R&W Insurance: A Victim of Oversaturation, Expanded Coverage, and Underpricing

I pioneered the representation and warranty (“R&W”) insurance business in the early 1980’s by responding to private equity asset sellers and their large law firm counsel, seeking an insurance solution to eliminate the seller escrow holdbacks required by acquirers to assure cash was available to compensate for breaches of seller R&W in the sale transaction, thus preventing a full cash distribution of sale proceeds. The alternative was a deep buyer discount to the cash purchase price in exchange for the buy-side cost of the R&W policy.

I was prepared, for the sake of getting through the purchase and sale transaction, to substitute a seller escrow with a sell-side R&W policy. In the event that the seller was unwilling to absorb this cost, a buyer-side R&W policy whose expense the buyer could discount from the purchase price transaction could be used.

I was not willing to undertake this facilitative solution that enabled purchase and sale consummation without due diligence. I would always charge the due diligence expense to the buyer of the R&W policy; first, to gauge the seriousness of the buyer’s intent and, second, to support the due diligence review of the R&W with the prospective buyer or seller insured, and their outside counsel, who negotiated the R&W prior to deal closure. 

I would insure specified representations enumerated in the purchase and sale agreement, and incorporate them numerically in the agreement to the manuscripted R&W policy. Those representations typically included WARN Act representations for employees being laid off, environmental representations, property representations, civil litigation representations, identity and salary representations for employees staying with company post-acquisition, leasehold representations on leased property, welfare benefit plan representations, intellectual property representations, tax representations, and occasionally, specified income statement representations–to name a few.

As private equity acquisitions and sales of private company assets accelerated beginning around 2014, I was very careful about underwriting financial and income statement representations. I also underwrote numerous R&W deals originating in London, Italy, Norway, and Guernsey Island—all of which resulted in no claims.

Up until about 2016, I would get a 10% rate on line for traditional non-financial representations, commonly referred to as “fundamental representations,” with occasional income statement line item representations. For example, if I wrote a policy for $20 million dollars I would collect a $2,000,000 premium plus a $50,000 front-end due diligence and legal fee. That way, even if a prospective insurance purchaser walked away from the deal, my costs and expenses were covered.

Both types of deals, sell-side and buy-side, were treacherous but became even more so as insurance providers looked for new products that could fuel top line growth. In that regard, there was the never ending quest by brokers to reduce premiums, increase commission paid, and broaden coverage–paired with market receptivity to these overtures, fueled by over capacity and competition.

What became commonplace was for insurance companies and transactional liability specialists to bolt on Managing General Agents (“MGAs”) to cover more line item income statement representations, and to compound this expansion of coverage by providing coverage to aggregate income statement losses subject to EBITDA multiples. This effectively allowed for a post-purchase price adjustment at the expense of the R&W insurer all for a premium of 2% of the purchase price, no due diligence fee, higher brokerage commissions. 

At the same time, due diligence was increasingly performed by newly minted underwriters out of law school with no background in the business, at significant unallocated cost to the insurer. Unlike allocated costs such as defense fees, those costs cannot be passed on to reinsurers because they are a cost of doing business.

In any event, what I used to do as a one person business is now being done across an industry of hundreds of people at enormous cost, with expanded coverage, higher commissions, and deteriorating loss results.

If you write a seller-side policy with these expanded coverage terms, you are incentivizing the seller to stretch the truth in its income statements to achieve a higher sales multiple in a private company sale transaction, at the expense of the R&W insurer.

The buy-side transaction may be even more challenging since it is a first-party product with a proof of claim policy that has a very tight response triggers and claim personnel who may not be adequately trained to handle these complex financial accounting losses. These include understatements of liabilities, costs, and inventory obsolescence, and overstatements of income. 

Each of these line items is payable as a loss if proven and that is further exacerbated by paying the aggregated line item income statement delta between what was represented at sale and the delta based on damage calculation multiplied by the 11-15 time EBITDA net income multiple during the acquisition frenzy.

I am available to assist on either side of the transaction as an experienced, trial-tested, and court certified expert.