If an auto insurer knew 18 to 29 percent of cars were going to crash this year and that the rate and severity of these crashes were increasing, your premium would be much higher than it is today.
And if every single car on the road were custom built for drivers that had a tremendous pressure to drive very, very fast, it would be an underwriter’s worst nightmare.
It’s a situation that’s analogous to Representations & Warranties insurance, and it should provide some reason as to why these policies, at least up until recently, were often quoted, but seldom bought.
With premiums typically ranging from 2 to 5 percent of deal size, both buyers and sellers looked to other approaches, such as escrow accounts. Today, however, we see increased legal requirements and constricted time frames, creating a situation ripe for unintentional errors.
Buyers in an acquisition transaction purchase Representations & Warranties insurance to help protect against financial loss arising from breaches of—as the name implies—representations and warranties made by a seller during the deal process.
To a lesser degree, sellers also purchase this insurance to help protect against financial loss arising from buyers claiming such breaches.
In recent years, claim frequencies have spiked 7 percent on aggregate, with 18 percent of policies resulting in a claim when purchased on the buy side and a shocking 29 percent when purchased on the sell side. This frequency increases the larger the deal size—deals valued at over a billion dollars resulted in a claim a quarter of time.
Here’s a closer look at the distributions of Reps & Warranties claims:
- About 47 percent of claims were between $100,000 and $1 million, averaging $300,000
- 47 percent were between $1 million and $10 million, averaging $3.5 million
- About 7 percent were more than $10 million, with an average payout of $22 million
Here are the top five most common claims:
- Financial statements (20 percent)
- Compliance with laws (15 percent)
- Discrepancies in a company’s contracts (14 percent)
- Tax-related (14 percent)
- Intellectual property (8 percent)
Within the Financial Statements category above, the breakdown is as follows:
- Accounting rules breaches (26 percent)
- Misstatement of AR/AP (25 percent)
- Undisclosed liabilities (19 percent)
- Misstatement of inventory (17 percent)
- Overstatement of cash holdings or profit (13 percent)
The most notable change is in the “compliance with laws” category, jumping from 5 percent of claims in prior years to 15 percent.
Here’s the distribution of claim reporting:
- 27 percent claims reported in the first 6 months after the deal closes
- 48 percent reported between 6 to 18 months after the deal closes
- 17 percent reported 18 to 24 months after the deal closes
These facts and figures should prove why it’s important that these policies often have seven-year tails, and must be customized to the unique risk profile of the parties and of the deal.
Richard B. Hagemeier, Bolton Executive Vice President, also contributed to this article.
Information provided via AIG’s Global M&A Insurance Claims study.