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Intro: Hello and welcome to Insured Success, a podcast brought to you by Reed Smith's insurance recovery lawyers from around the globe. In this podcast series, we explore trends, issues and topics of interest affecting commercial policy holders. If you have any questions about the topics discussed in this podcast, please contact our speakers at insuredsuccess@reedsmith.com. We'll be happy to assist. 

David: Hello and welcome to another episode of Insured Success. Thanks for joining us. My name is David Cummings. I'm a partner at Reed Smith in our insurance recovery group. A way of just a little bit of background. My practice focuses on navigating insurance coverage, disputes, litigation, mediation and arbitration for our corporate policyholder clients, as well as helping those clients navigate insurance placements, renewals claims and the like all with their insurers. An ever growing part of that practice involves a product called representations and warranties insurance or reps and warranties insurance. That's a topic of our discussion today. So before we get started, I have a few introductions are in order. Uh I'm joined today by my colleague, Lauren Gubricky, an associate in Reed Smith's insurance recovery group. Hi, Lauren. 

Lauren: Hi, Dave. Thanks for having me. 

David: I’m also joined by our guest, Jeff Buzen, a partner in financial lines at McGill and Partners. Hi, Jeff. And thanks for joining us today. 

Jeff: Thanks Dave. Great to be here. 

David:So, between the three of us, we're gonna cover a few topics today. So I'm gonna start and provide a high level overview of reps and warranties insurance, what it is and how it's used. Then I'm gonna pass it to Lauren who's going to focus on reps and warranties claims and a few best practices. And along the way, we're gonna talk with Jeff to provide us with some insights and trends with respect to the reps and warranties market. So with that, let's get started. So let's start with a quick overview, reps and warranties insurance. What even is it? At at a very high level in a private equity deal, we have company A, the buyer purchasing company, B, the seller. So as part of that purchase and as a result of information borne out through due diligence, the seller makes certain reps and warranties regarding its business. Those can include ongoing risks, contingent liabilities, reps related to financial statements and so on. Traditionally, to hedge against the risks of inaccurate or incomplete information, the asset purchase agreement would provide recourse to the buyer in the form of an indemnity provision and the way that works is a seller would have to back that obligation with funds in the form of a hold back or escrow uh and keep those funds in place for a negotiated survival period, often for several years. Now, the issue is that these indemnity provisions can be the source of extensive negotiations in and of themselves negotiations that could add layers of unwanted complexity to a deal. Um And that may result in delays and disagreements. And in some cases, historically, the deal could collapse entirely over, over these disagreements and these negotiations. So insteps reps and warranties insurance. This product was developed to at least in part to avoid these issues and speed up deals by shifting the risk to a third party insurance company. This allows for higher indemnity limits and survival periods without material increasing seller exposure all while being able to keep up deal pays to close quickly and not be bogged down by extensive disagreements or negotiations between the buyer and the seller. So what do these policies look like? So they can be purchased by the buyer as first party coverage or the seller as third party coverage in practice though the overwhelming of them are buyer side. The actual scope of coverage is determined by those specific reps and warranties in the asset purchase agreement and that agreement is generally incorporated into the policy itself. It's a very general matter. Although these, these policies can differ from deal to deal and insurer to insurer. The insurance covers inaccuracies or gaps in the reps and warranties that cause loss or liability to the buyer and although the exclusions too can vary depending on the specifics of that deal and the industry and the reps and warranties at issue. There are a few common exclusions that we see across policies. One of those is an exclusion related to known issues. This type of exclusion is common, not just in reps and warranties, insurance, but really across the full range of insurance coverage. It excludes coverage for losses attributable to issues that the parties were aware of at the time of placing coverage under the general theory that you, you just, you cannot purchase insurance for existing or known loss. A second, common exclusion is purchase price adjustments. Often the asset purchase agreement allows for a post closing purchase price adjustment based on financial metrics calculated as of that closing date. And so reps and warranties policies generally exclude losses deemed attributable to the that adjustment mechanism. Another one is uninsurable, criminal fines and penalties. This is also a common exclusion, not just in reps and warranties, but across policies of all types and in many cases tracks state law providing that such fines and penalties simply are not insurable. The rationale here is that such fines are attributable to willful or intentional and therefore uninsurable activities or emissions. And then there are just traditionally a few itemized coverage carve outs. Two common ones, for example, are asbestos and underfunded pension liability rationale here with, with these carve outs as well as others. Is that other types of insurance are intended to be responsive to claims of this nature. So with that background and overview, I'd like to turn it over to Jeff to talk a bit more about his perspective as a broker in the reps and warranties insurance market. But first a little bit more about Jeff. Jeff Buzen is a partner in McGill and Partners mergers and acquisitions group where he focuses on structuring marketing, negotiation, and broking representations and warranties insurance, as well as tax liability insurance and other bespoke contingent liability insurance solutions. Jeff works on transactions spanning the entire mergers and acquisitions market. However, he has extensive experience in the financial services, food and beverage and life sciences sector. So Jeff, thank you again for joining us today. 

