What Is Representations and Warranties Insurance?

Fundamentals of Representations and Warranties Insurance

Representations and warranties (R&W) insurance covers financial losses from inaccuracies or breaches of statements made by a seller in a merger or acquisition (M&A) agreement. These statements are factual assertions about the target company or its assets, intended to induce the buyer to proceed with the transaction. Warranties assure these representations are accurate.

This insurance acts as a risk transfer mechanism, shifting the financial burden of unknown and unintended breaches from the transacting parties to an insurer. Rather than relying solely on traditional indemnification provisions, which might tie up seller proceeds in escrow or lead to protracted disputes, R&W insurance provides a direct source of recovery for the buyer. It protects against losses, including defense costs, that arise if any of the seller’s representations and warranties prove to be untrue post-closing.

R&W insurance mitigates risks associated with post-closing disputes and potential financial liabilities. It allows for a cleaner exit for sellers by reducing or eliminating the need for large escrow accounts, enabling them to distribute sale proceeds more quickly. For buyers, it offers enhanced protection and a streamlined claims process against a financially robust third party, the insurer, rather than directly pursuing the seller. This approach fosters smoother negotiations and can make a buyer’s bid more competitive in an auction setting.

Parties and Their Roles

Representations and Warranties insurance involves three primary parties: the Buyer, the Seller, and the Insurer, each with distinct interests and responsibilities. The Buyer typically procures the policy and is the primary insured party, though seller-side policies also exist. This arrangement provides the buyer with direct recourse against a financially stable insurer for covered losses, reducing the need to pursue the seller directly for breaches. A buyer-side policy can also allow for extended coverage periods and higher limits than a seller might otherwise agree to provide.

For the Seller, R&W insurance offers a significant advantage by limiting their post-closing liability. Traditionally, sellers might place a portion of their sale proceeds in an escrow account (typically 10% to 15% of the deal value for one to two years) to cover potential indemnification claims. With R&W insurance, this escrow amount can be substantially reduced or even eliminated, allowing sellers to access their funds more quickly and achieve a “clean exit” from the transaction. This is particularly appealing for private equity sellers who aim to distribute proceeds to their investors without lingering contingent liabilities.

The Insurer serves as the risk bearer, underwriting the policy and providing coverage for breaches. Insurers conduct due diligence, reviewing transaction documents, data room materials, and buyer’s reports to assess risk before issuing a policy. They investigate and pay out claims within the policy’s terms. The insurer’s role facilitates the M&A transaction by providing a reliable mechanism for addressing unforeseen issues, instilling greater confidence for both the buyer and the seller.

Scope of Coverage and Common Exclusions

R&W insurance policies cover financial losses from breaches of the seller’s representations and warranties as outlined in the acquisition agreement. Coverage extends to all representations and warranties about the target company or its assets. Common areas of coverage include financial statements, tax matters, compliance with laws, material contracts, and intellectual property. The policy protects against inaccuracies unknown to the buyer at policy inception.

Despite broad coverage, R&W policies include specific exclusions. Claims from breaches that were known to the buyer or seller prior to the policy’s effective date are excluded. This prevents parties from seeking coverage for issues they were already aware of and did not disclose. Other common exclusions involve forward-looking statements or projections, which are inherently uncertain and not factual representations of the present.

Policies also exclude certain highly specific or difficult-to-quantify risks. These can include post-closing purchase price adjustments, unfunded pension liabilities, and certain environmental liabilities unless specially underwritten. Issues related to net operating losses (NOLs) and transfer pricing are excluded, although the market for these exclusions can evolve. The specific scope of coverage and applicable exclusions are subject to negotiation and vary from policy to policy.

Obtaining Representations and Warranties Insurance

Securing an R&W insurance policy begins early in the M&A transaction process, initiated by the buyer through an insurance broker. The first step involves submitting preliminary underwriting materials to solicit non-binding indications (NBIs) or quotes from insurers. These initial quotes provide an overview of potential premiums, retentions (deductibles), and any immediate areas of concern for the insurer.

Once a preferred insurer is selected, the formal underwriting process commences, which entails an underwriting fee ranging from $25,000 to $50,000, depending on the deal’s size and complexity. During this phase, the insurer and their legal counsel conduct their own due diligence, reviewing the buyer’s due diligence reports, the seller’s data room, and the draft acquisition agreement. This thorough review by the insurer helps validate the representations and warranties and identify potential risks.

A diligence call is part of this stage where the insurer, deal team members, and third-party diligence providers discuss findings and address any remaining questions. Following this, policy terms are negotiated, and a draft policy is provided. The entire underwriting process, from initial NBI to policy binding, can take approximately one to two weeks, though tighter timelines are feasible. The policy is bound concurrently with the closing of the M&A transaction, providing immediate coverage for the buyer.