Tail Insurance – What Is It and Why You Need It
If you’re in the process of selling your company, the buyer or buyer’s attorney may be insisting that you purchase something called tail insurance and you’ve never heard that phrase before.
What’s a tail? What’s tail insurance? Why do I need it, and why do I need it now that I’m selling my business?
I’m going to answer those questions coming right up.
Okay, so you’re in the process of selling your company and the need for tail insurance has come up and you’re not really sure what it is or why you need it. Especially given the fact that you’re exiting the business – why do you need to buy more insurance now?
Well, it’s actually not more insurance, it’s an extension of what you already have.
Tail insurance is sort of a weird name that’s been used to describe the more formal term of “extended reporting period” or ERP and it will apply to claims made policies you may already have, such as E&O or Errors & Omissions Insurance, Cyber Insurance, and D&O or directors and officers liability insurance.
It may even apply to contractors’ E&O insurance if you’re in the construction trades.
Why do you need Tail Insurance for the sale of your company?
The policies I described are all written on a claims-made policy form and one of the features of claims-made is that for a claim to be covered it must be “made” or reported to the insurer of the policy which is effective at the time of the reporting.
Another unusual feature of most claims-made policies is that they contain something called a change in control provision which says that when 50% or more of the insured company is sold, merged, or consolidated into another company, the policy terminates as of the signing of that merger agreement.
There are some differing extensions in different policies in different states, but for now, just assume that when you sell your firm your claims-made policies automatically terminate.
So, what’s the problem or issue?
Well, due to the nature of a claims-made policy and the risks they insure there is always the potential of latent claims – meaning something may have occurred prior to your closing date – it could have been 3 months ago, it could have been three years ago – which could give rise to a claim post-closing.
As I mentioned earlier for a claim to be covered in a claims-made policy, the policy must be in effect when it’s reported to the insurer, and given that your policy terminates at the closing there’s now no active policy to report it to.
That creates an uninsured liability for the buyer which is why they are requesting that you purchase a tail. The tail holds the window open to report claims post-close for acts that occurred pre-close.
Now you may be saying, well, why doesn’t the buyer in this example just report this claim to their insurer post close?
Good question. The answer is that claim did not involve the new owner so it’s not covered under their policy. Again, leading to the need for a tail.
So, how does a tail or extended reporting period work?
Prior to closing on your deal, when you have a claim made policy or policies you should contact your broker to discuss this issue and coordinate this with your attorney as well to make sure you have everything buttoned up. But this is how it looks graphically:
There could be claims lurking out there that haven’t been reported so the buyer wants protection for those potential claims so you’re required to purchase a tail of anywhere from 3 to 6 years. Often that duration will be negotiated based on indemnity agreements.
This tail or extended reporting period only permits claims which had their origin prior to the termination of the policy to be reported.
if somehow there’s an act that took place say 5 or 6 months after the policy terminates, the tail will not pick that up.
That’s likely a liability of the buyer and should be covered under the new policy they purchase for the company or the policy the buyer already had and merged the sold company’s exposure into.
What does Tail Insurance cost?
Most claims-made policies will indicate what the cost of an extended reporting period or tail will be for one to three-year options and the range for the three-year option is about 130% to 200% of the expiring policy’s annual premium.
So if you’re paying $20,000 a year for an E&O policy the 3-year tail will cost you anywhere between $26,000 to $40,000.
In some situations, you may need to provide a 6-year tail and most claims-made policies don’t include their pricing options out this far, so your broker will need to negotiate that with your insurer, but expect it to be pricy.
Now, what if you don’t have E&O, D&O, or Cyber and the buyer of your firm is mandating that you did?
It seems odd, but again the buyer wants to push potential liabilities away from them post-closing so here you’ll need what’s known as a run-off policy.
I did a video on that which goes into more detail, and you can view it here: D&O Run-Off Insurance. What it is, and why you may need it.
but it’s essentially a one-day policy with a tail to cover your obligations in a deal.
Okay, I think that covers most of the topics regarding tail insurance in M&A, but if you have a specific question or issue I didn’t cover here, reach out and let’s connect.