Jeff: Thanks Dave. 

David: And so we're recording this right about at the end of 2023. So I'd first be interested in your thoughts. Looking back on this past year. Have you seen any noteworthy trends or items of interest this past year or even further down the road that, that has impacted the placement or negotiation of these policies or, or really anything else? 

David: Yeah, definitely. And I think you provided a great overview of reps and warranties insurance and what it is, but a little bit about the history of the industry, right? It it really insurance solution started taking off a little less than a decade ago. Um And then, you know, into 2021 and 2022 you know, the kind of busiest times of of the M&A market in recent history actually of all time, right, utilization of reps and warranties insurance was very, very, very hot. Ok? And the utilization rate of reps And warranties insurance across M&A transactions continues to be high and perhaps even higher this year than it was in in recent years. But the M&A market itself is much slower than it was certainly in 2021 and into the first half of 2022. And so what that means is there are more insurers, more underwriters in the market, but because there are fewer deals getting done, there's this mismatch between the demand for reps and warranties insurance and the supply side, right, the insurance capacity available to underwrite transactions. And so that means it's a, it's a very insured favorable market at the moment. Pricing retention have come down a lot. There are a lot of new coverage enhancements that insurers are offering that weren't readily available even a couple of years ago. And so overall, I'd say it's been a good time, a good year to be a buyer of reps and warranties insurance for, for all of these factors. 

David: Thank you. That's, that's an interesting outlook. And, and so, you know, at this time of the year, a lot of clients are looking towards their deal activity for 2024. I'm sure the insurance market is also looking into what the next year in the, in the coming years might bring. Uh, do you expect any of these trends to continue into 2024 or what are, what are you seeing, uh, from a market perspective that might be the same might change or, or really just might be interesting? 

Jeff: Yeah, I mean, ultimately, my view is we're going to continue to have been an insured, favorable market so long as the M&A market remains at the current activity levels and or until insurers start to start to leave the reps and warranties market, whether that's because of claims or just because they feel they aren't making sufficient premium to justify being in the business. And so, you know, we closely, you know, obviously monitor M&A activity broadly. And I think, you know, I don't, I don't have a crystal ball, but there are some positive signs in recent weeks that suggest that 2024 should be a busier M and a year than 2023 certainly with inflation numbers coming down and the fed indicating that there could be, there should be rate cuts coming soon. Um So, you know, from that perspective, I think there will be more reps and warranties, uh demand for reps and warranties insurance next year. As it relates to the insurer side, you know, a lot of insurance and reinsurance renewals are ongoing as we speak. And so we're in close communication with our insurance carrier partners to make sure, you know, we want to hear how those renewal meetings are going and making sure they really are committed and going to be able to continue to provide reps and warranties insurance capacity for the long term. Because ultimately, when there, if and when there is a claim for our insured clients, we want to make sure, you know, it's a insurer that's still in the industry and is going to have the motivation to act commercially in a claim scenario and handle that, that claim in a, in a good way that won't harm their reputation in the market. And so, you know, so far early indications are, you know that these reinsurance renewals are going in some ways better than expected, right? And so some insurer insurance carriers are actually going to have more, a higher limit, more capacity in 2024 than in 2023 which is surprising to some because we are in this kind of depressed rate environment at the moment. But I think it's, it's a good sign that insurance carriers and reinsurance carriers are committed to this space for the long term. 

David: Thank you, Jeff, I appreciate your insight. And so with that, I think we should transition a bit to talk about reps and warranty's claims. And for that, I'd like to turn it over to my colleague Lauren Gubricky. As mentioned, Lauren is an associate in Reed Smith's insurance recovery group. She works on insurance coverage disputes for corporate policyholders of all types and industries. Many of are an increasing number of which are related to representations and warranties insurance issues and disputes. Lauren, thank you again for being here. 

