWI will be as a replacement or supplement to a seller indemnity.
Key findings include:
- Twenty-two percent of all policies placed between 2013 and 2017 resulted in claims.
- Claim size is increasing (which is attributable to larger deals and correspondingly larger insurance policies).
- Claims alleging multiplied damages have increased.
- There is no discernable difference in the frequency of claims for transactions that included a seller indemnity compared to those without; likewise, there was no difference in the frequency of claims in policies where the buyer and the seller shared the retention versus where the buyer was solely responsible.
- Larger deals were more likely to trigger a claim notice; however, despite increased claim frequency, a smaller percentage of claims made on large deals have resulted in payment (which could be explained by the larger retentions on larger transactions requiring the policyholder to incur a greater loss before the policy payment threshold is reached).
- Claim frequency was the same for private equity firms and strategic corporate policyholders.
- Approximately two-thirds of RWI claims are filed within a year of the corresponding transaction closing (which is attributed to the businesses being operated by the buyer and having completed its first audit cycle, during which time unknown issues are often uncovered).
- Claims that are reported after the first year typically relate to third-party litigation, tax audits or a breach of financial statement representations and warranties.
Frequency of Types of Breaches
According to the AON Report, the percentage of policies notified with a claim has increased steadily over the past several years, as have transaction values, limits placed and claim values. The AON Report also offers insight into the representations and warranties that are alleged to be breached most frequently. The "top six" categories of representations and warranties in which alleged breaches occurred were:
- financial statements (13.5 percent);
- compliance with applicable laws or governmental authorities (12.5 percent);
- tax (11 percent);
- labour and employment matters (10 percent);
- undisclosed liabilities (10 percent); and
- material contracts (9 percent).
Settlement of Claims
Since 2013, AON has been involved in more than 340 RWI claims made by its North American Clients. Of those claims: 18 percent settled within the retention; 12 percent became inactive over time; 12 percent resulted in a payment by the insurer; 4 percent were denied coverage; and 54 percent remain active. Of the claims that were denied: 77 percent were due to a specific policy exclusion, 15 percent were denied on the basis that the matter was previously disclosed by the seller and 8 percent were denied due to the insured's failure to comply with the terms and conditions of the policy.
- RWI is not a replacement for due diligence; the AON Report emphasizes the importance of comprehensive due diligence and offers insight into areas of interest that should be considered when drafting and negotiating definitive agreements.
- Regarding the availability of indirect, consequential and multiplied damages, buyers are well advised to preserve their ability to make claims for such damages under the RWI policy by ensuring that such damages are neither explicitly included nor excluded in the definitive purchase agreement.
- While the number of RWI claims has been increasing, the cost of RWI premiums has been decreasing and appeared to reach the floor in the summer of 2019; however, with the reduction in transactions due to COVID-19, some insurers are reducing premiums even further. This trend of reduced pricing may, however, be offset with pressure to increase premiums to account for the increasing frequency of claims being made.
- RWI depends on comprehensive seller disclosure and rigorous buyer due diligence: COVID-19 presents challenges to both. The result may be a shift toward drafting narrow, fact-specific representations and warranties and novel (and perhaps more extensive and protracted) due diligence processes.
- Time will tell whether COVID-19 will result in a market shift away from what has in the past decade predominantly been a seller's market and return leverage to buyers. If that happens, watch out for changes in deal terms and responsibility (as between sellers and buyers) for retention amounts.
Going Forward—Growing Reception of RWI in Canadian Deals
While we have observed some reticence to the use of RWI from counterparties or counsel who have not had an opportunity to use RWI previously, we continue to expect increasing use of RWI in M&A transactions in Canada. Two factors that may contribute to counterparty reticence are skepticism as to the claims process and whether legitimate claims will in fact be paid by the insurer. As awareness of RWI continues to grow, and in particular as there is greater experience of claims being paid and comfort with the claims process, we expect this reticence to subside.
The AON Report and the Marsh Report provide helpful information regarding the state of the RWI market and the effectiveness of RWI as a risk-management solution when buying or selling a Canadian business.