As the major player in the industry, AIG has been the long-standing, nearly sole source of claims information for the Representations and Warranty (R&W) insurance market. In 2020, Liberty Mutual, which has been actively writing M&A-oriented policies for about 10 years, issued its first such report based on their own experiences in this space.
An important factor to note is that overall, the number of claim notifications is going up, with 19% of policies bound in 2017 with notifications, up from the 14% from 2012 to 2015, and 15% in 2016. Liberty Mutual expects to hit or exceed 19% for policies written in 2018 and 2019; as notifications are still coming in steadily for those years.
Why the jump? Simple. As R&W insurance, which transfers indemnity risk to a third party (the insurer), has been…
- Recognized as advantageous for both Buyers and Sellers
- Opened up to smaller deal sizes, especially to the lower middle market transactions
- Reduced in price
… more policies than ever are being written. It’s only natural that the more policies there are out there, the more claims there will be. It does not point to a problem with this specialized type of insurance in the M&A world at all.
I’m not worried that this rising trend in notifications and claims will impact the viability of R&W insurance. Neither will this cause coverage to shrink or prices to rise. This trend is not foreshadowing a rate increase or lack of capacity.
Quite the contrary, because there are good reasons for this increase in notifications and claims: not only are more R&W policies being placed than at any point in history, including many deals in the sub-$250M transaction value, but policyholders are more aware that they can use their R&W policy for reporting.
The increased reporting of breaches in recent years will not trigger higher prices because properly underwritten deals have not suddenly become riskier to insure despite the increase in notification frequency. As the report points out, no more than a quarter of notifications actually result in a request for payment from the policyholder. And only a fraction of reported breaches actually exceeds the retention and lead to payment by the Insurer.
It’s also worth noting that tax-related notifications (in the form of audits) are among the most common breaches reported, usually within three years. Tax authorities aim or are required to commence an audit within one to two years of receiving returns due to the statute of limitations.
There may be nothing wrong, but because the IRS is launching an audit, policyholders will report it to the insurance company to put them on notice so they can bring their resources to bear to defend them if necessary. However, these audits usually do not result in a claim. Most agreements require a six-year survival period for tax Reps, which may not be necessary.
Overall, R&W insurance has established itself as credible, reliable, and sustainable. This is a respected, solid product. It’s on everybody’s checklist right now.
The simple fact that Liberty Mutual has issued this report is reassuring. AIG was the only insurance company to put out any information about claims before now. This new report shows this is a maturing market.
More competition brings better products and services and lower prices. It’s innovation in action.
It’s also important to note that insurers like Liberty Mutual and AIG do pay these claims. As Gareth Rees, Liberty GTS Chief Underwriting Officer, put it:
“In the past, R&W insurance was essentially something that helped solve a deal problem and get a deal over the line, but then often forgotten about post- closing. Now it is also seen as an asset from which an insured can recover value in the future, and much greater thought is given from the outset as to whether a policy claim exists.”
The Liberty Mutual report, 2020 Claims Study: Exclusive Insight Driven by 10 Years of Data, is worth a close look, especially the section on emerging trends in the claims R&W insurance policyholders make. Here are the issues they expect to be leading claims generators in the next 12 months.
Stock and Inventory Issues
There are a few elements at play in these types of claims, which, as you might expect, are most common in retail and manufacturing businesses and mostly involve slow moving, obsolete, or damaged stock. The COVID-19 pandemic has only intensified this trend.
There is more risk if the business is seasonal, or if the products in question are frequently updated or subject to price volatility or physical damage. There is even more risk, says the report, in so-called locked-box deals with no stock-take at, or following, closing.
Why are these claims relatively common?
Gareth Rees says: “The reality is that stock can be a difficult area to diligence, particularly on a deal that is moving very quickly. A lockdown situation obviously makes it difficult to carry out any physical checks.”
“Also, there will be many companies that have built up large quantities of stock as a result of the lockdowns, but which may not have updated their policies around obsolete and slow-moving stock to reflect this. This is an issue of heightened underwriting focus for our team at the moment.”
