In our first video on Reps & Warranties Insurance, I gave a broad overview of what this form of insurance does and how it’s used in the M&A process. Let me give you a brief recap; In a M&A transaction, the seller will agree to indemnify the buyer for breaches of the sellers reps & warranties. Traditionally that indemnity is securitized or backed by the seller placing a portion of the sale proceeds in escrow for a period of time – usually a year or two.
Reps and Warranties insurance changes that traditional process by having an insurance company stand in for that escrow and indemnify the seller for potential breaches and litigation.
In essence insurance eliminates the need for escrow and the seller walks away from the closing table with all the proceeds of the sale and a greater sense of security that if a claim is made by the buyer down the road, insurance will take care of it.
Today, let’s get into some of the specifics of middle market R&W insurance, starting with the costs.
The cost of reps and warranty insurance is comprised of two components.
The first is an underwriting fee which is the insurer’s charge for their attorneys and experts to review your contract of sale and evaluate their risk in offering the coverage. These experts will also conduct an underwriting call to discuss deal particulars that an application for R&W insurance can’t entirely gather.
The underwriting fee is usually around $30,000 but as deal sizes increase so can this fee. It’s not surprising to see the underwriting fee go as high as $50,000 for large deals over $50 million.
Then there is the actual premium which is anywhere from 2% to 4% of the insured amount, subject to an insurer’s minimum premium which is usually around $150,000.
The insured amount I just mentioned is typically 10% of the purchase price of the company.
So a firm selling for $25 million will purchase a $2.5 million R&W policy and the premium will land around $75,000, but subject to an insurer’s minimum premium of about $150,000 plus the underwriting fee of $30,000 for a total cost of $180,000 as an example.
So why would a seller be willing to pay $180,000 to insure the reps and warranties of an agreement?
The alternative to insurance is to place 10% to 15% of the sale price certain in escrow, usually for two years. In this example that would equal about $3 million.
That represents a sizable lost opportunity cost to the seller who could deploy that capital into their next deal, or into the market. If we take a conservative 5% ROI on that $3 million escrow – that’s about $300,000 of lost opportunity over two years.
Compared to the total cost of $180,000 for the insurance, it makes perfect sense to buy the coverage. Beyond just the economic advantages that R&W insurance can provide, the seller has a certain peace of mind, knowing that should an issue crop up in the near future they don’t have to go it alone and an insurer will step in to defend and pay claims.
Now when it comes to paying claims, it’s not entirely on the insurance company. There is a retention or deductible that the seller would pay before the insurance company pays.
Retentions are generally 1.5 to 3 percent of the purchase price, so using the example previously discussed, the seller will be kicking in anywhere between $375,000 to $750,000.
While that’s a sizable chunk of money on top of the premiums paid, keep in mind that without insurance, the seller’s entire escrow of $3 million is at risk, and then some.
In this discussion, I’ve focused this on the seller purchasing coverage, or sell-side policies, but in the middle market, buyers can also be the insured and purchase a buy-side policy. In fact, the majority of policies sold in the mid-market are buy-side policies.