representation definition in insurance

Financial Tips, Guides & Know-Hows

Home > Finance > What Is Representation In Insurance

What Is Representation In Insurance

Published: November 22, 2023

Learn about representation in insurance and its importance in the world of finance. Gain insights into how representation affects insurance policies and claims.

(Many of the links in this article redirect to a specific reviewed product. Your purchase of these products through affiliate links helps to generate commission for LiveWell, at no extra cost. Learn more )

Table of Contents

Introduction, definition of representation in insurance, significance of representation in insurance contracts, legal implications of misrepresentation in insurance, types of misrepresentation in insurance, remedies for misrepresentation in insurance contracts, factors influencing representation in insurance, best practices for accurate representation in insurance.

Welcome to the world of insurance, where individuals and businesses are protected from financial risks. When it comes to entering into an insurance contract, representation plays a crucial role. Representation in insurance is the process of disclosing accurate and relevant information to the insurer, ensuring transparency and honesty throughout the agreement.

Insurance contracts are legal agreements between the insurer (the insurance company) and the insured (the policyholder). These contracts are based on the principle of utmost good faith, wherein both parties trust each other to provide truthful information. Representation forms the foundation of this principle, as it ensures that the insurer has an accurate understanding of the risks involved in providing coverage.

As an insured individual or business, it is essential to understand the significance of representation in insurance contracts. Accurate representation not only helps in securing the right insurance coverage, but it also prevents potential legal issues that may arise due to misrepresentation or non-disclosure.

In this article, we will dive into the definition of representation in insurance, its significance, legal implications of misrepresentation, types of misrepresentation, remedies for misrepresentation, factors influencing representation, and best practices for accurate representation in insurance.

Representation in insurance refers to the act of providing accurate and relevant information to the insurer during the process of entering into an insurance contract. It involves disclosing all material facts that may impact the insurer’s decision in providing coverage. Material facts are those facts that could influence the insurer’s assessment of risk or the premium charged.

When applying for insurance, the insured (policyholder) is required to provide complete and truthful information about themselves, their property, or the risks being insured. This information includes personal details, financial information, previous claims history, and any other relevant information that may affect the insurance coverage.

The representation process is a crucial step as it forms the basis of the insurance contract. It allows the insurer to assess the risks involved accurately and determine the appropriate terms, conditions, and premium for the policy. The insurer relies on this information to make an informed decision about whether to accept or deny the application, as well as to set the appropriate coverage limits and pricing.

The insured has a legal duty to disclose all relevant information accurately and honestly. Failure to provide accurate representation can result in the denial of a claim or the voiding of the policy. It is essential for the insured to be diligent in providing all necessary information, as any omission or misrepresentation can have serious consequences.

It is worth noting that representation in insurance extends beyond the application process. Throughout the duration of the policy, if there are any changes or updates to the information provided initially, such as changes in the insured’s circumstances or risk profile, it is the insured’s responsibility to inform the insurer promptly.

In summary, representation in insurance refers to the process of providing accurate and complete information to the insurer during the application and policy period. It is a crucial aspect of insurance contracts, ensuring transparency, fairness, and the proper assessment of risk by the insurer.

Representation plays a vital role in insurance contracts, as it ensures transparency, fairness, and the accurate assessment of risks by insurers. Here are some key reasons why representation is significant:

