Transaction Insurance: Beyond Indemnification
In a healthcare transaction, indemnity provisions are used as a way to protect the buyer from suffering any monetary hits from unexpected issues that could arise in the deal post-closing. However, in modern deals sometimes indemnity is not enough. This is where a more recent idea of transaction insurance comes into play for the deals that deem insurance a secure fit.
James Epstein, partner with Pepper Hamilton believes that transaction insurance is becoming a growing trend that a lot of people are taking advantage of; however, not everyone is taking advantage of it.
“The reason is that it tends to truncate some of the discussions that buyers and sellers have about the extent of representations and warranties that are provided in a transaction since the exposure of the seller is generally quite limited as compared to a traditional transaction where they provide a full indemnity from 5 to 20 percent of the total purchase price,” Epstein says.
“In this case, oftentimes their exposure is limited to one percent or so of the aggregate purchase price for the transaction. There are some costs associated to offset that. Ordinarily those costs are split between the buyer and seller, but at the end of the day the seller’s exposure is much less than it would typically be in a traditional deal.”
Epstein adds that buyers are also typically able to obtain some greater protections than they might otherwise be able to obtain directly from a seller.
Markus Bolsinger, partner with Dechert explains that the importance of transaction insurance depends on the deal, but transaction insurance is more important in the context of an auction, which financial buyers often do.
“When I started looking into transaction insurance it in the late 2000s, you had a competitive advantage if you used it because you could do things and agree to things that other people looking to get a full indemnification package from the sellers couldn’t do, and therefore you had the leg up.Everyone has caught on and today, if you don’t use it as a buyer, you have to pay a substantially higher price than anyone else in the process in order for a seller to get comfortable with a traditional indemnification package rather than having an underwriter assume a good deal of that risk,” Bolsinger says.
Epstein echoes that and says that typically, transaction insurance comes into the picture if a company is sold through an auction process.
“Nowadays, a lot of sellers are going out and saying they want the buyer to obtain rep and warranty insurance. That’s the start of the process. There are two different kind of policies, a buyer’s policy and a sellers’ policy,” Epstein says, emphasizing the buyer policy.
In a buyer’s policy, Epstein says the seller essentially says to the potential buyer that they want them to obtain rep and warranty insurance. Then, what will happen is the buyer will retain a broker or consultant and they will scrub the marketplace and seek quotes from a series of different companies. Depending upon how robust the markets are, and how busy the insurance companies are, the buyer can see anywhere from one to six quotes on each deal.
“Those are preliminary numbers, and what then happens is the buyer really has to pick a horse that they want to ride. That company will then piggyback on the diligence that is being done by the buyer since they will want to review legal reports, financial reports, and other consultant reports that the buyer has sought to be generated in the transaction. Then they will do some of their own digging around and ultimately come back with a more developed proposal which will have costs, deductibles, exclusions. Some typical exclusion includes wage and hour claims, healthcare regulatory claims. There are some areas and some types of transactions where insurance really is not a product that can generally be used. One of those is the healthcare field. There are some people who are working on products to try and bridge that gap and fill the void,” Epstein says.
Matthew Heinz, senior managing director at Aon says in the healthcare world, the rep and warranties side had been challenging because clients could not get coverage for healthcare regulatory issues like billing and reimbursement issues regarding Medicare and Medicaid.
Heinz says that with recent developments in transaction insurance products, several carriers now are covering that supported by specific diligence provided by a healthcare consultant who looks at claim files and does a full blown claims file review.
Rep and Warranties and Taxes
Epstein explains that the typical kind of transaction is a middle market transaction where there is an enterprise value from 100 to 500 million dollars.
“Oftentimes you will see insurance that covers about ten percent of the enterprise value of a transaction. So, you are getting coverage for 10 to 50 million dollars of potential exposure. That is the sweet spot of the transaction. You can do larger transactions by layering different insurance companies on top of each other. It tends not to work for the smaller transactions because pricing becomes a little bit prohibitive in that case,” he says.
Bolsinger delving into representation and warranty insurance says this insurance and any residual contractual indemnification should work together so that the insurance supplements the small(er) risk that lays with the seller and the two contracts are otherwise synchronized.
“If you compare traditional indemnification arrangements from a few years ago with rep and warranty insurance today, rep and warranty insurance is, at the end of the day, the better package, but it comes at a price,” Bolsinger says.
“There are certain things, however, you can’t do in a rep and warranty policy that you could do in a traditional indemnification arrangement because the underwriter is in a different position than a seller and doesn’t derive a benefit from the underlying sale. For example, a seller could agree that a buyer would be indemnified even if the buyer knew about a breach. Obviously, that wouldn’t work in an insurance policy. Similarly, a rep and warranty insurance will not insure a buyer against any covenant breaches of a seller, with the exception of a covenant to hold a buyer harmless for pre-close taxes. That would just be against the core principle of underwriting that you don’t want to create something that is a moral hazard.”
Bolsinger adds that the purchase and sale agreement gets negotiated much faster with a rep and warranty package. Sellers get comfortable with the boxes around their limited indemnification exposure, so that whole negotiation is a lot smoother and less adversarial.
Heinz confirms that a rep and warranty policy generally covers unknown pre-close tax liabilities.
“To the extent that there is an identified tax issue unearthed in the due diligence process, the rep and warranty carriers won’t cover that. So, we have to look for an alternative policy to get those covered, and there is a separate market for identified tax issues. The types of things that we often see are any kind of pre-close restructuring that was intended to be tax-free, issues related to net operating losses, or benefits related issues. There is a whole gamut of tax positions that can be covered in a tax policy,” Heinz says.
“The policies are not designed to cover tax shelters or structured tax products, but rather positions with alow level of uncertainty that could have big dollar impact if the taxing authority took a different position.”
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.