Euclid team members Brittany Zimmer, Christopher Ziemba, Justin Giles, Carl Christian Rösiö, and Daniella Smith joined Financier Worldwide magazine to discuss transactional risk claims for its December 2023 issue. See below for the full article.
FW: Could you outline the role warranties and indemnities (W&I) insurance plays in managing transactional risk? What are the key benefits for buyers and sellers?
Zimmer: Warranty and indemnity (W&I) insurance enables several efficiencies in the deal process and in managing transactional risk. Sellers’ funds for potential claims are freed up for future investments rather than being tied for years in an escrow account, and buyers that have W&I insurance in their bids are more attractive to sellers. W&I insurance effectively ‘outsources’ the investigation and resolution of claims to an insurer that has the resources, expertise and experience to expeditiously work through the process. If issues arise post-closing, buyers can work through them with specialised insurers rather than directly with sellers. This not only frees up the time of senior personnel who stayed on with the company after closing, but also avoids potential tension at the company if there is a dispute.
Ziemba: Since its inception, representations and warranties insurance (RWI) has played an important role in the M&A process. As its popularity has grown over the past several years, RWI has become a key part of negotiations during a deal. Private equity (PE) buyers often look to RWI to manage deal risk, and strategic buyers are also utilising the product as they learn about the benefits of RWI. The key benefit is the transfer of risk to an insurance company. So in lieu of traditional seller indemnity, a carrier assumes the risk of a post-closing breach and corresponding loss. This benefits the seller by eliminating the need for an indemnification escrow, and benefits the buyer by eliminating the need to pursue the seller for indemnification.
Rösiö: Broadly speaking, W&I policies cover the risk that, following an M&A transaction, certain important things the buyer of a company believed to be true turn out not to be. A W&I policy is designed to step in and make the buyer ‘whole’ by covering the unknown unknowns – issues that were not flushed out in the course of the due diligence or disclosure process that come to light post signing and mean the buyer has paid too much for that company. Without a policy in place if an issue arises a buyer is faced with pursuing a claim against the seller, a process which can not only be costly and time consuming but also contentious and reputationally damaging.
Smith: When a company is sold the seller makes a series of statements in the acquisition agreement whereby it ‘warrants’ certain key facts about the company, such as its financial statements. If these warranties turn out not to be true then historically a buyer would have to look to the seller for compensation and potentially bring costly legal proceedings, however if a W&I policy has been put in place then an insurance claim can be made to compensate the buyer for the loss it has suffered. This means a buyer will be ‘made whole’ much more quickly and simply than if the policy was not in place. A key benefit for the seller is the classic ‘riding into the sunset’ advantage where the sellers are protected from the buyer coming after them post transaction, except in certain cases outlined in the W&I policy, such as fraud.
Giles: The main benefit for buyers is streamlining the process of recovery if a breach of representations is discovered. Instead of having to follow up with sellers, and potentially their counsel, who are likely busy with other matters and without any incentive to respond, buyers can work with a team fully dedicated to investigating the claim and paying any validated loss. For sellers, there is the opportunity for a clean slate after closing; there is no need to worry about hearing from buyers months after the fact. W&I insurance also frees up the need for large escrow accounts, further streamlining deals. W&I policies take what can be a messy and protracted process and seek to minimise any headaches arising out of the unpleasant discovery of a breach of representations in a deal.
FW: What types of issues commonly lead to a claim on a W&I insurance policy?
Ziemba: Any potential issues that can occur post-closing in the absence of RWI can and do lead to claims under an RWI policy. Even sophisticated buyers that have completed several prior deals are not immune to post-closing problems. Due diligence can sometimes miss issues which can result in a breach under the purchase agreement. The issues can involve various representations, including financial statements, material customers, condition of assets, tax, IP and compliance with laws. Any representation in the purchase agreement is fair game and can potentially lead to a claim.
Giles: The most common situation where a claim arises is when another entity, that is, one that is not a party to the acquisition agreements, contacts or sues the purchased company, alleging facts which, if true, would constitute a breach of representations in the acquisition agreement. Drilling down another layer, the most frequent context this arises in is when a tax authority initiates an audit of the purchased company asserting that taxes may not have been properly paid over the years. Claims also frequently arise out of the change of relationship between the purchased company and a customer, or out of errors within a company’s financial statements. These two types of claims can also quite severely impact the value of a purchased company.
Zimmer: W&I insurance claims run the gamut. Third-party claims, which are claims where a party other than the buyer or seller is claiming loss against the target company, can cover any issue related to the particular business that was acquired, from employment to intellectual property (IP) to government investigations. First-party claims, where the buyer is claiming direct loss, also vary, and some common examples include alleged inaccuracies in the represented-to financial statements, material customer or contract issues, and condition of assets claims.
