What is Rep & Warranty Insurance and How Does it Work?

Representation and Warranty insurance, often colloquially shortened to Rep & Warranty insurance, is a type of insurance policy purchased in connection with corporate transactions, which covers the indemnification for certain breaches of the representations and warranties in the transaction agreements. This is designed to provide additional flexibility in addressing these obligations, for example, by reducing or eliminating the need for an indemnity escrow by the seller.

This type of insurance can be purchased either by the seller or the buyer. Seller-side coverage is a form of liability policy that covers the seller’s liability for claims of breach of the representation or warranty. Buyer-side coverage is a form of first-party coverage directly compensating the buyer for alleged breaches by the seller.

Finding an M&A Middle Ground

There’s normally a tug-of-war in merger & acquisition deals: buyers often want extensive reps and warranties where sellers want minimal reps and warranties. Buyers typically want to hold back funds and indemnity escrow in case of a seller breach of those reps and warranties.

The key point of negotiation of Representation and Warranty insurance is the number of limits and retentions. Limits are often set at about 10% of Enterprise Value, with retentions typically in the range of 1-3% of Enterprise Value. Premiums generally range from about 2-4% percent of limits. The responsibility for the amount within the insurance policy’s retention is often split between the parties in the form of the deductible in the transaction agreement.

Representation and Warranty insurance can also provide a mechanism for recovery whenever pursuing the seller is expected to be difficult. Some examples of this would be if there are multiple sellers, if there are foreign jurisdictions involved, or if there may be some insolvency concerns. Buyers should be aware, however, that Representation and Warranty Insurance does not provide as broad coverage as a seller escrow of the same size and so it’s not always an ideal replacement.

Rep & Warranty Insurance Limitations

While it has many uses, this type of insurance does not cover known breaches which must be disclosed. If the buyer, for example, has a particular concern about the way the seller has been handling the environmental issue, Rep & Warranty insurance – coupled with an environmental representation – is not a good solution in this case.

In addition, there are certain standard exclusions, such as asbestos or an unfunded pension liability, and the insurance company will perform a detailed underwriting process to determine whether these exclusions exist. During this process, they may add deal-specific exclusions directed at high-risk areas, like excluding environmental and product liability representations, or manufacturers of heavy equipment.

Therefore, to the extent that reps and warranties insurance is used to replace part of the seller’s escrow, the recovery available to the buyer will not be as broad. Rep & Warranty insurance also provides payment of a premium and upfront underwriting fee and will have a retention that leaves some of the risks on the buyer.

How Fast is the Rep & Warranty Process?

The underwriting process to purchase insurance can be as short as seven days, although the initial phase of the underwriting can start much earlier. A key issue for counsel is coordinating the retentions – definitions of loss in subrogation clauses in the Rep & Warranty Insurance to match those in the purchase and sale agreement – as well as the party’s intent as to the risk formed by each party in different situations.

At its heart, Rep & Warranty insurance is just like any other type of insurance – it offers additional protections to parties in a transaction and acts as a safeguard against possible liability or agreement infringement. Depending on the particular situation, Rep & Warranty insurance can even streamline the transactional process by avoiding an unnecessary escrow action.

However, purchasing this insurance is not always the proper approach. At Richards Rodriguez & Skeith, our business law attorneys specialize in corporate transactions, negotiate buyer/seller agreements, and advise on insurance decisions. Contact us today to discuss your company’s transactional and insurance queries.