A representation is a statement made in an insurance application that the prospective insured represents as true to the best of his or her knowledge.
What is the difference between warranty and representation in insurance?
When merging two enterprises, both the seller and the buyer are most satisfied when everything goes as planned. Hiccups in mergers and acquisitions (M&A) are not unusual, though. In some cases, the buyer may learn that the seller failed to disclose critical facts about the company. The buyer may opt to seek compensation in this instance. In contrast, the seller may believe that the buyer is demanding too much money as a result of the seller’s failure to reveal critical facts, and that the process is taking much longer and longer than expected.
A breach of representation or warranty can be controversial, costly, and time-consuming to resolve. Representation and Warranty Insurance can help both the buyer and the seller by covering costs and preventing legal problems.
What are Representations and Warranties?
The term “representation” refers to any representations made by the seller prior to entering into a sale agreement on which the other party is expected to trust. Consider the following scenario: “Last year, our company produced a profit of $25 million.” A warranty ensures that the representations are accurate. Consider the following scenario: “Last year, our firm produced a $25 million profit, and if I’m wrong, I’ll refund you.” Both the buyer and the seller are expected to disclose pertinent facts and make representations in mergers and acquisitions. Both parties may be held accountable for erroneous representation or breach of warranty if one of them misrepresents or fails to provide important information.
- You operate a huge beverage company and want to buy a smaller soft drink firm. A special crystal-clear soda that tastes like lemonade generates 90% of the sales for the smaller company. They pledge to provide the well guarded secret recipe to you as the new owner, allowing you to continue manufacturing it and running your business as usual. Everything appears to be fine after the sale is completed. Customers begin to complain that the unusual crystal-clear lemonade soda tastes different after your first batch ships, and you fear you were not given the exact recipe. Consumers say they won’t buy the beverage any longer, resulting in a decline in sales. You file a lawsuit against the soft drink company’s seller for violation of warranty and representation.
What is Representation and Warranty Insurance?
In mergers and acquisitions, Representation and Warranty Insurance is used to safeguard against damages and losses resulting from seller breaches of warranty or erroneous representation. Policies can be acquired by the buyer, seller, or both parties, and most buyer-purchased policies provide coverage for the seller as well. Representation and Guarantee Insurance provides monetary compensation to buyers for losses resulting from a seller’s breach of representation or warranty. Representation and Warranty Insurance covers the seller’s liability and may lessen or eliminate the need for an escrow.
Previously, the buyer in an M&A transaction had to rely on money that had been set aside in escrow. In extreme circumstances, the buyer personally bargained with or sued the seller after the transaction was completed. After the merger or acquisition is completed, Representation and Warranty Insurance considerably lowers the need for the buyer or seller to seek legal action against one another. As a result, both parties will have a smoother leave.
Representation and Warranty Insurance vs Traditional Escrow Process
Companies are increasingly turning to Representation and Warranty Insurance as an alternative to the usual escrow process in mergers and acquisitions. In a classic escrow arrangement, a portion of the M&A purchase money is held back for a period of time to ensure that the seller performs all of the selling agreement’s responsibilities and commitments. Buyers and sellers can avoid this process by purchasing Representation and Warranty Insurance, which pays the seller 100% of the purchase price when the sale closes and transfers liability to the insurance company.
- If the buyer discovers a breach of warranty or an erroneous representation after the merger or acquisition is completed, the seller promises to reimburse the buyer.
- The buyer puts aside 10-15% of the total purchase price and provides it to a third party (known as “escrow”). When the contract is completed, the seller receives only 85-90 percent of the agreed-upon final price.
- The escrow funds are used to compensate the buyer for any damages or losses incurred as a result of a breach of warranty or inaccurate representation. After an agreed-upon length of time, usually 12 to 24 months, if there is no breach of warranty or inaccurate representation, the seller receives the remaining 10-15% of the agreed-upon purchase price.
There are frequently exceptions and limitations in the form of caps, time limits, and exclusions (for example, your company must declare a breach of warranty within two years of the contract and can only receive $3 million).
