Representations and Warranties Insurance: What Is It and Why Would You Need It?

Parties utilize representations and warranties as a core component of merger and acquisition agreements to ensure that they have a clear understanding of the risks involved in acquiring a business from a seller or target company. Representations and warranties insurance is utilized to protect both buyers and sellers from inaccuracies in those representations and warranties. In many instances, management is not aware of those inaccuracies when transaction documents are executed or are aware of potential issues, but not necessarily the likelihood or magnitude of the risk. The presence of representations and warranties insurance can facilitate negotiations of agreements where indemnification obligations can become a sticking point in discussions between the parties and can provide comfort to both sides.

Sellers can be more certain of retaining the proceeds they receive from a sale. They may be able to reduce or eliminate escrows of proceeds. Sellers are indemnified by the insurance company for defense costs and losses resulting from successful claims.

Buyers receive the comfort of having a source of recovery if problems arise. In particular, buyers may be able to obtain relief directly from an insurance company without having to pursue the seller.

Originally, representations and warranties insurance was perceived as prohibitively expensive when it was introduced in 1997. Now, that perception has changed, and many entities commonly utilize representations and warranties insurance as an essential part of every transaction. The sweet spot for insurance is generally for deals in the $20 million to $1.5 billion range, although we recently found insurance to be a viable option in a $10 million transaction. Premiums are usually in the two to four percent range for each dollar of coverage, but the premium costs can vary. Buyer policies are generally more expensive because the seller is deemed to have more information in its possession and provides less risk of a breach.

Once a decision has been made to acquire a policy, care must be taken to carefully examine and understand the scope and exclusions of the policy. For example, seller policies typically exclude coverage for fraud whereas buyer policies do not. Policies also include a deductible in the one percent to high three percent range. Minimum premiums range from $75,000 to $150,000. The underwriting fee to an insurance company can start in the $15,000 to $25,000 range to conduct appropriate due diligence. Approximately seven to ten insurance companies currently provide representation and warranties insurance.

Whether you are a purchaser or a seller, it is important to understand the benefits and risks associated with representation and warranty insurance. The availability of such insurance may mean the difference between closing a deal or not, and if it closes, being able to eliminate much of the uncertainty that often follows the end of a transaction.