by Stephen Davidson in New York and Jennifer Drake in Toronto, with Aon Transaction Solutions

Roughly 20% of representations and warranties insurance policies issued between 2016 and 2018 had claims made on them within three years after the policy inception.

The most common claim is for breach of financial statement representations.

Representations and warranties insurance, or RWI, has become common in M&A transactions where sellers require buyers to look to an insurance policy, rather than to the seller, for damages in excess of a deductible, that result from breaches of representations given in connection with the sale. The policies do not cover breaches of covenants. (For more detail, see "Representations and Warranties Insurance" in the October 2018 NewsWire.)

The claims rates on policies issued since 2019 are still developing.

There were few claims before 2016, so most North American claims activity has occurred over the past six years, and claim frequency has remained steady year over year.

The 20% claim rate does not mean that all of the claims allege loss greater than the retention amount. Many claims are made in an abundance of caution or with knowledge that loss will merely erode the retention.

Roughly 5% of policies have claims where loss is alleged to be greater than the retention, but that number has risen over the past 18 months, and now we see more claims where the insured is seeking a payment than we did a few years ago.

Nature of Claims

Financial statement breaches are the most commonly alleged breach of a representation and warranty, having been cited in almost 20% of all claims.

Representations regarding undisclosed liabilities, compliance with laws, and taxes are the next most common bases for claims, with breaches of the material customer representation following close behind.

In terms of claim payments, financial statement breaches remain at the top as well, accounting for over 35% of the total amount paid by insurers despite making up only 20% of claims.

Material customer breaches also have resulted in a disproportionate amount of claim payments, accounting for fewer than 10% of all breaches noticed but more than 17% of claim payouts.

It is not surprising that financial statement and material customer claims have seen significant payouts. Both types of breaches often lead to a larger insurance payout than the dollar-for-dollar amount of the loss, whether as a straight multiple of EBITDA or some other type of loss calculation. However, we also have seen greater pushback from insurers where they believe that the impact of the breach does not lead to long-term recurring losses. The calculation of loss can be a source of debate between insurers and insureds in the claim process.

Most claims are made in the first 12 months after a policy is issued. This makes perfect sense, as many breaches should become apparent either when a buyer takes over the target or goes through the first audit cycle.

However, as use of representations and warranties insurance grows, we have begun to see more claims being made in the subsequent two years. Many of those claims — particularly those made in the third year after inception — tend to be third-party claims that would not become apparent until the claim is raised by an outside party, but more first-party claims are being made after the first 18 months as well.

Claims Process

Many companies have not yet had to make an RWI claim and do not know what to expect from the process.

Aon's North American Transaction Solutions practice has seen more than 600 claims on RWI policies in the last four years through the end of 2021 and has assisted during that period with claim resolutions resulting in payments of nearly $600 million, with over $850 million of loss recognized by insurers, including erosion of retentions. (Insurers recognize a larger loss than the actual claim paid because the amount of retention eroded does not count towards the payout.)

Most policies allow a claim to be filed at the first sign of a potential loss.

Here are some common pitfalls to avoid.

First, do not delay in submitting notice of a claim.

Throughout the RWI claim process, communication with the insurer is key. This starts when the policyholder becomes aware of a breach or potential breach of the transaction agreement.

A policyholder should submit a claim to the insurer as soon as possible after it has sufficient knowledge and information to confirm the reasonable likelihood of a breach, even if the resulting loss is still being determined.

Unlike some other insurance policies, absent unique circumstances, there usually is no downside to submitting a claim under an RWI policy. Each policy is transaction specific, meaning there is no renewal process during which claim history may be scrutinized. An ordinary claim on one transaction is unlikely to influence an insurer when underwriting a separate future transaction, unless the insurer believes that the insured somehow has acted inappropriately in the claims process.

In our experience, insurers have very rarely denied a claim on the basis of a failure to provide timely notice. However, informing the insurer early of any issues that the policyholder encounters has proven to be important to ensuring that all potential avenues of mitigation can be considered, and insurer input can be given in a timely manner. For example, when an insurance carrier is kept up to date in real time about new developments, it is better able to react quickly, including by providing consent in time-sensitive situations, such as a settlement with a third party.

In addition, this also usually means that the insurer has early notice about any costs that are being incurred by the policyholder to deal with the breach, which can prevent a situation where an insurer feels prejudiced by actions taken or costs incurred without its knowledge.

Next, preserve, compile and assess supporting information and documents.

One potential area of friction in the RWI claim process relates to the detailed investigation that often is undertaken by insurers to confirm that there is a breach and that the resulting loss is covered by the policy.