Rösiö: Many of the largest claims arise from breaches of accounts or financial statements warranties. Often financial statement warranty claims relate to more complex accounting areas requiring a significant degree of estimate or judgement on the part of the preparer. These issues can, for example, be related to an insufficient reserve set by the target for obsolete stock or unpaid services or incorrect revenue recognition. Any kind of error in the financial statements can cause the acquired company to have less earnings than the buyer expected – an obvious problem in many instances. The severity of financial statement warranty claims tend to be higher than other types of claims, on average, because they may impact overall enterprise value and result in loss based on diminution of value.
Smith: While the types of claims on our W&I policies are similar across all jurisdictions, in Europe, the Middle East and Africa (EMEA), claims relating to tax warranties are more frequent than in North America and we have seen a real uptick in claims arising from tax audits. These can be routine audits or audits relating to a specific issue or type of tax. There has been discussion about what has given rise to this uptick in tax-related claims and one answer is that governments across EMEA are trying to recoup more funds than ever before, following the expensive toll of the coronavirus (COVID-19) lockdowns.
FW: In the event of an issue arising that may give rise to a claim, what steps should be taken by the insured?
Rösiö: In the first instance, an insured should start gathering all of the potentially relevant information and ensure that nothing is accidentally deleted. We recommend the insured then looks at the policy and at the warranties in the sale and purchase agreement that have been insured to determine whether one or more of those warranties may potentially have been breached. We then recommend looking at the policy and considering whether there is an exclusion that might be relevant, whether the warranty or warranties that might have been breached are insured, and whether the issue was ‘disclosed’. If, after considering all of these points, the insured thinks it may still have a claim, then we recommend notifying the insurers promptly and involving them from an early stage.
Smith: We would recommend speaking to the broker who helped place the policy. Most brokers have claims advocates who specialise in W&I and will be able to help an insured decide whether it has or potentially has a valid claim. They will also be able to assist in preparing a claim notice and presenting insurers with the relevant information that they will need to assess a claim. Once a claim notice has been received, we would recommend that the insured, the broker and the insurers organise a call to discuss the issues and how the claim process is going to proceed. Communication is key to a good claims process and the claims that get resolved the quickest are the ones where the parties involved adopt a collaborative and open approach.
Zimmer: In our experience, it is best when the insured notifies the insurer as soon as possible after discovering any actual or potential breach, third-party claim, or loss. Claim notices that provide more detail are often the most helpful to kickstarting a claim investigation, but it is preferable for an insured to provide notice sooner and with less detail, rather than later and with more detail. Put differently, insurers can be more focused and nimbler throughout the investigation stage if they are looped in from the beginning, which benefits both insureds and insurers during the claims process.
Ziemba: The insured has paid a premium for its RWI policy and rightly deserves a high level of responsiveness and customer service from its carrier. Claims processes should be designed to be collaborative with the insured. Therefore, it benefits the insured to be as proactive as possible in submitting a claim or issue that may give rise to a claim, and to be as detailed as possible when submitting a claim notice. This allows insurers to partner with the insured as they investigate the claim and to tailor any requests for additional information that may be needed to minimise disruption to the insured’s business.
Giles: A great first step is to reach out to the broker as they often have greater experience with making a claim and can discuss next steps and how to collect information to present the claim. It can be tempting to wait until every stone has been turned before making a claim, putting in the notice voluminous information about the issues. But it is often better to put the insurer on notice earlier on. It is typically the case that insurers will have questions and need certain information to confirm coverage; this information may be different to what an insured may gather but could come from the same sources potentially leading to duplicative effort. If information is available, sharing it is immensely helpful, but often looping in the claims team earlier on in the process can minimise effort and lead to a more efficient result.
FW: What do insurers take into account when assessing whether there is cover and determining the nature and extent of any related loss?
Smith: Determining the nature and extent of loss can sometimes be rather complex; other times it can be relatively simple. Often it comes down to the substance of the claim in question. For instance, if a third-party claim against the target has caused the loss, the amount claimed may simply reflect the full value of the loss. However, if we are instead looking at the overall impact of a warranty breach on the value of a target, assessing loss can be more complex. How much less would a buyer have paid for a company if it had known about the breach of warranty? Often, though, this assessment will benefit from accounting or valuation specific expertise, which may, for instance, help to explain any valuation model used or the rationale behind the application of any multiple.
