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.
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.
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:
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:
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.
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:
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:
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.
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.