1 Introduction

Mergers and acquisitions (M&A) involve transactional risks, no matter how extensive and accurate the due diligence process is. Information asymmetries are inherent in most M&A deals, and it is no surprise that post-M&A disputes arising from inaccuracies and misrepresentations in seller’s disclosures are common, and severity of claims is on the increase.Footnote 1 This raises the question as to how transactional risk can be effectively managed and allocated.

Representations and warranties included in acquisition agreements typically address this issue, as they facilitate the transfer of information to the buyer, reducing information asymmetry.Footnote 2 In private transactions they are generally accompanied by indemnification provisions by which the seller or the selling shareholders undertake to indemnify the buyer if representations and warranties turn out to be inaccurate after the closing. Escrow arrangements may also be in place, providing that a portion of the sales price is placed in escrow and can be paid to the seller subject to certain conditions.

When negotiating representations and warranties and indemnification and escrow requirements transacting parties clearly have contrasting interests, as while the buyer wishes to obtain the maximum degree of protection, the seller seeks to minimize its liability. There could also be cases, especially in public company transactions or distressed sales, where the buyer may have no effective remedies against the seller after the closing.

To remedy issues related with seller’s indemnities, insurance companies created some innovative products, generally known under the catch-all name of “transactional insurance,” and providing coverage for risks arising out of extraordinary corporate transactions, including risks related to breaches of representations and warranties, tax liabilities, pending or potential litigation and other contingent liabilities.

This chapter explores the role that insurance can play in managing transactional risk, considering whether it can serve as an efficient alternative to more traditional, contractual solutions like indemnity and escrow requirements.

The chapter rests on both practical and theoretical grounds. From a practical point of view to consider the role of insurance in M&A is undoubtedly relevant, as global demand for transactional insurance has grown substantially over the last decade and insurance is regarded ever more as a common risk management tool in M&A.Footnote 3 From a theoretical and systematic perspective, the question arises as to whether, by allowing parties to transfer transactional risks in exchange for a premium, insurance has the potential to enhance the overall social benefit facilitating the conclusion of beneficial M&A transactions or, on the contrary, may bring about distortion to M&A contracting, as it transfers liability from the parties that have superior access to information to the insurer, potentially triggering moral hazard and adverse selection problems.

In this context, the chapter proceeds as follows. After this Introduction, Sect. 2 focuses on traditional contractual solutions to manage transactional risk and mitigate potential liabilities, highlighting their main drawbacks. Section 3 turns to transactional insurance, examining representation and warranty insurance, tax liability insurance, litigation buyout and contingent liability insurance. Section 4 considers whether insurance can qualify as an efficient risk-transfer tool in M&A, also considering potential issues of moral hazard and adverse selection. Section 5 concludes.

2 Contractual Solutions

Representations and warranties are typically included in acquisition agreements to remedy information asymmetry and manage transactional risk. They are made by the buyer and the seller to each other to provide full disclosure of all information relevant to the transaction. Whereas the buyer’s representations and warranties are mainly intended to prove its ability to legally execute the deal, the representations and warranties made by the seller are aimed at providing an accurate and complete description of different aspects of the company being sold.Footnote 4

Representations and warranties generally concern a company’s organization and good standing, capitalization, subsidiaries, organizational authority to enter into the agreement, financial statements, absence of undisclosed liabilities, property titles, contracts, litigation, compliance with law and agreements, taxes, employee benefit plans, labor disputes, environmental matters, and insurance policies.Footnote 5

Transacting parties warrant in the acquisition agreement that their representations are complete and accurate. In particular, if the seller’s representations and warranties turn out to be inaccurate before the closing, the buyer may reject or renegotiate the contract (bring-down clause), while if a breach is discovered after the closing, in private transactions, the buyer is normally entitled to get indemnification from the seller.Footnote 6