Lauren: Thanks, Dave. Happy to be here and happy to talk about the claims process and best practices, at least from the policyholder perspective. So, you know, Jeff touched on this already, but when a buyer asserts that a seller has breached a representation or warranty or at least has breached multiple reps and warranties, these breaches can have a serious financial impact on the company. And we've seen this impact be upwards of tens or hundreds of millions of dollars and the claim process is really where it all gets sorted out. So in the past few years, I've been able to handle a number of these claims and in our world, they range from, you know, relatively small amounts around $50,000 or so to many millions of dollars and regardless of the amount that's in dispute for these claims, there are certain procedures and best practices that policyholders should remember as they go through this process. So some of these, we all are probably familiar with just from claims handling under more traditional lines of insurance. Um And some of these are a little bit more unique to reps and warranties claims. So what is not unique to reps and warranties claims but is especially important for these types of claims is that the policyholder really needs to conduct a robust factual investigation before submitting anything to the insurance company. So typically after closing, the buyer discovers um a particular issue that really should have been disclosed prior to closing. Um obviously, that's not a great situation to be in. But the good part is that now that the deal has closed, the buyer now has access to the information and people and can really just start conducting an investigation from the beginning and see the buyer might know that there's a problem and think that the reps and warranties policy will cover them. But without knowing the specific details of the breach and the loss, the buyer can't really know like which representations or warranties were actually breached. So this is really the time that the buyer is to determine, you know, what is the loss or at least, do you have a reasonable estimate of the loss? What caused the loss? Um Does the loss involve negligence or does it rise to the level of fraud? And importantly, what was known about the loss prior to closing and who knew about it? Reps and warranties policies are usually pretty specific as to whose knowledge triggers a breach. And the policy and the purchase agreement will usually identify certain people by name or at least identify people like by title. Um And so this whole factual investigation process is the most time intensive part of the claim and many times, you know, the the deal has closed, people are moving on, you're running with the business making good money, but then uh we have to deal with the threats of warranties claim. But it is so important that everybody gets together and has all of the information that you can possibly get on the claim before submitting an actual claim to the insurance company. The next part of the claim process is really just at least from the policyholder side is really just taking a look at the transaction agreement itself and the policy with the purchase agreement like Jeff and Dave were talking about, you're really just looking at the specific representations and warranties. You know, Dave touched on a few of these, but most of them have typical reps and warranties like compliance with certain laws and compliance with taxes. Um but some transaction agreements may have industry uh specific representations and it's often the case that one breach or one loss will implicate multiple representations and warranties. With the policy itself, you're looking to see if any exclusions apply and also taking a look at the really practical things like limits the retention, things like that. And finally, once we've done this big investigation and we know what the policy says, we know what the purchase agreement says, you're ready to start drafting and submitting the claim. So most policies are really specific on what needs to be included in an actual claim. It typically requires a narrative of what has happened. An identification of specific representations and warranties that were breached, or potentially breached, or likely to be breached, and a reasonable estimate of the loss as you know it at the time of submitting the claim. And this is what kick start the claim process. Um The insurer has a set amount of time that they're required to at least respond to the claim. And like in other claims under more traditional lines of insurance, um they'll probably issue like a preliminary coverage letter broker is often involved in this process. Um And there's a further exchange of information and that's when the policyholder will start to see any coverage issues that might arise. And so, you know, I recently dealt with a pretty large representations and warranties claim just a couple months ago. What happened in this claim was that there was an undisclosed change in the law that severely affected the buyer's profits. And so one issue that the insurer raised was how this particular change in law affected our company individually versus other quote similarly situated companies. And that's sort of a term of art. And we had done this robust factual investigation like I mentioned, and so as soon as that coverage issue was raised by the insurer, we already had good information on these other, you know, similarly situated companies and were able to very quickly respond to the insurance company’s coverage issues and request for more information and ultimately successfully resolve the claim through mediation. So I won't continue to bore everybody with this claims process. But that's sort of an overview of how these reps and warranties claims happen and how a policyholder can best position themselves for coverage under the policy. So, Jeff, I know you talked a little bit earlier about some trends in the market with respect to your placement and pricing and so on, but transitioning to claims a little bit, are there any claims activity that you think is having sort of an outsized impact on the market right now? 

