Legal Insights
Our September 2024 overview, “Closing with Confidence: Representations and Warranties Insurance in M&A,” introduced the mechanics of representations and warranties insurance (R&W), including its policy types, coverage framework, and economic features. This DE Insight builds on that foundation by examining the practical considerations that determine whether, and how effectively, R&W insurance serves the parties in a given transaction. While R&W insurance can facilitate cleaner exits, reduce escrow friction, and provide additional recourse for certain breaches, it is not a one-size-fits-all solution, and it should not be a substitute for careful legal diligence, drafting, and negotiation.
What Role Does R&W Insurance Play in a Transaction?
R&W insurance is a type of transactional risk insurance available in two primary forms: buy-side policies and sell-side policies. Although policy structure, premiums, retentions, underwriting costs and typical coverage ranges are important threshold considerations, a policy’s practical value often depends on how well it is coordinated with the transaction documents and on the role counsel plays throughout that process. The policy does not replace the purchase agreement, and the purchase agreement remains the foundation for determining what representations were made, what risks were disclosed, and what losses may be recoverable. Counsel is therefore essential in drafting and negotiating the representations, reviewing the disclosure schedules, and ensuring that the insurance coverage aligns with the actual risk allocation negotiated by the parties. Some key considerations for clients considering R&W insurance are: whether the risks are insurable, whether R&W insurance premiums and terms are commercially reasonable for the client’s transaction, and whether practical benefits of the R&W insurance policy are worth the economic costs and extended due diligence and underwriting process.
Insurable vs. Non-Insurable Risks in M&A Deals
Not all risks are insurable. Each transaction carries its own risk profile, and insurability will depend on each deal’s individual specificities. Although R&W insurance commonly addresses categories such as financial statement errors, undisclosed liabilities, IP claims, tax matters, and material contract issues, the practical scope of coverage is shaped by the depth of diligence, the quality of the disclosure schedules, and the precision of the representations in the purchase agreement. In each transaction, covered representations may also extend to labor disputes, noncompliance with laws, lost or altered customer and supplier contracts, building and major equipment condition, and environmental problems.
However, R&W insurance does not cover known material issues that are uncovered during the due diligence process, issues of which the buyer’s deal team had actual knowledge, purchase price adjustments and forward-looking representations and warranties, or breaches of covenants in the purchase agreement, such as the requirement to pay off company indebtedness as of closing. Sellers will typically remain liable for claims related to these items, including a portion of a claim for breaches of fundamental representations that is greater than policy limits.
Counsel helps clients distinguish between risks that may be insurable and risks that must be addressed elsewhere in deal documents, whether through special indemnities, escrows, purchase price adjustments, closing conditions, or other negotiated protections.
Deal Size and Economics of Coverage
Not every deal will benefit from R&W insurance. In some deals, the costs of the policy, the underwriting process, and the scope of exclusions may outweigh the practical benefit of obtaining coverage. The deal economics should be evaluated contextually. Premiums, retentions, policy limits, broker fees, diligence costs, and the overall size of the transaction all affect whether coverage is commercially reasonable.
R&W insurance may not be worth it when diligence has been weak or rushed. Particularly when diligence is disorganized or highly compressed, then the insurance carrier may narrow coverage, add exclusions or price the risk less favorably. If a transaction has too many exposure areas that an insurer may carve out, then buyers may pay for a policy that is not useful. Where the parties are comfortable with a traditional indemnity structure, and there is no pressure for a clean exit, R&W insurance may not be cost effective.
Counsel can assist clients in deciding whether the policy will meaningfully improve the parties’ risk allocation, or whether it will simply add to the cost and complexity of the deal. In smaller deals, this analysis is paramount, where indemnity protections alone may be justifiably more efficient than purchasing an insurance policy.
The Practical Benefits and Boundaries of R&W Insurance
Buyers and sellers both benefit from the inclusion of R&W insurance. Buyers can avoid litigation in the event of a breach of representations, distinguish their bid in an auction, and receive more protection than a traditional seller indemnity. Sellers can benefit by limiting the amount of money held in escrow, having a clean exit, and funding greater distribution to selling partners at closing, which often benefits minority owners more than majority owners. Additionally, having R&W insurance can bridge contract negotiations between the buyer and seller.
While both parties may obtain benefits from the addition of R&W insurance, the benefit will only make a meaningful difference if the policy is coordinated with the transaction’s documents. Counsel will ensure that the transaction documents and policy are in harmony with one another, so that their client is not expecting an outcome that was not properly represented in the policy.
Where Does Counsel Add Value?
Legal counsel should guide your process. Counsel is particularly important during the due diligence process, as underwriters will scrutinize the depth and organization of the buyer’s review when determining the scope of coverage. A well-organized diligence review can support broader coverage, while an ineffective due diligence review may result in exclusions, higher premiums, or limited protection. Counsel can assist with coordinating the underwriting process, identifying exclusions and coverage gaps, and ensuring alignment with the purchase agreement. However, R&W insurance cannot erase transaction risk entirely. All policies contain exclusions, underwriting limitations, retention amounts, survival considerations, and claims procedures that must be understood in the context of the broader deal.
Even when R&W insurance is obtained, the purchase agreement is still the guiding principle for the parties’ risk allocation. Counsel must consider how the policy interacts with the representations, indemnity provisions, survival periods, escrows, carveouts, disclosure schedules, and closing conditions. If the agreement and the policy are not aligned, then the buyer may discover after closing that a risk they assumed was insured is excluded, narrowed, or subject to limitations.
Finally, legal counsel plays a pivotal role in bridging the gap between client, broker, insurer, and opposing counsel. This role includes coordinating due diligence calls, reviewing underwriting questions, helping the client respond accurately, and identifying key issues that may affect coverage before they become closing problems.
Key Takeaways for Deal Parties
The key takeaway for buyers and sellers contemplating R&W insurance is simple: involve deal counsel early. The value of a policy depends not only on the policy terms, but also on the quality of the due diligence process, careful drafting of the purchase agreement, and effective coordination among all deal parties.
R&W insurance should be used as a tool in deals, and not as a requirement. Deal size, cost, known risks, timing, industry, the scope of diligence, and the parties’ negotiating leverage all affect whether the policy adds meaningful value. Therefore, counsel plays a key role in helping clients decide whether R&W insurance will provide a smoother closing or a false sense of security.
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This DarrowEverett Insight should not be construed as legal advice or a legal opinion. This Insight is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. Please reach out to us if you need help addressing any of the issues discussed in this Insight, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.
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