Representations and warranties are among the most heavily negotiated provisions in the sale and purchase agreement. Unlike buyers, who want absolute representations and warranties, sellers insist on limiting their potential liabilities by using knowledge and materiality qualifiers. A knowledge qualifier limits the seller’s statements to the best of its “knowledge,” with the buyer insisting on interpreting the term as knowledge after a reasonable investigation, while the seller as knowledge of a fact without any duty to investigate.Footnote 7 Materiality clauses, on the other hand, limit the accuracy of representations and warranties by providing that the representations must be true and correct in all material respects. A fact is regarded to be material if a reasonable investor would consider it important in making a decision on an acquisition transaction. Besides, materiality may also refer to the effect of a breach of representations and warranties, excluding liability for inaccuracies that do not have a material adverse effect.Footnote 8

If a breach of the seller’s representations and warranties is discovered after the closing, as noted above, indemnification provisions would require the seller to pay damages. Indemnification provisions also permit to allocate specific risks pending on the acquired company, that have been disclosed in the representations and warranties and the consequences of which cannot be calculated before closing, such as pending litigation, unpaid tax obligations or violations of environmental or labor laws.Footnote 9 Indemnification provision are common in private transactions, while in transactions where a public company is being acquired, representations and warranties generally do not survive the closing and no indemnity may be available to the buyer for breaches discovered after the closing as, especially in listed corporations with dispersed shareholders, it would not be feasible to get indemnification from selling shareholders. In addition, a lower degree of information asymmetry is generally found in public deals than in private transactions, given the disclosure requirements imposed on public companies and the consequent amount of information that is publicly available.Footnote 10

Normally the seller wants the indemnification periods to be short. The term may vary from one to three years after the closing except for some claims such as tax, environmental or property and title that may survive beyond.Footnote 11

As for the indemnifiable damages, the buyer is likely to want unlimited coverage for the reasonable cost of satisfying the incurred liabilities in addition to the amount necessary to put the buyer in the position it would have been in without the breach of the representations and warranties. This may result in a request for damages in excess of the purchase price. Sellers, on the contrary, want to set a ceiling on the indemnity obligations and, at the most, agree to indemnify up to the purchase price.Footnote 12 Generally, indemnification limits are well under the purchase price.Footnote 13

Moreover, the seller may insist on including a deductible or a “basket” to restrain claims for minimum damages. In the first case, when a loss suffered by the buyer exceeds the stipulated deductible amount, the seller is liable only for the amount of the loss above the deductible. If a “basket” is used, the buyer agrees not to assert indemnification claims until the aggregate amount of losses exceeds a specified basket amount. When the buyer’s losses exceed the basket amount, the seller is liable for the total amount of the losses.Footnote 14

It should be noted, however, that there may be virtually no remedy for a breach of representations and warranties where no identifiable seller remains after the closing. This, for example, may be typical of asset purchases from companies that go into liquidation after the transaction, and more generally in distressed sales. Where the seller is privately held, the buyer may demand that (large) selling shareholders participate in the representations and warranties and that indemnification rights are conferred against them.Footnote 15 If the shareholders consent, they will usually want the guarantee to survive for as short a time period as possible. This solution instead is impracticable where the seller is a publicly held corporation with dispersed shareholders.

To protect himself from potential liabilities associated with the transaction, the buyer may also seek to defer the payment of part of the purchase price and put the unpaid portion in a holdback or escrow account. Transacting parties, nevertheless, need to agree on the amount to place in escrow, the length of time the proceeds are escrowed, the conditions of the escrow. Further, the seller is not likely to accept escrow arrangements without an increase in the purchase price.Footnote 16

3 Transactional Insurance

When negotiating representations and warranties and indemnification provisions transacting parties have contrasting interests and need to reach agreement on several key points, including the scope of representations and warranties, the survival period, the definition of indemnifiable damage, indemnification limits, the portion of price to put in escrow. The possibility of deal breaker issues is strong. When disagreement does not result in the failure of the transaction, the compromise agreed to by the parties might be substantially different from their initial expectations. Should a breach of the seller’s representations and warranties be discovered after the closing, the risk that the buyer is left with no effective remedies exists.Footnote 17

In this context, to overcome the drawbacks associated with representations and warranties and indemnification provisions, and facilitate the conclusion of the deal, parties increasingly avail themselves of transactional insurance.

