The use of reps and warranties insurance has exploded, with the market for the liability policy growing roughly fourfold last year, but that rapid growth has left insurers struggling to keep up.
The market for R&W insurance, which covers a breach of a representation or a warranty in a purchase and sale agreement, has emerged as a sought-after term for sellers and an important tool for buyers looking to distinguish themselves in a competitive auction.
The market grew to some $12 billion in policy limits in 2014, up from just about $3 billion in limits two years prior, according to the best estimates of brokers trading in the policies. Given that policies, on average, cover about 10 percent of a deal’s enterprise value, that means roughly $120 billion worth of M&A transactions last year carried R&W insurance.
“Financial sponsors are always looking for the most effective and the most efficient way to use capital,” said Kirk Sanderson, vice president of transactional risk at insurance brokerage firm Equity Risk Partners. “And the most effective and the most efficient way to deal with indemnification and escrow is to outsource that risk with an insurance policy.”
As a result, insurance groups struggled to keep up with last year's record demand. The industry as it stands now only has about half a dozen key players — American International Group Inc., Allied World Assurance Co. Ltd., The Hartford Financial Services Group Inc., Ambridge Partners LLC and Concord Specialty Risk. And at the end of last year, the workload was so heavy that smaller deals were often brushed aside.
“Two years ago, supply outweighed demand, and on any particular deal you might get three to four quotes, with the insurers fighting hard to win good business,” said Jeremy S. Liss, a private equity-focused partner with the corporate group at Kirkland & Ellis LLP, one of the law firms brokers credit for the rapid rise of the R&W insurance industry.
“But the dynamic has shifted as more and more deals use the product, and the insurers are struggling to hire additional underwriters to keep pace with increased demand,” he said. “The process now takes a little longer, and the pricing is a little higher.”
Despite the delays, insurers are embracing their enhanced negotiation leverage to push back on some terms.
“There has been more focus on the sellers’ responsibility,” said Mark Thierfelder, chair of the global private equity practice and New York corporate and securities practice at Dechert LLP. “The insurers would prefer that the sellers have some skin in the game."
“At the end of last year, you began to see some insurers with respect to certain transactions focusing on a gap between the deductible in the purchase agreement and the retention under the policy in order to address the perception of moral hazard,” Thierfelder said.
Reps and warranties insurance as a product has existed for at least 15 years, but it is only within the past three years that the market for it has come into its own.
A major turning point occurred when, on selected deals, some insurers agreed to be silent on the type of damages that could be recovered, rather than explicitly excluding consequential, multiple-based and other similar damages, said Liss.
“Now it is at the point we are able to tell clients that if they buy insurance, they will get virtually the same — and sometimes better — terms as they would get from the seller,” he said.
A strong sellers’ market has helped the product grow, but experts agree that now use of the insurance has reached a point where it should be able to continue even without a strong sellers’ market.
“I find that after a client uses the product once, they are going to use it again,” said Craig Schioppo, a managing director with the transactional risk insurance group at Marsh USA Inc., one of the industry’s top brokerage firms.
The benefits to buyers and sellers alike are just too strong. For buyers, the appeal comes from a broader set of representations, a broader indemnity and a longer survival period — terms sellers negotiate fiercely if they are on the hook for violations of representations and warranties, as is the case when insurance isn't in play.
For sellers, insurance grants access to all sale proceeds at once, which allows sellers to avoid the huge opportunity cost that comes with leaving a sizable chunk of the profits tied up in escrow — which typically only yields the current going bank interest rate. With interest rates currently sitting at about 0.25 percent, that appeal is particularly strong.
Since insurance replaces the need for a third-party escrow account, the seller can take that money and reinvest it elsewhere for a higher rate of return, or it can make investors happy by returning greater profits all at once.
“The ability to reinvest that capital and to return capital to investors is very valuable,” Sanderson said. “If private equity firms aren’t returning at least 10 to 15 percent on their money, they view it as losing money. That’s the opportunity cost.”
Moreover, buyers and sellers that frequently work together are able to avoid acrimony in the event an issue does arise, with claims going to the insurer rather than the counterparty.
But for the industry to be able to maintain its current rate of growth, insurers are going to need to be able to keep up.
What the industry needs now is more overall capacity to write greater aggregate limits of liability, and more manpower to keep up with the need to write more policies, experts agree.
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