• Accuracy in Risk Assessment: Accurate representation allows insurers to assess the risks involved in providing coverage. By providing complete and truthful information, the insured helps the insurer understand the specific risks associated with the individual or the property being insured. This enables the insurer to set appropriate coverage limits, determine the premium, and make informed underwriting decisions.
• Foundation of Utmost Good Faith: Representation is a fundamental principle of insurance contracts based on the principle of utmost good faith. Both the insured and the insurer have an obligation to act in good faith, providing all material information honestly and transparently. This principle helps foster trust and mutual understanding between the parties involved.
• Protection Against Fraud: Representation acts as a safeguard against fraudulent activities. By requiring accurate information, insurers can detect attempts to deceive or manipulate the insurance process. This helps protect the industry from fraudulent claims and ensures that resources are allocated fairly and appropriately.
• Preservation of Contract Validity: Inaccurate representation or non-disclosure of material facts can have serious consequences. If the insured fails to provide accurate representation, the insurer may have grounds to void the policy or deny a claim. Proper disclosure helps maintain the validity of the insurance contract and ensures that coverage remains intact.
• Provision of Adequate Coverage: Complete and truthful representation helps the insured obtain the most suitable coverage for their needs. By providing accurate information about their risks and circumstances, the insured ensures that the insurance policy adequately protects them in the event of a covered loss, reducing the chances of being underinsured or uninsured.

Overall, the significance of representation in insurance contracts lies in its ability to promote fairness, trust, and proper risk assessment. By providing accurate information, both the insured and the insurer can enter into a valid contract with a clear understanding of the risks involved and the terms of coverage.

Misrepresentation in insurance refers to the act of providing false or misleading information to the insurer during the application process or throughout the policy period. Misrepresentation can have significant legal implications for both the insured and the insurer. Here are some key legal implications of misrepresentation in insurance:

• Voiding of the Policy: If the insured makes a material misrepresentation, meaning a misrepresentation that could have influenced the insurer’s decision to provide coverage, the insurer may have the right to void the policy. This means that the policy is considered null and void, and the insurer is no longer obligated to provide coverage or pay any claims.
• Denial of Claims: If misrepresentation is discovered after a claim has been filed, the insurer may have grounds to deny the claim. This can be particularly damaging if the insured has suffered a substantial loss and relied on the insurance coverage for financial protection. Denial of claims due to misrepresentation can lead to financial hardship for the insured.
• Legal Liability: In cases of deliberate or fraudulent misrepresentation, the insured may be held legally liable for their actions. Legal penalties can vary depending on the jurisdiction, but they may include fines, damages, or even criminal charges. Insurance fraud is taken seriously and can result in severe consequences for the individual involved.
• Loss of Coverage: Misrepresentation can also lead to the loss of current and future coverage. If an insurer discovers that the insured provided false information, they may choose to terminate the existing policy and refuse coverage in the future. This can make it challenging for the insured to find alternative insurance options.
• Impact on Premiums: Misrepresentation can have an impact on insurance premiums. If the insurer finds out that the insured provided false information, they may adjust the premium accordingly or charge additional premiums to account for the increased risk. This can result in higher costs for the insured and make insurance less affordable.

It is important for both the insured and the insurer to be aware of the legal implications of misrepresentation in insurance. Insured individuals should ensure they provide accurate and truthful information to the best of their knowledge, while insurers should have robust mechanisms in place to detect misrepresentation and take appropriate actions to protect their interests.

Misrepresentation in insurance can take various forms, ranging from innocent mistakes to deliberate falsification of information. Understanding the different types of misrepresentation can help insured individuals and insurers identify potential issues and take appropriate actions. Here are some common types of misrepresentation in insurance:

• Innocent Misrepresentation: This type of misrepresentation occurs when the insured provides false information unintentionally or unknowingly. It may be due to a lack of knowledge or misunderstanding of the facts. Though not intentional, innocent misrepresentation can still have legal consequences if the misrepresentation is material and influences the insurer’s decision to provide coverage.
• Negligent Misrepresentation: Negligent misrepresentation refers to the situation where the insured makes false statements without exercising reasonable care or researching the accuracy of the information provided. The insured may not have intended to deceive the insurer but failed to exercise due diligence in ensuring the accuracy of the information.
• Deliberate Misrepresentation: Deliberate misrepresentation, also known as fraudulent misrepresentation, involves the intentional provision of false information. This type of misrepresentation is a deliberate attempt to deceive the insurer and obtain insurance coverage or benefits fraudulently. It can lead to severe legal consequences, including criminal charges.
• Concealment: Concealment occurs when the insured intentionally omits or hides material facts that should have been disclosed to the insurer. Failure to disclose an important fact that would have influenced the insurer’s decision to provide coverage constitutes concealment. It is important to note that the insured has a duty to disclose all material facts, even if not explicitly asked by the insurer.
• Misrepresentation by Silence: Misrepresentation by silence occurs when the insured fails to provide relevant information that is material to the insurance contract. This can happen when the insured deliberately chooses not to disclose a known fact that could affect the insurer’s assessment of risk or the premium charged.