Introduced in the United Kingdom and the United States in the 1990s, transactional insurance was not widely used at first mainly due to its novelty and lack of confidence by parties, high premiums and limited availability of coverage. With time, however, the market for transactional insurance has evolved: available coverage is now broader, terms are more favorable, and rates are lower as there is more competition among insurers,Footnote 18 while risk aversion of transacting parties has risen.Footnote 19 Coverage has also become more widely known: global demand for transactional insurance nowadays is ever more on the rise, especially in the U.S. and U. K. markets,Footnote 20 but also in continental Europe where the use of this type of insurance is on the increase.Footnote 21

In particular, insurance products for M&A transactions include: representation and warranty insurance,Footnote 22 tax liability insurance, litigation buyout and contingent liability insurance.

3.1 Representations and Warranties Insurance

Representations and warranties insurance is the most widely used type of transactional insurance.Footnote 23 It became available towards the end of the 1980s in the United Kingdom and about a decade later in the United States. This type of insurance provides coverage against financial losses resulting from breaches of representations and warranties. It can serve as either a surety or indemnity of the seller’s indemnity obligations.Footnote 24 In the first case, the sale and purchase agreement includes indemnification provisions and the insurance policy serves the purpose of replacing completely or in part an escrow. In the latter case, insurance either can be entirely substituted for the seller’s indemnity obligation or may be used as an additional layer of coverage over a lower amount of indemnification liability assumed by the seller.

Insurance is tailor-made to the needs of the individual transactions. Underwriting can be quite complex, and it is advisable that insurance companies and brokers are involved from the initial stage of the deal structuring process. Insurance companies and brokers, however, have gained adequate experience over time and are able to provide coverage within a limited period, meeting the deal timetable.Footnote 25 The applicant is expected to cooperate closely with the insurer and provide relevant information. The acquisition agreement is submitted to the insurer along with other relevant documents to promote underwriting review.Footnote 26 Once the insurer has reviewed all the materials, it issues a non-binding indication letter, presenting the general terms of the proposed coverage. If the applicant decides to execute the non-binding indication letter, then the insurer conducts a thorough review of the transaction with the possible assistance of outside counsel, basically re-examining the due diligence process performed by the parties and makes a final decision as to whether to insure the risk and at what conditions.Footnote 27

The insured under a representations and warranties insurance policy can be the buyer (buyer-side policy) or the seller (seller-side policy). A party to the transaction may also purchase coverage for the other party and vice versa.Footnote 28

A buyer-side policy provides indemnity to the buyer for losses resulting from a breach of the seller’s representations and warranties. It allows the buyer to recover losses directly from the insurer without having to pursue remedies against the seller.

A variety of reasons may lead buyers to purchase representations and warranties insurance. A buyer-side policy can be useful, for example, when the acquirer cannot successfully negotiate the desired level of indemnification from the seller or when it is concerned with its ability to recover damages because the seller may have financial difficulties or because recourse against the seller would be otherwise ineffective and expensive. Insurance can also be used strategically by a buyer to gain a competitive advantage over other bidders and avoid entering into endless negotiation with the seller over indemnification requirements. This way a buyer can accept a lower indemnification ceiling and may not need to insist on a holdback or escrow account, thus increasing the competitiveness of its offer.Footnote 29 A buyer may also consider that insurance coverage is less expensive than the growth of the purchase price demanded by the seller to afford the same level of indemnification. In addition, in public company transactions, where no indemnity is available to the buyer for breaches discovered after the closing, insurance can be a substitute for seller’s indemnity.

A seller-side policy indemnifies the seller for, or pays on behalf of the seller, any loss resulting from claims made by the buyer for inaccuracies in the seller’s representations and warranties. Seller-side policies may be used when sellers, especially private equity firms, want to reduce their potential liability post-closing to the smallest amount possible, exiting the business and distributing sale proceeds to their investors or immediately reinvesting the proceeds. A seller-side policy also permits the seller to provide potentially interested buyers with higher indemnification limits, thereby making the deal more attractive and reducing the need for a holdback or escrow.

