What Is Cap Insurance Coverage in Financial Transactions?

Cap insurance coverage, often known as Representations and Warranties (R&W) insurance, is a specialized product designed to mitigate specific risks in corporate deals. This coverage protects parties from financial losses arising from inaccuracies or breaches of statements made about a business. It acts as a financial safeguard, providing a mechanism for recovery without directly impacting deal counterparties. This product has become increasingly prevalent in mergers and acquisitions.

Understanding Cap Insurance Coverage

R&W insurance is designed to cover unknown and unintended breaches of representations and warranties made in business acquisition agreements. In a merger or acquisition, representations are statements of fact about the current state of the business being sold, such as its financial condition, assets, or liabilities. Warranties are assurances that these statements are true and accurate.

These representations and warranties are fundamental components of a purchase agreement. Historically, indemnification for breaches involved the seller placing a portion of sale proceeds into an escrow account. R&W insurance, however, acts as a financial backstop, providing a direct source of recovery for the insured party if a breach occurs. This reduces or sometimes eliminates the need for a large seller escrow. The insurance shifts the risk of post-closing liabilities from transacting parties to an insurance carrier, protecting against losses from inaccuracies in contractual statements.

Elements of Cap Insurance Policies

An R&W insurance policy contains several key structural components that define its scope and payout mechanisms. The policy limit specifies the maximum amount the insurer will pay for covered losses. This limit is often negotiated as a percentage of the overall transaction value, commonly ranging around 10%.

The retention, which functions similarly to a deductible, represents the initial amount of loss that the insured party must bear before the policy begins to pay. Retentions typically range from 0.5% to 1.5% of the transaction’s enterprise value. This amount is frequently shared between the buyer and seller, with the buyer often covering a portion or all of it before the policy activates. Policies may also feature a “drop-down” in retention after a certain period, such as 12 months.

The policy period dictates the duration for which the coverage is active, aligning with the survival periods of representations and warranties in the underlying transaction agreement. General representations typically have a survival period of approximately three years, while fundamental representations, such as those related to taxes or title, may extend to six or seven years. Covered risks generally encompass a broad range of inaccuracies in financial statements, tax compliance, undisclosed liabilities, and operational or legal compliance matters. Policies also include specific exclusions, such as breaches of representations known to the insured prior to the policy’s inception, forward-looking statements, or certain environmental liabilities.

Applications of Cap Insurance

R&W insurance is widely utilized in mergers, acquisitions, and divestitures to streamline the deal process and manage post-closing risks. Its predominant use is in private company transactions, where it has become a standard component of the M&A toolbox. The insurance mitigates the risks associated with breaches of representations and warranties, which are often a point of contention in purchase agreement negotiations.

Policies can be structured as either buyer-side or seller-side coverage. Buyer-side policies, which are the most common (accounting for 90-97% of policies placed), protect the acquiring party directly from financial losses caused by a seller’s misrepresentations. This allows the buyer to recover losses from the insurer rather than pursuing claims against the seller. Seller-side policies, though less frequent, protect the selling party against claims made by the buyer for breaches, providing a cleaner exit and reducing contingent liabilities.

The application of R&W insurance helps facilitate transactions by bridging gaps in buyer and seller expectations regarding risk allocation. By transferring risk to an insurer, it can reduce or eliminate the need for large escrow accounts, allowing sellers to receive more of the purchase price at closing. This can make a buyer’s bid more attractive in competitive auction processes. While the buyer often initiates and purchases the policy, the costs, including premiums which typically range from 2% to 4% of the coverage limit, can be negotiated and shared between the parties.