Representations and Warranties Insurance (RWI) is a specialized insurance product designed for parties engaging in merger and acquisition (M&A) transactions and certain other transactions where representations and warranties are given, such as in connection with the making of minority investments. RWI provides buyers[1] insurance coverage for a seller’s breach of the representations and warranties it makes in the M&A transaction agreement and offers a “synthetic tax indemnity” that mirrors the tax indemnities customarily given by sellers to buyers in M&A transactions. RWI is billed as a win-win for buyers and sellers alike: buyers get better representations and warranties coverage — both in terms of scope and survival period — and sellers eliminate the classic ~10% indemnity escrow and, in some cases, successfully negotiate for the elimination of all indemnity obligations in respect of representations and warranties.

Initially, RWI faced several challenges to widespread adoption. Without substantial deal volume and a limited number of insurance options, policy terms and the scope of coverage varied substantially from deal-to-deal. Pricing was out of reach for most buyers and the underwriting process was inefficient. The industry quickly adapted, however. Today, nearly 40 participants underwrite RWI in virtually every segment of the M&A industry, which has brought pricing down and facilitated streamlining of the underwriting process. Now, the process for purchasing a buy-side RWI policy can be completed in a matter of days. The process consists of the following steps:

1. Broker Engagement and Insurer Selection. RWI policies are obtained via specialty insurance brokers. The broker collects basic information about the transaction and prepares a submission summarizing the transaction structure, the nature of the business, and the scope and material terms of the coverage sought. Insurers respond to the submissions with non-binding indications of coverage, often referred to as a Non-Binding Indication Letter (NBIL).
2. Underwriting. Once an insurer is selected, the insurer conducts its own review of the buyer’s third party due diligence reports and due diligence materials provided by the seller to the buyer via an electronic data site. The diligence phase concludes with an underwriting call between buyer and the underwriters, which gives underwriters the opportunity to address questions to buyer.
3. Policy Negotiation and Binding. RWI policy negotiation customarily begins after the underwriting call and runs in parallel with the completion of underwriting until the policy is “bound” and insurance coverage commences.

As part of providing coverage, insurers expect buyers to have thoughtfully considered the representations and warranties asked of seller in the context of seller’s business and conducted due diligence commensurate with the scope of representations requested. Insurers also expect the buyer and seller to have negotiated the transaction at arm’s length as if RWI did not exist, which includes sellers fulsomely disclosing known exceptions to any representations and warranties.

The Framework of a RWI Policy

An individual familiar with insurance policies but unfamiliar with RWI would find an RWI policy at once familiar and bizarre. As RWI is designed to insure matters that happened pre-closing —rather than during the policy term — the policy operates on a “claims-made” basis and leverages many core concepts common to all claims-made policies. These core concepts are discussed below in Basic Insurance Terminology. Unlike most lines of insurance, however, buyers of RWI insurance hold more leverage than the average insured because the pool of buyers of RWI is limited, and those buyers are highly sophisticated. While many terms are now standardized, RWI policies are still heavily negotiated in a way that is foreign to most types of insurance. RWI policies also contain unique provisions to accommodate the unique dynamics of insuring businesses being purchased and sold.

A well-negotiated RWI policy strikes a balance between the competing goals of buyer, seller, and insurer. Buyers seek financial protection and deal certainty on a post-closing basis by securing comprehensive coverage for potential breaches. Sellers aim to limit their post-closing liabilities and push for policy structures that minimize or entirely eliminate their indemnity obligations (i.e., the “clean walk-away”). The insurer needs to underwrite policies that accurately reflect the risks of the particular target such that potential loss exposure is reasonable relative to the premium earned after consideration of retention. Even though most RWI policies are ‘buy-side’ policies (i.e., the buyer is the “insured” and the seller is not a necessary party to the RWI policy), buyer, insurer, and seller generally have input in the RWI policy negotiation process because the seller leverages its negotiating position vis-à-vis buyer in the M&A transaction itself to push for its best interests in the RWI policy.