It is crucial for insured individuals to provide accurate and complete information during the insurance application process and throughout the policy period. Likewise, insurers should have robust underwriting processes in place to identify and address any potential misrepresentations. By understanding the different types of misrepresentation, both insured individuals and insurers can work together to ensure transparency and maintain the integrity of insurance contracts.

When misrepresentation occurs in insurance contracts, there are various remedies available to address the issue and protect the interests of both insured individuals and insurers. These remedies aim to rectify the effects of misrepresentation and restore fairness and integrity to the insurance contract. Here are some common remedies for misrepresentation in insurance contracts:

• Policy Voidance: If a material misrepresentation is discovered, the insurer may choose to void the policy. This means that the insurance contract is considered null and void from the beginning, and the insurer is released from any obligations to provide coverage or pay claims. Voidance may be applicable for both innocent and deliberate misrepresentations.
• Claim Denial: In cases where misrepresentation is discovered after a claim is filed, the insurer may have grounds to deny the claim. If the misrepresentation is material and has a direct impact on the claim, the insurer can refuse to pay the claim, citing the breach of the duty of utmost good faith. The insured may lose the opportunity to receive compensation for the loss.
• Premium Adjustment: Insurance contracts are based on the assessment of risks, and misrepresentation can affect the accuracy of this assessment. In cases where misrepresentation is discovered but does not warrant policy voidance or claim denial, the insurer may adjust the premium. The premium adjustment reflects the accurate risk assessment, ensuring that the insured pays an appropriate premium based on the disclosed information.
• Rescission: Rescission is a legal remedy that allows the insurer to cancel the insurance contract and return both parties to their pre-contractual position. Rescission typically occurs when the misrepresentation is fraudulent, deliberate, or material. It involves the return of premiums paid by the insured, and both parties are released from their contractual obligations.
• Limited Coverage: In some cases, if the insurer discovers misrepresentation but does not choose to void the entire policy, they may limit the coverage provided. The insurer may exclude certain risks or impose specific conditions to mitigate the effects of the misrepresentation. This ensures that the insurance contract remains valid and enforceable, but with adjusted terms and conditions.

The specific remedies available for misrepresentation vary depending on the jurisdiction and the nature of the misrepresentation. It is crucial for both insured individuals and insurers to be aware of their rights and responsibilities regarding misrepresentation. Open communication, transparency, and honesty are key to avoiding misrepresentation and maintaining the integrity of insurance contracts.

Representation in insurance is influenced by various factors that can impact how individuals provide information and insurers assess risks. Understanding these factors is essential to ensure accurate and transparent representation in insurance contracts. Here are some key factors that influence representation in insurance:

• Knowledge and Understanding: The level of knowledge and understanding of insurance policies and terms can influence how individuals represent themselves. Those with a strong grasp of insurance concepts may be better equipped to provide accurate and comprehensive information to insurers.
• Communication and Disclosures: Effective communication between the insured and the insurer is crucial for accurate representation. Clear and concise disclosures from the insurer, as well as proper guidance and clarification, can ensure that the insured understands the information required and can provide it accurately.
• Cultural and Language Factors: Cultural norms and language barriers can affect how information is represented in insurance. Different cultural backgrounds may have varying approaches to disclosure and interpretation of risks. Language barriers can also impact the accuracy of representation if the insured has difficulty expressing themselves or fully understanding insurance terms.
• Complexity of Risks: The complexity of the risks being insured can influence how accurately they are represented. Highly technical or specialized risks may require a deeper level of understanding and expertise to accurately disclose and assess.
• Professional Advice: Individuals may seek professional advice from insurance brokers, agents, or advisors when representing themselves. The quality of advice received can impact the accuracy and completeness of the information provided.
• Regulatory Frameworks: Legal and regulatory frameworks surrounding insurance can shape representation practices. Regulatory requirements may dictate specific information that must be disclosed and the consequences of misrepresentation. Compliance with these regulations is crucial for both insured individuals and insurers.
• Trust and Incentives: The level of trust between the insured and the insurer can influence the depth and accuracy of representation. Trustworthy insurers that prioritize customer satisfaction may encourage insured individuals to provide full and accurate information. Additionally, incentives provided by insurers, such as discounts or additional coverage options, can motivate insured individuals to represent themselves accurately.

These factors highlight the complexity of representation in insurance and the need for open communication, understanding, and compliance with regulatory requirements. Insured individuals should make every effort to provide accurate and complete information, while insurers should create an environment that encourages truthful representation and provides appropriate guidance throughout the process.

Accurate representation is crucial in insurance to ensure fair and transparent coverage for all parties involved. To promote accurate representation, insured individuals should follow best practices during the application process and throughout the policy period. Here are some best practices for accurate representation in insurance:

• Provide Complete Information: Insured individuals should provide all requested information in the application form accurately and honestly. It is important to disclose all material facts that could influence the insurer’s decision to provide coverage.
• Understand Insurance Terms: Take the time to understand insurance terms, policy coverages, and exclusions. If there are any questions or confusion, seek clarification from the insurer or insurance agent to ensure accurate representation.
• Document Information: Keep documentation and records of important information related to the insurance coverage. This includes policy documents, correspondence with the insurer, and any changes or updates to the insured’s circumstances or risks.
• Update Information Promptly: Notify the insurer promptly of any changes to the information provided, such as changes in address, occupancy, or material changes to the risks being insured. Failure to update information can lead to inaccurate representation and potential claim denials.
• Be Diligent in Disclosures: Be diligent in providing accurate and complete information, even if not explicitly asked by the insurer. The duty of utmost good faith requires insured individuals to disclose all material facts that could affect the insurer’s assessment of risk.
• Seek Professional Advice: If unsure about any aspect of the insurance coverage or the information to be provided, seek advice from insurance brokers, agents, or advisors. They can provide guidance and ensure accurate representation.
• Review Policy Terms and Conditions: Take the time to review the policy terms and conditions thoroughly. Understand the coverage limits, deductibles, and any specific conditions or exclusions that may apply.
• Report Claims Promptly: In the event of a loss or claim, report it to the insurer promptly and provide all necessary documentation and information accurately. Prompt reporting ensures a smooth claims process and helps prevent potential issues of misrepresentation.
• Maintain Transparency and Honesty: Maintain transparency and honesty throughout the insurance relationship. Communicate openly with the insurer and promptly respond to any requests for additional information or documentation.

Following these best practices can help insured individuals maintain accurate representation in insurance contracts. It promotes transparency, ensures proper coverage, and reduces the risk of claim denials or policy voidance due to misrepresentation.

Representation in insurance is a critical aspect of insurance contracts, ensuring transparency, fairness, and the accurate assessment of risks. Insured individuals have a legal obligation to provide accurate and complete information to insurers, while insurers rely on this information to make informed decisions about coverage and premium calculations.

Misrepresentation in insurance can have significant legal implications, including voidance of the policy, denial of claims, and potential legal liability for the insured. It is crucial for insured individuals to be diligent in providing accurate representation and promptly updating the insurer about any changes in their circumstances or risks.