- Your startup is acquired by a much larger software firm. They opt for a typical escrow process to finalize the purchase. Your smaller company receives a $10 million payment from the larger corporation. The larger business sets aside $1 million as an escrow holdback from the sale as part of the sales procedure. When the deal is completed, your company receives just $9 million of the $10 million that was promised. After two years have passed and the larger firm has determined that there has been no breach of warranty or inaccurate representation, your startup will receive the last $1 million it is owed. You and your co-founder want to put this money into new businesses, but you can’t since $1 million is in the escrow holdback account.
In some situations, the buyer has the ability to seek compensation in excess of the escrow amount. This means that the seller is still liable and may be required to work with the buyer years after the merger or acquisition is completed. This is a significant disadvantage for many sellers, and it is one of the reasons why Representation and Warranty Insurance has grown in popularity in recent years. When organizations have Representation and Warranty Insurance, the insurer assumes all payment and obligation, and sellers can collect 100 percent of the agreed-upon purchase price at the closing of the agreement.
Benefits of Representation and Warranty Insurance for Buyers
The buyer is usually the party in an M&A deal with the most to benefit from R&W Insurance. The following are some of the advantages of Representation and Warranty Insurance for the buyer:
- Improved security and coverage – Rather of relying on the seller in the event of a breach of warranty or misrepresentation, consumers can be paid through a reputable insurer. Given that the liability is being assumed by an insurer, sellers may also be more prepared to provide larger warranties and representations.
- A seller may be more likely to pursue a contract with a buyer who provides lower or no escrow or holdback since the seller will be able to earn a higher percentage of the purchase price at deal closing.
- More time to find problems R&W Insurance extends the time buyers have to find faults, frequently beyond the two-year maximum that is typical of escrow.
Benefits of Representation and Warranty Insurance for Sellers
- Clean departure By removing escrow or a holdback, sellers can get the cash of a sale immediately after it closes, avoiding any post-closing liabilities.
- R&W Insurance can cover the costs of defense and settlement in the event of an unforeseen difficulty, such as a breach of warranty.
- Passive seller protection R&W Insurance can shield any minority or passive investor who was not in direct control of the business but may be liable under joint and several liability.
Limitations of Representation and Warranty Insurance
Though Representation and Warranty Insurance might provide additional protection for your company, it does have limitations. Standard exclusions for Representation and Warranty Insurance include the following:
The duration of most policies is between three and six years. This is, however, a longer term than the usual escrow method’ customary indemnification period.
How much does Representation and Warranty Insurance cost?
A deductible or self-insured retention is usually included in Representation and Warranty Insurance policies. While the amount varies based on the risk of the transaction, it is typically between 1% and 3% of the total transaction price.
The premium is determined by the risk assessment of the insurer, the coverage limit, the length of coverage, and the deductible or retention amount. Most insurance firms charge between 1.5 and 3.5 percent of the coverage limit, and the premium is normally paid once for the duration of the policy.
If the policy’s coverage maximum is $20 million, for example, the premium will range from $300,000 to $700,000. Premiums are usually set at a minimum of $150,000. The coverage of most insurance is typically 10% of the total purchase price.
Final Word
Representation and Warranty Insurance is a tempting alternative to standard escrow in M&A transactions. As a purchaser, you are effectively acquiring a warranty or representation protection plan backed by a recognized insurance. You can also skip escrow and obtain full money at the time of closing as a seller. R&W Insurance has grown in popularity in recent years, and as it grows in popularity, premiums will continue to fall. You should think about Representation and Warranty Insurance if you’re purchasing, selling, or combining a private firm.
What is representations & warranties insurance?
“Representation & Warranty Insurance” (“R&W Insurance”) is a form of insurance policy obtained in conjunction with corporate transactions that covers indemnity for specific violations of the transaction agreements’ representations and warranties.
It is intended to give the Seller more flexibility in dealing with these commitments, for example, by lowering or removing the requirement for an escrow.
R&W Insurance is growing increasingly popular, and the amount of R&W Insurance sold has expanded dramatically in recent years. According to one estimate, it is now utilized in 20-25 percent of private transactions in the United States.
