What Is Reps and Warranties Insurance?

Representations and warranties (R&Ws) are key elements in mergers and acquisitions (M&A), allocating risk between buyer and seller. These statements of fact about the target company, made by the seller, are relied upon by the buyer. Breaches can lead to financial losses. R&W insurance is a specialized product mitigating risks from these assurances. It safeguards both parties by providing direct recovery for R&W inaccuracies or breaches.

Understanding Reps and Warranties Insurance

Reps and warranties insurance is a specialized policy protecting buyers or sellers in M&A from financial losses due to inaccuracies or breaches. It transfers breach risk to an insurance carrier. This facilitates M&A by bridging valuation gaps and reducing large indemnity escrows. Sellers gain a cleaner exit, freeing up proceeds post-closing.

For buyers, R&W insurance offers greater protection than seller indemnity, with higher recovery caps and longer claim survival periods. Sellers limit their post-closing indemnity exposure, allowing faster, more certain proceeds distribution. It makes deals more attractive, providing strong protection for unforeseen liabilities. It shifts disputes into claims against an insurer, simplifying the post-closing process.

In M&A, “representations” are statements of past or present fact made to induce a contract, like financial statement accuracy or undisclosed liabilities. Conversely, “warranties” are promises that certain facts are true; if untrue, the warrantor compensates for damages. For example, a seller might warrant ownership of intellectual property or compliance with laws. A breach occurs when a statement proves untrue or misleading post-closing, harming the buyer.

Key Components of a Policy

A typical R&W insurance policy includes several elements defining its M&A scope. Policyholders are usually buyers, benefiting from seller R&Ws. While seller-side policies protect sellers from indemnity claims, buyer-side coverage is more common, providing direct recourse against the insurer for losses.

The policy limit defines the maximum amount the insurer pays for losses. Negotiated based on transaction size and risk, it often ranges from 10% to 30% of the acquired company’s enterprise value. For example, in a $100 million transaction, the policy limit might be $10 million to $30 million.

Retention, also called the deductible or threshold, is the initial loss the insured bears before payout. It often mirrors the seller’s indemnity cap or is a percentage of transaction value, commonly 0.5% to 1.5% of deal size. Once losses exceed this, the insurer covers the remainder up to the policy limit.

The policy period specifies the duration of coverage, aligning with the R&W survival period in the M&A agreement. It generally extends for years post-closing: often three for general R&Ws, and up to six or seven for fundamental R&Ws like title to shares or tax matters. This ensures coverage matches supported contractual obligations.

The premium is the policy cost paid by the insured. It is typically a percentage of the policy limit, often 2.5% to 4% for a standard policy, varying by industry, risk, and market conditions. For example, a $10 million policy limit might incur a premium of $250,000 to $400,000.

Insurance brokers specializing in M&A help clients navigate the market, structure coverage, and negotiate terms with insurers. Underwriters assess transaction risks, evaluating diligence materials. They decide policy issuance and terms, determining premium, retention, and exclusions based on risk.

What the Policy Covers

Reps and warranties insurance policies cover financial losses from unintended breaches made by a seller in M&A. Common R&Ws insured relate to financial statement accuracy, tax compliance, contract validity, legal adherence, and intellectual property. Coverage also extends to environmental matters, employee benefits, and litigation. For example, if a company’s financial statements overstated revenue, leading to a buyer’s loss, the policy generally covers it.

However, these policies contain common exclusions limiting coverage. Forward-looking statements or projections, being uncertain, are generally not covered, as they are not facts. Purchase price adjustments, like working capital true-ups, are typically excluded; these settle the final deal price, not R&W breaches. Covenant breaches (promises to perform actions post-closing) are not covered, as the policy focuses on past or present facts.

Known issues disclosed by the seller before policy inception are excluded. Insurance covers unknown, unexpected breaches, not risks already known and priced into the deal. Policies may exclude highly specialized or risky areas, such as environmental liabilities, pension underfunding, or identified litigation risks deemed too high to insure. For example, if a company faces a significant lawsuit, the policy likely excludes coverage for that litigation.

Policies generally do not cover seller fraud, but some may provide “synthetic fraud” coverage for buyer losses if the buyer was unaware at closing. This allows buyer recovery from the insurer without directly pursuing the seller. Coverage scope and exclusions are negotiated and outlined in the policy, reflecting each transaction’s unique risk profile.

Obtaining Reps and Warranties Insurance

Securing an R&W insurance policy involves a structured process beginning early. The initial step involves contacting an R&W insurance broker, who guides parties through the market and tailors coverage. The broker acts as an intermediary, leveraging expertise to solicit competitive bids.

Once engaged, the underwriting process begins, requiring extensive information for insurers. This includes the draft purchase agreement and disclosure schedules detailing exceptions. Insurers require access to buyer due diligence reports, like financial, legal, tax, and environmental assessments, to evaluate underlying risks.

After initial review, insurers provide indicative quotes and non-binding offers, outlining terms, pricing, and exclusions. These quotes allow deal parties to assess coverage viability and cost-effectiveness. As the transaction progresses, the insurer conducts focused due diligence of documents and reports, often calling the buyer’s deal team and advisors to clarify information and address concerns.

After the insurer’s due diligence, a negotiation phase occurs where final policy terms, exclusions, retention, and premium are finalized. This negotiation is often iterative; the insurer provides a final binding quote once information is reviewed and questions addressed. The policy is formally bound, typically at or just prior to M&A closing, ensuring coverage for deal completion.

If a covered R&W breach is discovered post-closing, the policy outlines a claims process. The insured notifies the insurer of the claim, providing documentation to substantiate the loss. The insurer assesses the claim based on policy terms, and if valid, pays out losses, providing financial recovery.