Factors such as knowledge, communication, cultural considerations, and regulatory frameworks influence the representation process. Insured individuals should be aware of these factors and strive to provide accurate and complete information, while insurers should create an environment that encourages truthful representation and provides guidance throughout the process.

To ensure accurate representation, insured individuals should follow best practices, including providing complete information, understanding insurance terms, updating information promptly, and seeking professional advice when needed. Transparency, honesty, and open communication between insured individuals and insurers are key to maintaining the integrity of insurance contracts.

In conclusion, accurate representation is essential for the successful functioning of insurance contracts. By upholding the principles of utmost good faith and adhering to best practices, insured individuals and insurers can establish a foundation of trust and ensure fair and transparent coverage for all parties involved.

What Is A Misrepresentation On The Insurance

20 Quick Tips To Saving Your Way To A Million Dollars

Our Review on The Credit One Credit Card

Deferred Income Tax: Definition, Purpose, And Examples

When To File For Tax Return 2015

Latest articles.

Personal Loans 101: Understanding Your Options with Poor or No Credit

Written By:

8 Ways to Generate Passive Income with Cryptocurrency

Next-Level Learning: Examining the Advantages of Online Post-Master’s FNP Education

The Recipe for a Balanced Life: Mixing Online Learning With Health and Wellness

Money Matters: Master Your Financial Future

Related post.

By:  •  Finance

Please accept our Privacy Policy.

We uses cookies to improve your experience and to show you personalized ads. Please review our privacy policy by clicking here .

• https://livewell.com/finance/what-is-representation-in-insurance/

About Chubb: About Chubb

About Chubb: About Chubb in the U.S.

About Chubb: Careers

About Chubb: Citizenship

About Chubb: Investors

About Chubb: News

Claims: Claims

Claims: Claims Difference

Claims: Claims Resources

Claims: Report a Claim

Login / Pay My Bill: Login for Business

Login / Pay My Bill: Login for Individuals

Login / Pay My Bill: QuickPay for Businesses

Login / Pay My Bill: QuickPay for Individuals

Login / Pay My Bill: Login to CRS

Contact Us: Contact Us

Contact Us: Global Offices

• File a claim
• Get a quote

Representations and Warranties (R&W) Insurance

Emerging Risk Considerations in Global M&A Transactions. Learn More Here.

Available for both buyers and sellers in a transaction, representations and warranties insurance provides protection against financial losses¹, including costs associated with defending claims, for certain unintentional and unknown breaches of the seller’s representations and warranties made in the acquisition or merger agreement.

R&W Policy Highlights

• Available for both buyers and sellers in a transaction
• Facilitates mergers and acquisitions by protecting deal participants from unintentional and unknown risks
• Offers additional protection to the buyer beyond the negotiated indemnity cap and survival limitations in a purchase agreement
• Enables the seller to reduce the amount of funds held back in escrow

Benefits of a Buyer-Side R&W Insurance Policy

• Provides the seller with a “clean exit” by reducing or eliminating the need to establish escrows or purchase price holdbacks, thereby enabling the seller to more quickly distribute greater portions of the purchase price to its investors in a private equity context or to retain proceeds in an owner/operator context
• Enables the seller to reduce the amount of funds held back in escrow, enhancing the seller’s return on its capital in the current low interest rate environment
• Protects buyers against the collectability or solvency risk of an unsecured indemnity provided by a seller (e.g., a financially distressed or non-U.S. seller or multiple sellers)
• Distinguishes a buyer’s bid in a competitive auction process by requiring a seller to provide short survival periods, modest liability caps and reduced escrow amounts for breaches of representations and warranties in a bidder’s draft purchase agreement
• Preserves key relationships by mitigating the need for a buyer to pursue claims against management sellers working for the buyer
• Affords an alternative recourse to shareholders in public to private transactions

Benefits of a Seller-Side R&W Insurance Policy

• Backstops negotiated indemnity obligations — a key benefit for private equity or venture capital funds at the end of their life cycle
• Protects minority/passive sellers concerned with joint and several liability for indemnifying the buyer
• Provides additional comfort for individual or family sellers  

¹ In excess of retention

Transactional Risk Claims Scenarios

Transactional Risk Insurance Products

Representations & Warranties Insurance

Tax Indemnity Insurance

Seeking a business insurance quote?