No substantial differences typically exist in the structure and wording of representation and warranty insurance policies between the U.S. and the U.K. (and more generally European) market. The scope of coverage is determined in connection with the representations and warranties made by the seller in the sale and purchase agreement. The insurer normally selects the representations and warranties to insure and may also intervene on the wording of the representations and warranties, restricting or clarifying their scope for coverage purposes only. A policy may also be issued on a “blanket” basis, thereby covering all the seller’s representations and warranties except for those excluded.Footnote 30

Indemnification requests unrelated to representations and warranties are generally not covered. Some insurers, however, have also started offering a more innovative type of coverage—so-called synthetic representations and warranties insurance—that allows the buyer to agree to a set of representations and warranties directly with the insurer, removing the need for the seller to give representations and warranties in the sale and purchase agreement. This type of coverage can be advantageous for both transacting parties, as the seller would exit the transaction without the risk of facing liability for breaches of representations and warranties, while the buyer, in an auction scenario with multiple bidders, can make its acquisition offer more competitive.

Representation and warranty insurance policies typically contain a prior knowledge exclusion that excludes coverage where the insured had knowledge of circumstances leading to the breach at the time the policy incepted. The policy defines the persons who may have actual knowledge of a breach as those who supervised or conducted any due diligence in connection with the acquisition agreement, and/or those who supervised, prepared, or negotiated the acquisition agreement (“deal team members”). The names of the deal team members are generally listed in an appendix attached to the policy.Footnote 31

Further, seller-side policies generally exclude coverage for breaches resulting from the seller’s fraud. This exclusion may be subject to a final adjudication of fraud before becoming applicable, otherwise a mere allegation of fraud can be an argument for the insurer to deny coverage. A severability clause may be inserted, ensuring coverage for innocent co-insureds. Buyer-side policies, instead, do not contain a fraud exclusion and, therefore, are considered to provide broader coverage,Footnote 32 and they represent almost the totality of the policies issued.Footnote 33 Other exclusions specific to representation and warranty insurance may concern unfulfilled projections and forward-looking statements and losses due to price adjustments based on the seller’s net worth determined after a post-closing audit.Footnote 34

Insurance coverage usually begins with the closing of the transaction and is provided for at least the survival period set in the acquisition agreement. It is quite frequent, however, that the policy period lasts beyond the survival period indicated in the acquisition agreement, to the advantage of the parties involved in the transaction. In general, policy periods may vary between 18 months and four years. A different expiry date may also be set with respect to some of the seller’s representations and warranties.Footnote 35

Depending on the need for coverage that parties to the transaction may have, policy limits can be set up to $50 million, although larger programs may be structured on a case-by-case basis. Broader coverage may be achieved through tiered insurance programs that combine primary insurance with excess insurance, thereby increasing coverage limits even up to $200 million per transaction.Footnote 36

Both buyer-side and seller-side policies contain some form of risk retention. Typically, deductibles between 1% and 3% of the transaction value are included, depending, for example, on the type of business being acquired, the due diligence performed, the nature and scope of the representations and warranties. The insurance premium generally ranges between 2% and 8% of the amount of insurance purchased, depending on the nature of representations and warranties, the policy period and the retention applied.Footnote 37

3.2 Tax Liability Insurance

Tax liability insurance is another solution aimed at facilitating M&A deals. Tax considerations are clearly important in M&A transactions and often parties are not able to obtain in time an advance tax ruling clarifying the treatment that will be applied to a proposed transaction. Uncertainty regarding tax results may even obstruct the completion of a proposed deal.

Tax liability insurance allows parties to reduce or eliminate potential tax exposures resulting from the tax treatment of a transaction. It covers unexpected tax liabilities resulting from an unfavorable tax authority’s ruling. Most policies also cover the costs of contesting the tax authority’s ruling, including the expenses of outside counsels and accountants, as well as interest, non-criminal fines, and penalties,Footnote 38 provided that fines and penalties are insurable under the applicable law.Footnote 39

Policies are generally written on a manuscript basis to meet the specific needs of the individual transactions. To promote underwriting review, the prospective insured is generally required to provide the insurer with a tax opinion prepared by the taxpayer’s counsel, along with supporting documents and possible correspondence with the tax authorities.Footnote 40 After evaluating the tax risk, the insurer usually sends a non-binding indication letter, stating the general terms and conditions of the proposed coverage. Once the applicant decides to execute the indication letter, the insurer conducts a thorough review of the transaction, with the assistance of outside counsels and advisors, and a final coverage decision is made.

