As representation and warranty insurance (RWI) remains white-hot in the U.S. M&A mid-market, a number of additional underwriters have entered an increasingly competitive market. That has spurred interesting developments in deal terms in the U.S. and Canada this past year. We discuss some trends from the past 12 months that are worth keeping an eye on in 2018.
In just the last 12 months, premiums on the heart-of-the-market policies—those underwriting deals with US$100 million to US$500 million enterprise value—have dropped to 3.0% – 3.4% of EV. This represents a meaningful price cut from the previous 3.25% – 3.75% range. Even better pricing is available where the underwriting market views the deal as a good risk. In those cases, premiums can be as low as 2.5% of EV.
Not surprisingly, increased competition by new market entrants in the U.S. and Canada is the key driver for the drop in pricing, as newcomers like Blue Chip, XL Catlin and Euclid challenge the established underwriters like AIG and Ambridge.
Special Considerations Regarding Québec
Despite the overall theme of expansion and growth in the U.S. and Canada, this past year marked a reduction in underwriter interest in “QC based deals,” that is, those governed by Québec law or involving a named insurer located in Québec. Under Québec law, insurers may be on the hook for defense costs, regardless of the limits of liability of the policy. Some insurers attempt to mitigate this exposure in a side letter or waiver, but the risk remains too great for most.
Cyber Security Comes Into Focus
While competition may put pressure on insurers to slim down their standard exclusions from coverage, one area where underwriters appear less willing to take on risk is cyber security. Carriers are increasingly flagging cyber security as an area of heightened underwriting and, in certain cases, insurers insist on an outright exclusion for cyber security matters. Buyers—especially buyers of targets dealing with personally identifying information—should be prepared to demonstrate the target has adequate cyber liability coverage and a clean history when it comes to data breaches and hacking.
As Retentions are Dropping, “Public-Company Style” is En Vogue.
Where a year ago, a buyer could routinely expect to accept a self-insured retention (i.e., the deductible under the RWI) of 1.25% – 1.5% of EV, a 1% retention has become standard. And where once underwriters expected to see seller skin in the game as a matter of course—typically by splitting the retention evenly between a seller-funded escrow and buyer-funded deductible—brokers are now seeing 20% – 25% of their deals being underwritten with no seller indemnity.
Those no-seller indemnity deals will generally still attract higher policy premiums—in the range of an extra 25 basis points—but a retention of 1% looks similar to what a buyer deductible might have looked like a few years ago in a competitive conventional private M&A deal. This, in turn, has motivated some buyers to agree to do private M&A deals “public-company style,” that is, letting seller off the hook with respect to any indemnity recourse.
If the transaction is “public-company style,” underwriters will not always underwrite coverage for pre-closing taxes.
While endorsing the “public-company style” paradigm may allow a buyer to distinguish itself (e.g., in a hot auction), the competitive edge comes with costs beyond the extra 25 bps in insurance premium. For example, a buyer should consider what else it is giving up—beyond recourse to seller for breach of reps—when agreeing to a no-seller indemnity deal. The reason for this is that “public-company style” is a binary proposition and agreeing to this construct also cuts off a buyer’s recourse for breach of covenants, company debt and transaction costs not picked up in the purchase price adjustment, and exposures in excess of the RWI policy limit. Notably, not all of these risks can be mitigated through buying more RWI coverage. Also of note, if the transaction is “public-company style,” underwriters will not always underwrite coverage for pre-closing taxes.
Hybrid Coverage May Provide the Right Protection at the Right Price
While the public-company style recourse package can be an attractive bargaining chip, for some buyers it may prove conceptually difficult to let a seller off the hook entirely, particularly on the fundamental reps.
As a solution, buyers may wish to consider tiered coverage, for example to get a typical 5% or 10% coverage policy on the general reps, but to layer on an additional tier of coverage for just fundamental rep breach. This fundamentals-only tier can be purchased at a lower premium than the general reps—reportedly under 2%—given the low frequency of fundamental rep breaches and given that these reps are relatively easy to diligence.