R&W Insurance is available as Buyer Side or Seller Side coverage. A liability policy that covers the Seller’s liability for allegations of breach of representation or guarantee is known as Seller Side coverage. Buyer Side Coverage is a type of first-party coverage that compensates the Buyer directly for alleged Seller breaches. A Buyer Side policy that also protects the Seller is a frequent variety (by barring the insurance company, except in cases of fraud, from pursuing the Seller after it makes a payment to the Buyer for a breach). This variation is frequently used to decrease a Seller’s escrow or other liability to representation and warranty claims while still allowing the Buyer to collect in the event of a breach.
The size of the limits and retentions is a major subject of negotiation for R&W Insurance. Limits are frequently established at 10% of enterprise value, with retentions ranging from 1-3% of enterprise value. Premiums typically vary from 2% to 4% of the policy limits. The responsibility for the amount within the retention of the insurance policy is frequently split between the Buyer and the Seller in the form of a deductible in the transaction agreement.
R&W Insurance can help a buyer in a variety of ways. It can make a bid more appealing in an auction setting by lowering the Seller escrow while still offering Buyer security. The Buyer can obtain insurance to cover bigger amounts and longer survival periods than the Seller is willing to accept (generally 3 years for general representations and 6 years for fundamental and tax representations). When chasing the Sellers is considered to be difficult (for example, if the Sellers are numerous, in foreign countries, may be insolvent, or have remained in the target’s management), R&W Insurance can provide a vehicle for recovery.
However, buyers should be advised that R&W Insurance does not give the same level of coverage as a Seller escrow of comparable size, and hence is not a suitable substitute. R&W Insurance does not cover known breaches (which must be declared), thus if the Buyer is concerned about the Seller’s handling of a tax issue, R&W Insurance in combination with a tax representation is not the answer. There are also some basic exclusions (such as asbestos and underfunded pension liability), and the insurance firm will conduct a thorough underwriting and may add deal-specific exclusions aimed at high-risk areas for the target (for example, excluding environmental and products liability representations for a manufacturer of heavy equipment). An escrow’s indemnification can cover more than just breaches of representations and warranties; it can also include breaches of covenants and specific indemnities, which would be excluded from an R&W Insurance policy. As a result, to the extent R&W Insurance is used to replace part of the Seller’s escrow, the Buyer’s recovery will be limited. The insurance also requires a premium payment and an upfront underwriting cost, as well as a retention that places some risk on the Buyer.
R&W Insurance is frequently utilized to decrease or eliminate the requirement for a Seller’s escrow, allowing more of the earnings to be distributed sooner. It can give the Seller a smoother departure with less contingent liabilities. It could also be purchased to safeguard a non-controlling passive or minority investment.
The underwriting procedure for R&W Insurance can be completed in as little as seven days, while the beginning stages of the process can begin considerably sooner. Working with an insurance broker to submit basic information and drafts of the transaction documents to one or more insurance firms is the initial stage of the procedure. After that, the insurance firms submit non-binding indications of the coverage they are willing to supply, along with premium estimates. If the parties agree to proceed, the insurance company will charge a non-refundable underwriting fee (typically between $15,000 and $40,000) to conduct its due diligence. The insurance firm will give a draft insurance policy when it has completed its due diligence, and this is often followed by some coverage negotiation.
The coordination of the R&W Insurance retentions, definitions of loss, and subrogation clauses to match the purchase agreement and the parties’ intent as to the risk assumed by each party in different situations is a critical problem for counsel. Counsel can also assist in fighting back against the insurance company’s deal-specific exclusions in order to restrict or eliminate them. Other aspects of the policy could be up for discussion as well.
Environmental impairment liability plans, political risk policies, and policies that cover failure to qualify for expected tax or regulatory treatment are all examples of transactions that may require additional types of insurance. In addition, an M&A transaction may have a variety of effects on the target’s current or historical insurance program. A Few Things You Should Know About Insurance and M&A Transactions is a good place to start.
What does a representation in an insurance contract qualify as?
An implied warranty is a representation made in an insurance contract. The phrase “rescind” refers to the act of terminating or voiding a contract.
What is the difference between a representation and concealment?
A negative act is the failure to do anything that is necessary, but representation is a positive act when the insured volunteer such details. Concealment normally occurs before the insurance contract is written, whereas a representation may be made at the time of the contract’s issue.
What is a representation in an agreement?
A representation is a statement of fact that is true on the day it is made and is used to persuade another party to enter into a contract or take another action. A warranty is a promise of compensation if the claim is proven to be false.