Accounts Receivables
As with the previous trend, we are likely to see a pandemic-related impact here as well, which is why underwriters are taking a closer look at “the size of the accounts receivable figure in the accounts relative to the size of the balance sheet and asking more questions around this issue.”
Common allegations with regards to accounts receivable claims include the setting of inadequate bad debt reserves and errors in quantifying the acquisition’s total accounts receivables. In some cases, it’s unclear in these times whether a customer on the books is “real” or will disappear or even shut down due to COVID.
Software Licensing
Essentially, this is when you have onsite audits from software providers to check how many people at a company are using software that has been licensed. According to Liberty Mutual’s report, these types of audits are on the rise.
An acquired company could state that they have 100 licenses, but it turns out that 300 employees are actually using the software. That’s a big no-no. Punishments range from penalties, to a requirement by the vendor that the company buy new software at list price and pay support costs.
This issue could be very impactful for SaaS companies and other tech businesses.
Insurers are taking a closer look at software licensing in the underwriting phase too, says the report, which states: “[We] expect it will also become an area of focus for buyers and their advisors during the due diligence process as target businesses become more digitally enabled and more reliant on licensed software.”
Revenue Recognition
When you sell a company, you can’t have zero cash in the bank on closing day. The incoming Buyer needs money for payroll, leases, etc. for, say, 90 days post-closing. The Buyer will make an amount, say it’s $9M, part of the deal. But they will ask the Seller what amount is needed for operating expenses for that 90 days.
This can be trickier than you might think when you consider the different ways revenue is recognized and then booked for accounting purposes. When there is a disconnect, a claim results.
According to the report, this is an issue particularly with project-based work. In these cases, revenue is recognized over time and compared to incurred costs, instead of in line with actual income received. The fact that the projects involved are long-term and have multiple elements makes this even more complicated. This means tougher due diligence in this area.
States the report: “We are increasingly looking for signs that management have been challenged appropriately in key areas of judgement associated with the entity’s revenue recognition practices and sufficient evidence has been obtained to support those judgements.”
This has become such as issue that SRS Acquiom is adding side-escrows for revenue recognized and net operating revenue in the deals they oversee.
Minimum Wage Legislation
Minimum wage provisions are excluded by most R&W policies. So, although this can be a serious issue to those companies impacted by employees’ claims for backpay, increased tax liabilities, and fines from governmental authorities, it’s not something that insurers have to worry about in most cases.
Reclassification of Contractors as Employees
State governments, facing reduced tax receipts and pressure from advocacy groups, are increasingly seeking to classify independent contractors as employees. California is the perfect example.
This could, says the report, “result in a large number of notifications with the potential for significant consequences for a business, both in terms of increased tax liabilities and payroll costs.”
Health and Safety
With increased regulation, especially in the real estate sector, and more stringent compliance measures, we are seeing more claims related to breaches of health and safety laws. The result, as the report states, are significant business disruption and remedial costs to get into compliance.
As the report states: “We anticipate that this will lead to buyers and their advisors focusing more on this area as part of their due diligence, with technical reports addressing this specific issue becoming more common.”
Climate Change
The Liberty Mutual report does see climate change as an area of concern and increasing risk, but it’s mostly an issue for companies operating in the European Union.
The Key Takeaway
As I stated earlier, more R&W insurance policies are being written, so more notifications are being made. More notifications that don’t result in claims being paid out means that R&W isn’t any riskier than before.
This trend of rising notifications actually points to sustainability and maturity in the R&W insurance market. As a result, we should have stable pricing for the foreseeable future.
One thing to keep an eye on are new trends related to COVID-19, with Underwriters scrutinizing new potential areas of exposure, such as:
- Labor-related third-party claims from contracts terminated on the basis of force majeure.
- Claims related to key customer insolvency where the warrantors knew that the customer was facing financial difficulty.
- Claims related to incorrect use of government-enacted job retention plans.
For guidance on the use of Representations and Warranty insurance in the time of COVID-19 and beyond, contact me, Patrick Stroth, at pstroth@rubiconins.com for all the details.