Basic Insurance Terminology

As noted previously, an RWI policy is a claims-made insurance policy and, as such, a working knowledge of general insurance terminology is required to properly negotiate an RWI policy. Below are notable terms that play critical roles in virtually every RWI policy.

Insureds and Loss Payees.

Most RWI policies are “buy-side” policies, meaning that the buyer under the acquisition agreement or a parent entity of the buyer is the “Named Insured.” The Named Insured is the primary point of contact for all matters related to insurance and has the broadest rights to enforce the RWI policy on its behalf and the behalf of all other “insureds,” such other insureds are generally referred to as “Additional Insureds.” Most buyers of RWI are private equity firms or institutions with multiple constituencies. Thus, it is common for RWI policies to include a Named Insured and Additional Insureds to ensure all buyer constituencies impacted by a loss (discussed below) have recourse. Additional Insureds may have more limited rights than the Named Insured depending on the relationship of the Additional Insureds to the Named Insured and their risk profile. Additionally, a policy may list a “Loss Payee”, which confers no rights to enforce the RWI policy, but directs payments to such person. For example, the buyer’s lender helping finance the M&A transaction subject to RWI may request to be a Loss Payee on the RWI policy, although it is more common to see lenders seek the right to cause Named Insured to collaterally assign the RWI policy in the event of default under its loan documents.

Limits of Liability; Retention.

Consistent with the historic ~10% escrow sellers gave buyers prior to the emergence of RWI, the ‘standard’ limit of liability for an RWI policy is 10% of the enterprise value of the target company — or its assets in an asset sale. However, 10% is not mandatory. Many quotes for insurance will request insurers price multiple options for limits of liability based on the buyer’s risk tolerance.

RWI policies almost always include some amount of retention, which is largely a function of the fact that almost all RWI policies include a materiality scrape. Retention, premiums, and underwriting fees all vary based on a number of factors, including the nature of the asset, the scope of insurance sought, and market conditions in the RWI industry. Many RWI policies provide for a “drop-down” in the amount of retention after 12 months, which derives from historic data that claims on most RWI policies occur within the first 12 months of policy inception. It is becoming more common, however, that claims for loss resulting from the breach of so-called “true fundamental representations” are not subject to any retention.

Subrogation.

RWI policies also include a concept of subrogation against the persons who made the representations and warranties in the underlying acquisition agreement. Not surprisingly, subrogation is one area where a seller will have strong opinions. Unlike more common insurance policies such as commercial general liability insurance, the insurer’s right of subrogation in an RWI policy is almost always limited to seeking recourse for the “fraud”[2] of the person(s) who made the representation at issue with limited exceptions.

Claim.

As a claims-made policy, making a timely and proper claim triggers coverage. RWI policies provide procedures for directing insureds as to when and how to make a claim. These policies also provide requirements for substantiating a claim, which vary depending on the type of claim (i.e., a claim may arise due to actions of a third party or may arise due to the buyer’s discovery of an issue once it gets into operations of the business), and provide dispute resolution procedures (discussed later). All RWI policies contain a limited coverage term (a/k/a “survival period”). A customary survival period is three years for “non-fundamental” representations and six to seven years for “fundamental” or “true fundamental”[3], tax, and (to the extent relating to tax) employee benefits representations.

Key Terms Defining the Scope of RWI Coverage

While RWI policies are ultimately claims-made policies, they contain a number of features unique to the product, and certain industry standards have evolved over time. The most obvious difference is the scope of coverage. Most RWI policies provide for an “Insuring Agreement” or “Insuring Statement” that can be as simple as the following:

“Subject to the terms and conditions of this Policy, the Insurer shall indemnify and reimburse the Insureds for, and shall pay to, or on their behalf, any and all Losses.”

The simplicity of the insuring statement belies the complexity of the underlying defined terms relied upon to define coverage. Using the insuring statement above, the defined terms can be unraveled:

Loss.