Zimmer: While each claim has its own flavour and level of complexity, at their core these claims essentially all come down to the same assessments: whether the language of a specific representation is inaccurate and therefore breached, whether there is loss stemming from that breach, and whether any other coverage issues apply, such as policy exclusions, mitigation, the availability of other insurance, and so on. Insurers will consider all available information the insureds provide, as well as try to overcome information gaps to the extent possible in order to make a reasonable assessment as to the availability and extent of coverage.
Ziemba: Just as with seller indemnity, coverage under a RWI policy is dependent upon whether or not there has been a breach under the purchase agreement, as well as corresponding loss. Breach and loss are often investigated in tandem to minimise the burden on the insured when responding to information requests. Insurers often engage outside advisers to assist in evaluating loss. The type of adviser is highly specific to the nature of the claim, and can involve accountants or other financial advisers, engineers and IP counsel. The insurer’s goal is to evaluate breach and loss as quickly as possible so the claim can be resolved and the insured can focus on running their company.
Giles: Every claim is a little bit different, but the main questions are the same: whether a representation in the acquisition agreement was breached and whether the insured suffered monetary loss or a devaluation of a purchased company as a result. The first question is, in theory, a bit more straightforward, though it can depend on the specific representation at issue. For example, if the claim arises out of a representation stating that a customer has not reduced its business, we will determine whether the customer did so and whether that fact was disclosed. Loss can introduce somewhat more complex issues. To keep the same example, there would be analysis of how the insured valued the business prior to purchase, the length of customer relationships generally, the profit from the customer, and other related questions.
Rösiö: Assessing cover is slightly different for each claim that we receive. This is because no deal is the same as the last. While it sounds obvious, the first question an insurer would normally ask is: has an insured warranty, in fact, been breached? Often, this can be quite clear cut, but other times, although a purchaser might find its target company is, post-acquisition, not performing as it had anticipated, this in itself does not necessarily correspond to a warranty breach. If this looks to be the case, or another potential issue, like a possible exclusion, is identified, an insurer will always look to flag this as soon as possible. Other times, while circumstances mean it may be fairly simple to determine ‘breach’ it can be much more complex to calculate what loss has been suffered. We find that being transparent in our position facilitates productive conversations and sometimes it is as simple as that we are just missing key information that can help unlock cover.
FW: What do you consider to be the essential components of an efficient claims process?
Zimmer: In my experience, the efficiency of the claims process boils down to communication and transparency. There is an inherent information asymmetry in this process whereby the insured or buyer is knowledgeable about the company, its operations, the issues and the related universe of documentation. There is a necessary learning curve for insurers during this process, and we have found it effective to manage expectations at the outset by laying out the process, establishing a cadence of the investigation, and explaining what information we require and for what purpose. Insureds appreciate transparency and accessibility during the process, and a direct line to claims professionals.
Ziemba: Communication is crucial to an efficient claims process. The sooner we receive the information we request as part of our investigation, the sooner we can determine coverage. That said, an insured often has to divert some internal resources to respond to information requests, so if questions arise regarding the need for certain information or if some of the requests are considered burdensome, proactive communication to discuss the best way to provide the information necessary to evaluate the claim is key.
Giles: An open line of communication and a cooperative, collaborative spirit are incredibly effective. For every claim, we try and speak with the insureds, their counsel if they have engaged them, and the insurance broker very early in the process, often within a week or two of receiving the claim notice. That allows us to introduce ourselves, explain the process, and answer any questions they might have. We have found that setting the tone early that we are available to help can ensure that the investigation moves smoothly from claim notice to information requests and follow-ups, to a coverage position.
Rösiö: A collaborative approach is key. We think transparency should cut both ways, and we always look to be as open as possible. We have no desire to trip anyone up, or look to disguise our true position. We instead want to work together to find a resolution.
Smith: We always find it helpful when claim notices are clear, concise and well supported with documentary evidence. We appreciate that pulling together the relevant information can often be time consuming, but taking this approach from the outset really can facilitate a swifter process. A good broker will help their clients understand what it is we need to see when an insured is submitting a claim notice, and we often find the process is smoother when a broker experienced in W&I claims is involved.
FW: When evaluating potential insurance to cover transactional risk, what key aspects should buyers and sellers take into account? How important is an insurer’s claims experience and claims-paying track record, for example?
Rösiö: Regardless of being a buyer or a seller, one needs to assess the complexity of the business being sold or acquired, in particular in terms of its jurisdictional spread, the quality and robustness of its internal controls when it comes to accounting and financial reporting, and whether the business has a proactive or a reactive approach regarding regulatory risk. A proactive seller can more easily ringfence potential tax and other contingent liabilities, such as disputes, with bespoke insurance solutions, rather than having lengthy and costly discussions with a buyer – or even multiple buyers – of the business. All of these aspects are instrumental for finding both matching insurance products but also for finding a matching insurer with corresponding expertise and experience. Given the ‘high severity, low frequency’ nature of transactional risks, we think that an insurer’s claims experience and claims-paying track record is of utmost importance, not only in terms of ‘getting paid’, but even more so the perceived experience and process of getting such a payment in the end.