The coverage period usually is aligned with the applicable statute of limitations. Generally, up to $20 million in coverage is available for any transactions, although larger limits can also be available. Retentions and premiums are determined on a case-by-case basis, also considering the nature of the transaction, the probability of adverse tax results, the probable cost of defense.Footnote 41

Tax liability insurance typically excludes coverage for purely tax motivated transactions, lacking a legitimate independent business purpose. Transactions qualified as tax shelter are not likely to be covered either. Further, coverage is generally not available for losses resulting from changes in the law and for transactions that are already under audit or are being contested by the tax authorities. A fraud exclusion is also included.Footnote 42

Tax liability insurance is ever more common in M&A transactions.Footnote 43 Private letter rulings from tax authorities, in fact, are normally time-consuming, while relying merely on the professional liability or error and omissions insurance coverage owned by tax advisors may turn out to be unsatisfactory.Footnote 44 Tax liability insurance may then allow parties to manage tax uncertainty in M&A transactions, also considering that there could be cases where indemnity obligations of the seller might be unfeasible or otherwise ineffective.

3.3 Litigation Buyout Insurance and Contingent Liability Insurance

Litigation buyout insurance enables transacting parties to manage risks resulting from any anticipated or ongoing litigation, arbitration or other claim involving liabilities either uninsured or underinsured.Footnote 45 Litigation buyout insurance can prove particularly useful, as pending or threatened litigation may hinder the closing of a transaction where, for example, financial sponsors withdraw or the settlement of the claim cannot be negotiated in time for the deal. Insurance allows parties to exactly quantify future exposures by transforming contingent third-party claims into a fixed insurance cost.

The policies are tailor-made to fulfill specific needs of individual transactionsFootnote 46 and can provide coverage for a wide range of matters, such as securities litigation, contractual disputes, products liability, intellectual property disputes, successor liability and employment practices liability.Footnote 47 Risks may relate to the litigation outcome or the amount of damages awarded. Insurance may cover either a particular known lawsuit or a portfolio of lawsuits or claims. Considering the uniqueness of the insured risk, premiums, policy limits, and the amount of retentions are set on a case-by-case basis, considering the severity of the underlying risk and the policy structure.Footnote 48

Litigation buyout insurance can be issued in three different versions: buyout, cap, and appeal hedge. The buyout provides coverage for all losses resulting from a specific dispute, including defense costs, while under the cap version the insurer assumes liability in excess of a certain amount that is retained by the insured and possibly covered through existing primary insurance. Appeal hedges, instead, permit the insured to secure the benefits from a favorable judgment against possible reversal on appeal.Footnote 49

The degree of defense control exercised by the insurer differs among the three types of insurance. In particular, in a buyout, the insurer normally assumes the entire risk in exchange for the complete control of the litigation. The insured, nevertheless, is required to cooperate and participate in the litigation. In a cap or hedge, on the contrary, the insured may maintain control of the defense, considering that it shares the same interest with the insurer.Footnote 50

In addition to fraud, insurance policies typically exclude coverage against claims for personal profit, including claims based on insider trading or for usurpation of corporate opportunities. Further, losses due to claims filed by governmental and quasi-governmental entities are not indemnified either.Footnote 51

Finally, it is worth noting that contingent liability insurance is also available, providing tailor-made insurance coverage for risks specific to single transactions, ranging from potential successor liability and losses deriving from defects or failure of property titles, to government and regulatory approvals, contractual disputes, environmental liability, employment matters and intellectual property infringements. Premiums and other policy conditions are determined on a case-by-case basis according to the nature of the specific liability to be insured and the overall structure of the insurance policy.