Loss is a heavily negotiated term. A customary loss definition first generically lists the various forms of adverse effects that may constitute a “loss” (e.g., damages, liabilities, claims, taxes, etc.) and then narrows the definition to only those adverse effects that arise from a “breach.” In defining the various liabilities or damages that can constitute loss, the parties may agree to track a corresponding definition in the acquisition agreement if one exists. No matter the route chosen, all parties must consider closely the intended scope of coverage in various contexts. For example, how do liability limitation and expansion provisions impact the policy (e.g., are punitive damages losses, should the statute of limitations under law bar a claim under the policy?)? Separately, how do the terms in the acquisition agreement affect loss (e.g., does the RWI policy apply all materiality scrapes, does it apply the net working capital collars as a limitation on Loss?)? It is common for insured loss to be calculated without regard to survival periods and other limitations of the acquisition agreement (e.g., baskets and caps) and apply a standard full materiality scrape.

Breach.

As a loss only arises in the event of a breach, this term is critical in determining coverage. A breach is usually defined by reference to two concepts: (1) a breach, misrepresentation, or inaccuracy in the “Covered Representations and Warranties,” or (2) an occurrence of an event subject to the “Pre-Closing Tax Indemnity.”

(1) Covered Representations and Warranties. This term references the sections of the acquisition agreement containing the representations and warranties subject to insurance. An insurer may not insure the representations and warranties exactly as written in the acquisition agreement, in which case the RWI policy will list exceptions where the scope of insurance coverage will not follow the representations and warranties as written.

(2) Pre-Closing Tax Indemnity. This term is intended to mirror the pre-closing tax indemnity historically given by sellers in M&A transactions. As transactions can take multiple forms for tax purposes, the scope of the pre-closing tax indemnity varies to reflect the intended tax structure of the acquisition.

Exclusions.

Every RWI policy includes a section that provides for exclusions from coverage, notwithstanding the event otherwise constituting a loss. There are two general categories of exclusions: (1) matters that the insurance carrier will not offer coverage under as a matter of its underwriting policies, which are set forth in the non-binding indication letter and thus often referred to as NBI exclusions, and (2) matters that constitute known breaches identified during due diligence. Some common NBI exclusions are listed below. Exclusions arising from due diligence are bespoke and vary significantly from deal to deal.

• Interim Breaches. Breaches occurring between signing and closing that were not disclosed or remedied. Many insurers offer interim breach coverage at the cost of an additional premium, and depending on the facts and circumstances of the transaction, it may require additional due diligence procedures to get insurers comfortable with the expanded risk profile.
• Purchase Price Adjustments. This exclusion is generally seen as a “no-double counting” mechanism. If the acquisition agreement reduces the purchase price on account of a known issue that may also be a breach, the purchaser cannot produce a windfall by additionally seeking RWI coverage.
• Pension Underfunding. This exclusion relates to liabilities related to underfunded pension plans. These liabilities can be orders of magnitude larger than the coverage under the insurance policy and difficult to calculate.
• Certain Environmental Liabilities. Environmental representations are generally covered, but certain known environmental issues that bring with them known remediation costs are excluded from coverage. Asbestos and polychlorinated biphenyls (PCBs) are two common exclusions. For Taft’s thoughts on PFAS in this context, we refer you to “David Bartoletti and Ina Avalon, Why RWI Insurers should Consider Excluding PFAS, Law360.com, May 2, 2024), Why RWI Insurers Should Consider Excluding PFAS – Law360.”
• Fraudulent Misrepresentation. Coverage excludes losses arising from intentional misrepresentation or fraud by the parties making the representations and warranties.
• Transfer Pricing. Transfer pricing refers to affiliate transactions where the parties may have incentive to manipulate pricing upward or downward for tax or other reasons in a manner inconsistent with arm’s length pricing. These matters are generally known risks and as such outside of the scope of RWI policies, which are intended to cover ‘unknown’ issues.

Additional Policy Terms

The terms described above constitute the principal terms that define the scope and duration of coverage. The remainder of the policy is usually dedicated to procedural matters, most of which only apply in the event the insured believes there is a valid claim to be made. Many of these terms are heavily negotiated.

Presenting and Processing Claims.

