What Is Representations and Warranties (RWI) Insurance?

Representations and Warranties (RWI) insurance has become a significant component in mergers and acquisitions (M&A) transactions. This specialized insurance product manages risks associated with statements and assurances made during a business sale. Its adoption has steadily increased, facilitating smoother and more secure deal-making processes. This mechanism supports both buyers and sellers in achieving their transaction objectives.

What is RWI Insurance?

Representations and Warranties (R&W) insurance is a type of coverage designed to protect against financial losses that may arise from unknown inaccuracies or breaches of statements made by a seller in a merger or acquisition agreement. These statements, known as representations, are factual assertions about the current state of the business being sold, intended to induce a buyer to enter the contract. Warranties are assurances that these representations are accurate and true.

The primary purpose of RWI is to allocate and mitigate risk related to these representations and warranties, protecting either the buyer or the seller. Before the widespread use of RWI, parties relied on escrow accounts, where a portion of the purchase price, typically 10% to 15%, was held back by the seller to cover potential post-closing claims. However, RWI has emerged as a more efficient and affordable alternative, especially for larger transactions, allowing sellers to receive their full proceeds more quickly.

Representations and warranties in M&A agreements cover various aspects of the target company. These typically include statements about the accuracy of financial statements, the existence and ownership of assets, and the absence of undisclosed liabilities. They also address compliance with applicable laws and regulations, the validity of material contracts, and the status of intellectual property.

The increasing demand for RWI has been influenced by a desire to streamline negotiations and provide certainty in M&A deals. It has become a standard tool, particularly in private equity transactions, where it is used in an estimated 75% of deals, and by larger strategic acquirers in about 64% of their acquisitions.

Key Elements of RWI Policies

RWI policies generally cover financial losses resulting from inaccuracies in the seller’s representations and warranties within the purchase agreement. Common areas of coverage include misstatements in financial reports, undisclosed tax liabilities, legal compliance issues, problems concerning material contracts, asset ownership, and intellectual property claims.

A primary element of any RWI policy is the “policy limit,” which represents the maximum amount the insurer will pay out for covered claims. This limit is frequently set at around 10% of the enterprise value of the target company or the assets being acquired. Another element is the “deductible” or “retention,” which functions similarly to a deductible in other insurance policies. It is the initial amount of loss the insured party must bear before the policy begins to pay. This retention typically ranges from 0.50% to 1% of the transaction price.

The “policy period” or “survival period” defines the duration for which the coverage remains active. For general representations, this period is often around three years post-closing, while for fundamental and tax-related representations, coverage can extend to six years. A “drop-down” in retention amount after the first 12 months is sometimes included, reflecting that many claims occur early in the policy’s life.

Like most insurance products, RWI policies contain specific exclusions. These commonly include issues or facts known to the buyer prior to closing, forward-looking statements, and certain specific liabilities such as known environmental issues or unfunded pension obligations. Fraudulent misrepresentations by the seller are also excluded from coverage. Specific exceptions or disclosures listed in the acquisition agreement’s schedules may also reduce the scope of coverage for those particular items.

RWI policies are structured as either “buyer-side” or “seller-side.” Buyer-side policies are the most common, naming the buyer as the insured party and providing direct recourse to the insurer for breaches. This allows the buyer to recover losses directly from the insurance carrier without pursuing claims against the seller. Conversely, seller-side RWI protects the seller by covering their potential liability for claims brought by the buyer alleging a breach of representations or warranties.

How RWI Insurance Facilitates M&A Transactions

RWI insurance provides a direct source of recovery for buyers in the event of inaccuracies or breaches of seller representations and warranties. This mechanism reduces the need for the buyer to rely on seller indemnification escrows, which traditionally tied up a portion of the purchase price. By shifting this risk to an insurer, buyers can secure a more robust financial backstop for potential post-closing issues. This approach also helps preserve ongoing business relationships with the acquired company’s management or continuing sellers.

For buyers, RWI offers recourse against a financially stable, highly-rated insurer, which can be more reliable than pursuing claims directly against a selling entity that may dissolve or have limited assets post-transaction. It also allows buyers to secure higher coverage limits and longer survival periods for representations and warranties than a seller might be willing to provide directly in the purchase agreement.

Sellers also gain advantages from the use of RWI, enabling a “clean exit” from the transaction. This means sellers can minimize or eliminate their post-closing indemnification exposure, allowing them to distribute sale proceeds more quickly and avoid contingent liabilities. The ability to release escrowed funds earlier or forgo an escrow entirely can improve the financial outcome for sellers. This can also translate into a higher purchase price in competitive bidding scenarios, as the buyer’s offer becomes more attractive.

RWI can bridge valuation gaps and overcome deal impasses that arise from differing views on risk allocation between buyers and sellers. By transferring the risk of unknown inaccuracies to a third-party insurer, RWI provides a solution that satisfies both parties’ risk appetites. This allows transactions to move forward that might otherwise stall due to disagreements over indemnification terms. In competitive auction processes, a buyer’s offer that includes RWI can be more appealing to sellers.

The Process of Obtaining RWI Insurance

Securing an RWI policy begins with the buyer’s initial contact with specialized insurance brokers who focus on transactional risk. The broker gathers essential information about the proposed transaction, including the target company’s financials and any available information memorandums. This information is then compiled into a submission for potential insurers.

Upon receiving the submission, insurers provide preliminary, non-binding indications of coverage, outlining potential premiums, retention levels, and any initial concerns. The next stage involves a detailed underwriting review, where insurers and their legal counsel meticulously examine the buyer’s due diligence materials. This includes reviewing financial audits, legal reports, tax analyses, and other relevant documents related to the target company.

The thoroughness of the buyer’s due diligence is important, as underwriters rely on this information to assess the risks. Following this review, negotiations take place regarding the specific terms of the policy, including the final premium, the exact retention amount, and any specific exclusions. Once all terms are agreed upon, the policy is bound, providing coverage for the transaction. The entire process, from initial submission to policy issuance, can be quick, sometimes completed within days once comprehensive due diligence is in place.