Jeff: Yeah, I think so, Lauren, I mean, when you look at most claim studies that are out there and you know, our own data internally at McGill and Partners, you know, it's, it's pretty consistent that about one in five policies will have claim notices submitted on them. Um But the the vast majority of those fall within the retention or are precautionary in nature. Um But so really, it's 5 to 7% of policies, give or take, have an actual loss paid out on it for the insurers come out of pocket, paying the insured for loss that's in excess of their retention or deductible under the policy. And that's, that's been pretty consistent year over year. But what's interesting is that since, as I mentioned earlier, 2021 was the busiest year on record for reps and warranties insurance that means right now in 2023 and 2022 insurers are getting more claims and claim notices than ever before because there's a kind of natural 6 to 18 month lag between when a deal closes and when a breach is actually discovered and submitted to the insurance carrier. And so insurers are getting more claim notices and more data on claims than they've ever gotten before as a result of that. And there are a lot of, I think interesting takeaways from all, all of these new claims that are coming up. And it's definitely impacting how insurers are approaching underwriting on the front end, right, when they're actually placing policies today. So, I mean, in particular, you know, where one area where we tend to see the most severe claims are whenever it's a claim that is impacting how the buyer valued the business at closing. Right. And so whether that's based on a theory of multiply damages or diminution in value, those tend to be the most severe claims. And importantly, insurers in the industry are paying out claims on that basis and recognizing for certain types of breaches that is the appropriate measure of damages. And let's say you have a, a $1 million issue, but you paid 15 times a multiple of EBITDA to value the business and this is a recurring $1 million impact on the business that's going to impair earnings, uh, in perpetuity, then the appropriate measure of damages might be $15 million instead of that $1 million. And so oftentimes these types of these breaches might relate to financial statements reps, but it also could relate to other types of reps as well such as material contracts. And so insurers are very focused on the due diligence that buyers are conducting. Not only on the the financial statements, that's kind of been the case for years and years and that will continue, but especially on those key customer and key supplier relationships. They want, they want kind of independent um diligence and verification that those relationships are strong and aren't going to go away post closing, that's going to result in some large loss, post closing. Uh Another area that's kind of emerging where we've see seeing more and more claims and particularly more and more severe claims relates to condition of assets and uh on condition of assets. There's actually a $1 billion, that's with a B, rep and warranty claim that's percolating in the market at the moment and for based on that claim alone, but also, you know, other claims and in relating to breaches of the condition of assets rep, you know, that's a rep that says that the physical assets of the target company are in good working condition, subject to ordinary wear and tear, right? And so now, insurers for asset intensive target companies are increasingly focused on um buyers conducting technical due diligence, reviewing maintenance logs, really you know, getting under the hood, so to speak and getting comfortable in getting the insurers therefore comfortable that, um, you know, there are the physical assets of the target are in good working condition and that, you know, you're not going to have some, some big surprise post closing when the buyer actually takes control of the business and turns out actually now all these, all this machinery, all this equipment needs to be completely overhauled because it isn't functioning properly. So, yes, there are lots of, lots of claims, many have been resolved successfully, many are ongoing and it's definitely having a big impact on, on how underwriting is, is being conducted. Um But ultimately, I think, you know, it's, it's for the best, right? We want we as the broker, right, we want to be in a position where we can advise our clients to make sure that they're scoping the due diligence in a, you know, what a customary buyer would do or a commercially reasonable buyer would do such that they can get coverage for all of these broad but really important reps and warranties that they're negotiating into their transaction agreements. 

David: Thank you, Jeff, again, very insightful and appreciate your advice and, and insight into the claims process that concludes our conversation today about all things, reps and warranties, insurance. Again, I'm David Cummings and I'd like to once more thank Lauren and Jeff for their time and insight today. This has been Insured Success. Thanks very much for listening and we hope you tune in again for our future episodes. 

Outro: Insured Success is a Reed Smith production. Our producer is Ali McCardell. This podcast is available on Spotify, Apple Podcast, Google Podcasts, PodBean and reedsmith.com. To learn more about Reed Smith's insurance recovery group, please contact insuredsuccess@reedsmith.com. 

Disclaimer: This podcast is provided for educational purposes. It does not constitute legal advice and is not intended to establish an attorney-client relationship, nor is it intended to suggest or establish standards of care applicable to particular lawyers in any given situation. Prior results do not guarantee a similar outcome. Any views, opinions, or comments made by any external guest speaker are not to be attributed to Reed Smith LLP or its individual lawyers. 

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