Zimmer: Buyers and sellers should consider an insurer’s execution, commerciality and claims-paying experience when evaluating potential insurance to cover transactional risk. Execution and commerciality on the front end ensure a streamlined process that should aid in the facilitation of getting the deal done, instead of being a hindrance. Claims-paying experience on the back end is crucial because the product is only valuable if it actually provides coverage when it is supposed to. An insurer with strong claims-handling experience and a good reputation in the market will provide its clients with a smooth and efficient process in the event of a claim.
Smith: More and more we are hearing that brokers and clients are choosing to place a policy with an insurer that has a proven track record when it comes to handling and paying claims – particularly when a client has had a bad W&I claims experience in the past. This makes total sense – a buyer of insurance wants it to be there when they need it.
FW: How do you expect the claims process to evolve going forward? What innovations and improvements are set to impact the way claims are processed and resolved?
Giles: W&I is still a relatively new product and continues to evolve and change. But every year that goes by, more buyers, sellers, counsel and consultants gain experience with W&I and with the claims process. It is our hope that the claim experience is a smooth and straightforward one. Though the issues can be complex, we do our best to streamline the process, learning more with each claim that comes in and building trust with the parties we deal with.
Rösiö: Insureds should have as efficient, effective and collaborative a claims process as possible. These sorts of claims, however, are not simple and can involve complex legal and valuation issues. It is essential, therefore, that insurers have a claims team capable of dealing with such issues while always remaining as commercial as possible.
Smith: A key part of resolving many W&I claims is ensuring that the parties can have a proper discussion about loss and valuation issues. Insurers may consider recruiting financial experts who are trained accountants and experienced with helping clients value companies. Having such expertise available will mean that insurers can move quickly to always understand both the legal and financial aspects of a claim and act as efficiently and commercially as possible.
Zimmer: Insurers must consistently refine their claims process and explore ways to make that process even more efficient. Having a large claims team in the W&I space, for example, provides the necessary bandwidth to implement a process whereby two adjusters can be staffed on each matter. This not only helps speed up the claims process for insureds but also provides team members the opportunity to gain more experience with a wider array of claims in a shorter period of time. Exposure to a wide variety of claims creates more well-rounded claims professionals and allows them to be innovative when presented with new challenges on claims.
Ziemba: The claims process will continue to evolve as RWI is utilised more and more frequently in deals. As both buyers and sellers continue to gain an understanding of the product and the benefits of RWI, the claims process will become more streamlined. One improvement we have already seen is insureds submitting more detailed claim notices, which include detailed calculations of loss and supporting documentation. This often allows us to issue very narrow information requests since we already have much of the information we need, which results in faster resolution of the claim.
FW: Looking ahead, what are your predictions for transactional risk and M&A-related claims over the coming months? To what extent do you anticipate a rise in claims activity?
Smith: We are constantly reflecting on the claims process and how to make it more streamlined and efficient. It is important to always look for ways to improve and make the next process even better. Technical expertise is key, as is staying up to date with all of the relevant legal and contractual side of things. Also important is pushing to be as commercial as possible and quickly working out what the really important issues are and what documents need to be made available.
Zimmer: The W&I industry has seen significant growth in the past several years. There has been increased interest from individuals in the legal and accounting advisory space, particularly from those who work on other insurance lines. Given that this is a bespoke product that is quite unique, with sophisticated parties on both sides, we anticipate that there may be a learning curve folded into interactions between seasoned W&I professionals and newer entrants in the space as both sides grapple with the complexity inherent in these claims.
Ziemba: We believe we will see a continued increase in the number of RWI claims in the coming months. It is important that buyers consider claims experience when choosing RWI, and whether they are partnering with a market player that has sufficient expertise and bandwidth to handle a claim should one arise.
Giles: We do expect that claims activity will continue to rise. Though W&I is a newer insurance line, more and more policies are being underwritten and we expect a proportionate increase in claims.
Rösiö: While it is too early to say whether the immense M&A activity we saw during the COVID-19 years will result in an increased notification rate, in terms of claims per transaction, what is certain is that we will see many claims coming to the transactional insurance market during 2023-25, given the M&A volume globally during 2020-22. Given this, we expect a continued focus and heightened scrutiny from insureds and their advisers on not only the process of handling their claims, but more so on the outcome of their claims – namely, whether the insurance delivered on its ‘promise to pay’ principle.