What happens if a representation is breached?
In the event of a breach or inaccuracy, the representations and warranties apportion risk between the parties and serve as the foundation for an indemnity claim. A breach or inaccuracy of a representation or warranty might also provide the opposite party the right to cancel the transaction or refuse to close it.
What are representations and warranties M&A?
In the realm of M&A, each party to a purchase agreement makes specific statements and warranties that serve as a basis for post-closing indemnification responsibilities and risk allocation. There are functional differences between a representation and a warranty, despite the fact that they are sometimes used interchangeably. A representation is a statement of past or current reality made by one party to persuade another to enter into a contract. A warranty is a promise that a statement of existing or future facts is or will be true, as well as an implied promise of indemnity if the statement is untrue.
Representations and warranties are frequently the most highly negotiated aspects of a contract. The amount and kind of representations and warranties are unique to each party, the contract’s nature, and the contract’s or interactions’ subject matter.
The representations and warranties made by a vendor serve a number of functions. They contain significant information regarding the stock or assets being sold, provide a basis for the buyer’s right to cancel before or at closing, and affect the buyer’s entitlement to indemnification by the seller and/or its principals. Depending on numerous criteria, including as each party’s negotiating position, the nature of the transaction, and the trade in which the parties operate, representations and warranties could favor either a buyer or a seller.
Standard representations cover due organization, legal existence and good standing, capacity and authorization to manage the business and enter into the agreement, and legal compliance. Other representations and warranties pertain to the agreement’s subject matter, including asset title, liens and encumbrances, intellectual property rights, taxes, and litigation. Rather of removing all claims and warranties (which will almost certainly raise red flags with the opposing side), a seller should try to qualify its representations and warranties. This can be done in a number of different ways.
Because it is not always possible to account for every single item that should be listed in an agreement, a seller may try to limit representations and warranties to only apply to “material” things and matters, and to add “knowledge” standards to limit the statement of fact to things that the seller actually knows about or should have known about. Another alternative is to limit the applicability of representations and warranties to specific time periods (for example, “during the last three years”). Most crucially, a seller should disclose as many exceptions to facts or conditions that are inconsistent with any related claim or warranty’s general statement of fact. This decreases the risk of future claims of violation of representations and warranties based on material condition non-disclosure. The seller can also propose a combination of the above notions. To avoid making an absolute statement of fact, a representation and warranty involving litigation and other actions could include language like “xcept as set out on Schedule X.XX, there are no pending, and to seller’s knowledge, threatened lawsuits, actions or other proceedings or governmental investigations relating to the eller’s properties or business.”
A buyer, on the other hand, wants the seller’s representations and guarantees to be as wide and unqualified as feasible. Broader representations and warranties often require a seller to provide more information during contract discussions and due diligence, and can offer a stronger foundation for the buyer’s post-closing termination and indemnification rights. The buyer can also use disclosure schedules to compel a seller to disclose certain critical business items, such as required permits, third-party consents, and employee benefit and compensation information. The buyer can use the disclosure schedules as a checklist of items to track and accomplish leading up to closing by forcing the seller to list these types of items. When the signing and closing dates are not the same, a buyer will want to include a “bring down” condition in the representations and warranties to ensure that the seller’s representations and warranties established at the signing date are still true and valid at the closing date.
Representations and warranties can be as complicated or as straightforward as the parties agree, but they are frequently the legal basis for the parties’ desire to execute an M&A transaction.
Our legal team has extensive experience on both the buy-side and sell-side of M&A transactions in a variety of industries, including healthcare, technology, real estate, and retail. Learn more about mergers and acquisitions on our Mergers and Acquisitions page.
What is M and A insurance?
M&A Insurance, also known as Transactional Risk Insurance, is a package of protections meant to assist both buyers and sellers in reducing risk and completing a transaction. Buyers and sellers, for example, are frequently concerned about the influence of contractual guarantees, taxes, and ongoing litigation on a merger or acquisition.
HUB can provide a customized M&A Insurance solution to address these concerns and give you the peace of mind you need to move forward with your discussions.
When referring to an insurance contract when must a representation be made?
Because representations are oral or written assertions made at the time of application or before the policy is issued, they can only be withdrawn or changed before the contract is issued.