M&A and Insurance: How businesses should protect themselves as they pursue M&A opportunities

With M&A transactions, the points of focus are usually on ensuring the right valuation, having a clear-cut deal rationale, solidifying expected synergies and outlining the potential business improvement and added value from pursuing such opportunity. But many underestimate the value and benefit that comes with mitigating risks to close a deal.

Given the current economic climate and uncertainties, companies should increase their due diligence efforts, which includes protection in the form of insurance. Some of the major concerns that will arise with M&A deals discussions this year are:

1. Is the buyer getting exactly what they are paying for?

2. How does inflation and interest rates impact business operations, especially with transactions involving international operations?

3. Is there any ongoing litigation or employee lawsuit as it relates to recent layoffs, understaffed employees, wage cuts, or unfavorable working conditions as result of layoffs, etc

With those concerns in mind, it's imperative for businesses seeking M&A opportunities to strengthen their risk mitigation efforts to include acquiring or revising insurance needed to protect them against any risk that arises from these transactions. M&A insurance is considered as a set of protections designed to help both buyers and sellers mitigate risk and facilitate the closing of a deal.

The most common types of M&A insurance are: Representation & Warranties Insurance and Contingent Risk Insurance.

Representation and Warranties "R&W" Insurance is a type of insurance coverage that helps protect a buyer and seller in a M&A transaction from financial loss if there is a breach of representations and warranties made by the seller. Representation and warranties are key guarantees of an M&A transaction at close that have been established and agreed upon during due diligence. If the seller breaches this agreement, they have to indemnify or compensate the buyer for such loss based on an escrow agreement. This escrow agreement between the seller and buyer, with an insurance broker typically as the third party and legal facilitator, usually states that if a seller breaches their representation, they must pay the buyer an amount that equates to a percentage of the deal value for a specific period of time; usually 10-15% over a 2-year period. The seller tends to run the risk of, most times unintentionally, breaching a representation in an transaction. This is why it's also beneficial for a seller to have R&W insurance coverage, not only the buyer.

Even though there might be breach, the buyer is still bound to the deal/share purchase agreement. The policy coverage is usually 10% of the M&A purchase price, of which the insurance company charges 2-3% of the M&A purchase price as a fee for issuing the policy. It's very rare that a seller would not fully disclose exactly what is being sold, but the recent scandal with Binance and FTX make it even more of a reason that adequate insurance coverage is needed as a safe haven.

Contingent Risk Insurance is a type of coverage to reduce and eliminate risk relating to the business of either the buyer or seller. These are risk that are identified and known during proper and thorough due diligence of the target company, and are typically not covered under Representation and Warranties. With the use of insurance, the buyer is able to pass these risk/losses from their balance sheet to their insurance. Some examples of these risk include ongoing litigation, shareholder disputes, employment disputes, regulatory exposure, or any in-house issues that can affect the buyer's reputation. Additionally, a buyer might seek coverage to ease shareholders' mind to let them know that the business is covered from risks associated with the target company. Even though these risks can be mitigated prior to closing, the financial consequences resulting from these issues are very significant if not mitigated and handled properly. This highlights the needs for having contingent risk insurance as a another safe haven.

Overall, mitigating known or unforeseen risk in a transaction is very important to deal success and business reputation. Strong due diligence along with appropriate coverage where needed is even more vital this year if businesses seek to pursue M&A in this economic climate.