What Is R&W Insurance and How Does It Work?

What Is R&W Insurance?

Representations and Warranties (R&W) insurance is a specialized financial product common in business transactions. This insurance protects parties involved in mergers and acquisitions (M&A) from financial losses. This article explains its purpose, how it works, and its components.

What R&W Insurance Is

“R&W” stands for Representations and Warranties, which are statements of fact made by one party to another in a business transaction, particularly within mergers and acquisitions. These statements, often in a definitive purchase agreement, relate to the target company’s condition, covering aspects like its financial health, legal compliance, and operational status. Breaches of these statements can lead to significant financial liabilities.

R&W insurance serves as a financial safeguard against losses from inaccuracies or breaches of these representations and warranties. It acts as a risk transfer mechanism, shifting potential financial burdens from the seller, or sometimes the buyer, to an insurance carrier. This product offers a practical solution to manage post-closing risks in M&A deals.

The primary purpose of R&W insurance is to facilitate M&A transactions by allocating risk more efficiently. It helps reduce the need for sellers to provide large indemnity escrows or holdbacks, allowing them to receive more of their sale proceeds at closing.

The parties in an R&W insurance arrangement typically include the buyer (usually the insured party), the seller (whose representations are insured), and the insurance company. While both buyer-side and seller-side policies exist, buyer-side policies are more prevalent. These policies protect the buyer against losses if the seller’s representations prove untrue post-acquisition.

R&W insurance shifts financial risk from the seller to the insurer for certain post-closing breaches. This allows sellers a cleaner exit from their business, with less contingent liability. For buyers, the insurance provides an additional layer of recourse beyond the seller’s indemnity, offering a more reliable source of recovery for covered losses.

This insurance also provides a non-adversarial path for recovery should a breach occur, protecting the ongoing relationship between the buyer and seller. Instead of the buyer pursuing the seller directly, the buyer can make a claim against the policy. This is beneficial if the seller is an individual or a private equity fund that has distributed proceeds.

Key Policy Components and Coverage

An R&W insurance policy is structured with several components that define its scope. These policies typically cover breaches of fundamental representations, such as those related to due organization and authorization, as well as general operating representations, including financial statements, tax matters, compliance with laws, and material contracts.

Policy Limit

This represents the maximum amount the insurer will pay out for all covered losses. This limit is typically a percentage of the transaction value, commonly ranging from 10% to 20% for smaller deals and sometimes higher for larger transactions. It is agreed upon during underwriting, reflecting the perceived risk.

Retention

Often called the deductible, this is the initial amount of loss the insured must bear before the policy pays. The retention amount is typically a small percentage of the transaction value, often ranging from 0.5% to 1.5%. It ensures the buyer conducts thorough due diligence and avoids claims for immaterial breaches.

Policy Period

This defines the duration for which the policy covers breaches. This period aligns with the survival period of the representations and warranties in the M&A transaction agreement. General representations typically have a policy period of around three years, while fundamental representations might extend for up to six or seven years.

Breach Definition

The policy includes a Breach Definition, which specifies what constitutes an actionable breach. This outlines the conditions under which a claim can be made and paid. It clarifies that a representation or warranty was materially inaccurate or false at the time it was made or at closing, leading to a quantifiable financial loss.

Exclusions

R&W insurance policies contain Exclusions that specify types of losses or circumstances not covered. Common exclusions include known issues identified during the buyer’s due diligence that were not specifically covered. Other exclusions may involve forward-looking statements, specific indemnities provided by the seller outside the policy, or purchase price adjustments. Environmental liabilities or certain pension liabilities are sometimes excluded if better addressed by specialized insurance or deal terms.

Buyer-Side vs. Seller-Side Policies

The vast majority of R&W insurance policies are buyer-side. A buyer-side policy directly protects the acquiring company from losses resulting from a breach of the seller’s representations. This structure is preferred as it provides the buyer direct recourse against the insurer, avoiding the need to pursue the seller post-closing. Seller-side policies are less common and protect the seller from a claim made by the buyer, but are rarely chosen due to the seller’s preference for a clean exit and the buyer’s desire for direct coverage.

The Underwriting and Placement Process

Securing an R&W insurance policy involves a structured underwriting and placement process, typically managed by an R&W insurance broker. These brokers guide the buyer through the application, negotiation, and binding stages.

Application

The process begins with the buyer, often through their broker, submitting transaction documents to R&W insurance carriers. These documents include the draft acquisition agreement, financial statements, and due diligence reports (financial, legal, tax, environmental). This provides insurers with an understanding of the deal.

Underwriting Review

Insurers conduct an Underwriting Review of the submitted materials. Underwriters review the buyer’s due diligence findings to assess risks associated with the seller’s representations. Insurers rely on the buyer’s diligence efforts, as these reports form the basis for their risk assessment. Underwriters evaluate potential liabilities that could lead to future claims.

Insurer Questions and Buyer Responses

This review often leads to Insurer Questions and Buyer Responses. Underwriters pose specific questions or request additional information based on their review. The buyer, in consultation with advisors, provides responses and clarifications. This exchange helps the insurer refine their understanding of risks and allows the buyer to address concerns.

Policy Negotiation

Once the insurer understands the risks, Policy Negotiation begins. This involves discussions between the buyer’s broker and the insurer regarding policy terms, including the policy limit, retention, policy period, and any exclusions or enhancements. The negotiation aims to tailor the policy to the transaction and the buyer’s risk appetite. This stage also includes agreeing on the premium, which typically ranges from 2% to 4% of the policy limit, depending on transaction size and perceived risk.

Binding the Policy

The final step is Binding the Policy, which typically occurs concurrently with the M&A transaction closing. All parties agree on the final policy terms, the premium is paid, and coverage becomes effective. This ensures coverage is in place when representations become binding and risk shifts to the buyer. The entire process can take a few days to several weeks, depending on deal complexity and party responsiveness.

Policy Claims and Resolution

When a buyer discovers a potential breach of a representation or warranty after the M&A transaction closes, they initiate the notification process to the R&W insurer. This involves providing written notice to the insurer as soon as practicable after discovery. The notification includes a description of the alleged breach, the specific representation breached, and an initial estimate of the potential loss.

Investigation Process

Upon receiving notice, the insurer begins its investigation to evaluate the claim. This involves a review of the buyer’s notification, transaction documents, due diligence reports, and other relevant information. The insurer assesses whether the alleged breach falls within coverage, considering the policy limit, retention, and exclusions. They also verify the nature and quantification of the loss.

The insurer may request additional documentation or engage in discussions with the buyer to gather necessary information. This can include financial records, legal opinions, or expert reports. The goal is to determine the claim’s validity and the amount of covered loss.

Retention’s Role in Claims

The retention plays a role in the claims process, as the insured must first incur losses up to this amount before the policy pays. For example, if a policy has a $1 million retention and the buyer suffers a $1.5 million loss from a covered breach, the buyer bears the first $1 million, and the insurer covers the remaining $500,000, up to the policy limit. This ensures minor breaches are handled by the buyer and the insurer handles more significant losses.

Potential outcomes for a claim include full payment, partial payment, negotiation, or denial. If the insurer determines the claim is valid and covered, they typically pay the agreed-upon loss amount, subject to the policy limit and after the retention is satisfied. Negotiations may occur regarding the exact loss amount or policy terms. If a claim is denied, the insurer provides reasons based on exclusions or other terms.