A policyholder faced with a breach that has led to notable damages may feel certain what happened and how it was a breach of the transaction agreement and why the loss calculation methodology is appropriate. However, when a claim is filed with the insurer, it is important to bear in mind that the claims professionals are different from those who underwrote the deal and are learning the details of the transaction and the claim from the ground up.

Policyholders should be proactive at the start of the claim process by taking steps to preserve, compile and assess the information and documents that provide support for the breach and associated loss.

Try to consider the facts and supporting information from the viewpoint of a third party starting from a place of limited knowledge and assess gaps in information as well as potential inconsistencies or facts that could be interpreted in more than one way.

Pulling the information together in a way that is easy for the insurer and its advisors to understand and being prepared to address grey areas, inconsistencies and possible questions can go a long way to making an investigation progress run more smoothly and efficiently.

Loss Calculation

Determine how best to support the loss calculation both before and after a claim arises.

When Aon reviewed its North American RWI claims data at the end of Q3 2021, only about 3.75% of all claims had been denied by the insurer. Most of these denials resulted from deal-specific exclusions that were contemplated during the underwriting process. While denials remain rare, we have seen many claims where the policyholder and the insurer disagree about the quantum of loss arising from a breach, in particular where loss calculations are more complicated than usual because the alleged loss is more than just dollar-for-dollar.

Where a policyholder alleges that a breach has led to recurring loss or a diminution in value of the target company and seeks to apply a multiple to calculate the damages, the insurer will take a close look at internal presentations, such as an investment committee memo and board minutes, and presentations to lenders as part of its investigation to confirm the appropriate damages methodology.

When a claim alleges that a breach has affected the value of the target company, insurers may also pay close attention to the deal negotiation process and could ask whether changes to the EBITDA over the trailing 12 months or other factors driving the valuation resulted in corresponding changes to the purchase price. This is something that a policyholder should be prepared to discuss with the insurer during the claim process and expect that an insurer may question a situation where the EBITDA being used to value the deal changed during the negotiation process, but the purchase price did not.

While this should not necessarily be determinative of whether the loss alleged is valid, it is an area we have seen insurers focus on when evaluating an insured's claim.

Some policyholders hire a forensic accounting expert to assist with the calculation of loss for complex claims. Situations where this may be warranted include breaches of the financial statements representation, a claim where the quantum is expected to be large, or the claim involves a multiple or other manner of calculating loss that is not dollar-for-dollar.

Experts also may be helpful when a breach involves an esoteric issue, such as compliance with a law or regulation or the condition of an asset. The assessment of whether it is worthwhile to retain this type of expert should be done on a case-by-case basis, but it may assist a policyholder in some instances to have an outside objective party help pressure-test the claim and the methodology for calculating loss, as well as identify various strengths and weaknesses.

The costs to work with an expert may ultimately be reimbursed under the RWI policy where the covered loss exceeds the policy retention and the language allows for it.

Insurer Subrogation

Beware of insurer rights under the RWI policy when negotiating a settlement.

Many RWI policies do not require the policyholder to pursue recourse against the seller in order to make a recovery from the insurer.

However, if the policyholder is negotiating a settlement of an indemnification or other claim against the seller, it is important to remember the RWI policy may give the insurer a right of subrogation against the seller. This right exists in the event of seller fraud (as specified in the policy) and only to the extent that the insurer makes a payment under the policy. Even in cases where there is no clear indication of fraud, insurers often are reluctant to give up this right and agree to a global release of the seller before its investigation is complete.

If a policyholder reaches a settlement with the seller on a claim that has the potential also to result in a payment under the RWI policy, a release containing a carve out for claims arising out of fraud generally avoids this issue, though it is a good idea to get the insurer's sign off on any release language before signing the settlement agreement.

If a seller insists on a full release, the insurer should be alerted as soon as possible to determine what information is needed for the insurer to consent to the language. In a claim situation where there is an indication of potential fraud by the seller, be prepared for substantial pushback from the insurer to a request to release its subrogation right.

When discussing a potential settlement with a third party that is not the seller, keep in mind that RWI policies typically require consent from the insurer in order to proceed and that the insurer will want to understand why the settlement is reasonable. Sometimes the consent requirement will apply to any settlement with a third party, while other policies will establish a threshold settlement amount above which consent is required.

To avoid undue delay in finalizing the settlement once it is reached, keep the insurer updated about settlement discussions and negotiations. This includes advising the insurer of any counteroffers, especially where it is anticipated that some or all of the ultimate settlement amount will be paid by the insurance policy.

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