4 Transactional Insurance in M&A Contracting

As discussed above, transactional insurance allows parties to overcome problems associated with seller’s indemnities and reduce exposure to transactional risk. In principle, insurance can prove to be particularly useful in no indemnity deals involving public company targets or distressed sellers, where it can act as a substitute for seller’s indemnity obligations, but it can also be used as a supplement to seller’s indemnity, when the buyer cannot negotiate the desired level of indemnification or when it is concerned about its ability to recover from the seller after the closing. In an auction with multiple bidders, insurance may also give buyers a strategical advantage over other competitors. Moreover, it permits to reduce or eliminate the need for escrow arrangements, and this seems especially important after the COVID-19 pandemic outbreak, as companies have been experiencing a deepening liquidity crisis and avoiding escrow requirements can provide enhanced liquidity to sellers.

It has been argued, however, that insurance may introduce potential distortions to the M&A contracting process, since the transfer of risk from the seller (i.e., the party that has superior access to information) to the insurer can create a credible commitment problem, as the seller may exercise a lower degree of care in providing relevant information to the buyer and this can undermine efficiency in M&A contracting. The fact that transactional insurance may bring about adverse selection and moral hazard issues in M&A contracting has also been emphasized.Footnote 52

The credible commitment problem is clearly more relevant to private transactions than public company transactions, since, as discussed above, when the target is a public company due diligence is mainly based on information that is publicly available and the buyer normally cannot rely on indemnity provisions to protect itself against inaccuracies in the representations and warranties, so that the concern for possible lower care exercised by the seller loses relevance in public company transactions. Even in private transactions, the transfer of transactional risk to the insurer seems not to exacerbate the credible commitment problem, which is ultimately counterbalanced by the buyer’s interest to conduct a thorough due diligence to gather information about the target and decide whether to enter into the transaction, negotiate certain terms or adjust the consideration to offer.

Also, adverse selection and moral hazard, which are typical issues in insurance, seem not to pose peculiar problems in M&A. Adverse selection implies that a risk pool will progressively consist of high-risk individuals, that value insurance more than low-risk individuals and have an information advantage over the insurer, thereby preventing the formation of an insurance pool. It should be noted, however, that adverse selection normally does not create significant problems to properly designated insurance arrangements.Footnote 53 Due diligence and representations and warranties restrain information asymmetries in M&A and allow insurers to set rates that discriminate based on risk. Moreover, it is fair to assume that adverse selection in transactional insurance would operate not profoundly different than in other sectors, such as D&O insurance, where information asymmetries exist but do not prevent the formation of an insurance pool.Footnote 54

As regards moral hazard, which basically implies that insurance reduces the insured’s incentives to avoid a loss, it should be noted that transactional insurance policies seem well designed to address moral hazard concerns. Policy limits, deductibles and exclusions as well as, in buyer’s policies, subrogation rights of the insurer in case of fraud by the seller align the insurer’s and insured’s interests, reducing parties’ incentives to exercise a lower degree of care.

Transactional insurance thus appears as an effective risk-transfer tool that can facilitate the conclusion of M&A deals. It allows parties to transform potential future liabilities into a quantified insurance premium that can be allocated as part of the purchase price, providing certainty and strategic advantages. A steadily increasing use of insurance in M&A deals can be expected.

5 Conclusion

No matter how extensive the due diligence, losses related to transactional risks in mergers and acquisitions occur. Traditional mechanisms used to allocate risk between transacting parties may turn out to be inefficient and inadequate. Representations and warranties and indemnification provisions are among the most heavily negotiated provisions in the sale and purchase agreement. The parties have contrasting interests during the negotiation of these terms and the possibility of deal breaker issues is strong. When disagreement does not result in the failure of the transaction, the compromise agreed by the parties may be inefficient and unsatisfactory for either or both of them. In some cases, depending also on the form of acquisition, there is a fair chance that the buyer will have insufficient remedies against the seller after the closing.

Transactional insurance provides effective solutions to manage transactional risk, whether related to indemnity obligations, tax uncertainty, pending or threatened litigation or other contingent liabilities. Insurance is tailor-made to meet the needs of transacting parties and may be used as a supplement or also a substitute for seller indemnity obligations. By spreading transactional risk, insurance can promote beneficial transactions that might not otherwise occur and enhance the overall social benefit, providing economic security at a fraction of the cost that it would take for transacting parties to protect themselves.