The allocation of risk through representations and warranties and the accompanying indemnification obligations is a primary source of contention in almost every private merger and acquisition transaction. Buyers aim to negotiate an expansive indemnification package as a means to cover the majority of post-closing losses (and may seek an escrow to facilitate recovery). Whereas sellers seek to limit their post-closing indemnification exposure by narrowing the scope of the representations and warranties, negotiating for short survival periods and inserting indemnity deductibles, caps and other limitations.
Representation and warranty insurance helps resolve this conflict by, in exchange for insurance premiums, shifting a majority of the risk from the transacting parties to a third-party insurance provider.
Representation and warranty insurance comes in two flavors: seller-side policies and buyer-side policies. Seller-side policies are purchased by or for the seller, and coverage terms generally track the survival periods and indemnification cap outlined in the underlying purchase agreement. A seller-side policy reimburses the seller for losses it incurs if it has to pay the buyer for a breach of a representation or warranty.
Buyer-side policies are purchased by or for the buyer, with coverage terms potentially being extended beyond the survival periods and indemnification cap. Buyer-side policies are more common in transactions, as they allow coverage to extend beyond the contracted limitations agreed upon by the parties and may cover the seller’s fraud. These policies allow the buyer to recover its losses for breach of a representation or warranty directly from the insurer.
Representation and warranty insurance may not be suitable for every transaction. For example, insurance is generally not suitable for smaller transactions (e.g., transactions of less than $20 million), as the premium costs and other expenses quickly outweigh the benefits. Therefore, careful consideration should be given to the specifics of each individual transaction when considering representation and warranty insurance.
Common situations where representation and warranty insurance may be beneficial include the following:
Accordingly, with regard to your M&A transaction, consider whether representation and warranty insurance may be worthwhile.
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