Claims must be presented in the time and manner agreed upon in the RWI policy. Timing for making a claim is usually tied to a representative of the buyer acquiring knowledge of a breach or potential breach. A valid claim notice needs to describe the claim in reasonable detail; insurers understand that the full scope of information necessary to validate a claim may not be known at the time a claim notice is made. Claims need to be presented during the survival period to which the claim relates, with limited exceptions. The policy will require the insurer to respond within a specified period of time stating whether it has accepted the claim, rejected the claim, or needs more information to substantiate the claim.

The insured will be expected to provide updates and documentation relating to any matter subject to a claim notice as the nature of the claim continues to evolve (e.g., updates as to litigation, new correspondence from a taxing authority, etc.) and the parties will each agree to make commercially reasonable efforts to cooperate in processing claims. A well-negotiated RWI policy balances the need to protect the insured’s privileged information against the insurer’s need to access sufficient information so that it can reasonably assess the merits of a claim.

Most policies will provide for specific terms outlining the insurer’s rights with respect to litigation, including the insured’s choice of counsel, the insurer’s right to be kept abreast of litigation developments — including settlement negotiations — and the insurer’s rights to participate in litigation and settlement negotiations. A well-negotiated policy strikes a balance between the insured’s need to act in the best interest of the target company — which may include seeking to settle — and the insurer’s desire to act in a manner that minimizes loss. For example, insurers usually have consent rights over the decision to settle litigation that constitutes a loss, but the consent right may be waived if the settlement does not exceed a predetermined portion of then-remaining retention.

Mitigating Losses – Buyer Actions and Other Insurance.

Insured parties are required to take commercially reasonable steps to mitigate losses, reducing the insurer’s potential payout. The negotiation in this area can be contentious. Insurers usually agree to the insureds’ requests that they not seek recovery or recourse from the sellers under the acquisition agreement (i.e., the insurance policy is first recourse) except (1) sellers’ fraud (as discussed in subrogation) and (2) recovering amounts that are subject to purchase price adjustment mechanisms in the acquisition agreement, which insureds generally get comfortable with (subject to insurer’s subrogation rights) because known matters have already been excluded from the policy and the net working capital mechanic used in U.S.-style M&A deals generally covers current liabilities (defined by reference to generally accepted accounting principles (GAAP) and/or sellers’ accounting principles).

RWI policies often overlap with other insurance policies of the target or buyer. As a general rule, RWI policies “sit excess” to — or pay after — other insurance policies of the target or buyer that cover the same scope of risk as the subject matter of the breach. In that circumstance, the loss is reduced by the amount[4] of any offsetting recoveries from another insurance policy that has been actually received (i.e., to avoid buyer windfalls from receiving double insurance coverage). Despite sitting excess to other insurance, the insured may be permitted to simultaneously pursue claims against the RWI policy and other insurance policies. This may create situations where the RWI policy pays out a claim that is arguably subject to coverage under other insurance policies, in which case the RWI policy may call for subrogation rights to pursue the claim against such other insurance.

Other “Boilerplate” Terms.

Most RWI policies are governed by Delaware law and require — or at least encourage — arbitration. Arbitration is generally seen as a cheaper and quicker alternative to court, which usually appeals to both parties. Because this is the prevailing practice, there is little public litigation regarding the interpretation of RWI policies.

As a product tailored to its private equity buyers, virtually all RWI policies contain language allowing for the assignment of the RWI policy to the insured’s affiliates and to subsequent buyers of the target business with few restrictions. RWI policies may also allow collateral assignment to lenders, which is often required by purchasers who engaged in a leveraged purchase.

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[1] The vast majority of RWI policies are procured by buyers to the M&A transaction rather than sellers. “Sell-side” policies create unique challenges for underwriters due to the fact that underwriters cannot look to the buyer’s due diligence as part of their underwriting function and instead must rely on sellers to provide information that backs up their own representations.

[2] The scope of the term “fraud” is a common negotiation point, the discussion of which is outside the scope of this writing.

[3] The scope of “true” fundamental representations becomes a dispute point from time to time.

[4] How to determine the “amount” is an oft-negotiated provision as netting concepts come into play.