Representations and Warranties | Practical Law

Representations and Warranties

Practical law glossary item 8-382-3760  (approx. 3 pages).

• Business Owner’s Policy
• Commercial Auto Insurance
• Commercial Crime Insurance
• Commercial Property Insurance
• Commercial Umbrella Insurance
• Cyber Liability Insurance
• D&O Insurance
• Drone Insurance
• General Liability Insurance
• Product Liability Insurance
• Professional Liability Insurance
• Workers’ Compensation Insurance
• View All Coverages
• Best Startup Insurance
• Best Small Business Insurance
• Best Legal Malpractice Insurance Companies 
• Best Cyber Insurance
• Best General Liability Insurance
• Best Commercial Auto Insurance
• Best Product Liability Insurance
• Best Professional Liability Insurance
• Best Workers Compensation Insurance Companies
• Best Business Owner's Policy
• Best Commercial Crime Insurance
• Automotive Service
• Building Design
• Cleaning Services
• Construction & Contracting
• Entertainment & Events
• Financial Services
• Food & Hospitality
• Health Care
• IT / Technology
• Personal Care
• Photography & Videography
• Real Estate
• Sports & Fitness
• Embroker Commercial Insurance Review
• Hiscox Commercial Insurance Review
• Chubb Commercial Insurance Review
• CoverWallet Commercial Insurance Review
• Business Term Loans
• Business Lines of Credit
• Startup Business Loans
• Equipment Financing
• Invoice Financing
• Online Business Loans
• Merchant Cash Advance
• Short-term Business Loans
• Personal Business Loans
• Business Acquisition Loans
• Commercial Real Estate Loans
• View All Types
• Best Small Business Loans
• Best Banks for Business Loans
• How to Get a Small Business Loan
• Business Loan Requirements
• Business Loan Interest Rates
• Average Loan Interest Rates for 2021
• Small Business Credit Cards
• Credit Card Processing Fees
• How to Accept Credit Card Payments
• How to Get a Business Credit Card
• Getting a Credit Card With Your EIN
• Business Insurance Glossary
• How much does small business insurance cost?
• How much does cyber insurance cost?
• How much is general liability insurance?
• What is a certificate of insurance (COI)?
• What is an insurance agent vs. broker?
• What is business liability insurance?
• What is the best small business insurance?

What Is Representation And Warranty Insurance?

Representation and Warranty Insurance protects against breaches of warranty or inaccurate representation in mergers and acquisitions.

Advertiser disclosure.

At AdvisorSmith, our mission is to bring clarity to business insurance and provide straightforward, honest research to empower small business owners. We, like you, are small business owners, and your success is our success. In order to accomplish our mission, we, at times, are compensated by our partners. While this partnership may influence where and how products appear on our site, it in no way impacts our research, recommendations, or advice. We feature products and services from companies we find reputable, whether or not they are our advertising partners. No partner can guarantee placement or favorable reviews on AdvisorSmith.

Get a quote on Business Insurance

When it comes to merging two businesses, both the seller and the buyer are happiest when everything goes according to plan. However, hiccups during mergers and acquisitions (M&A) are not uncommon. In some transactions, the buyer may discover that the seller neglected to disclose important information relevant to the business. In this case, the buyer may decide to seek compensation. Conversely, the seller may feel that the buyer is asking for too much money in response to the seller’s failure to disclose key information, and that the process is much longer and more drawn out than anticipated.

Addressing a breach of representation or warranty can be contentious, expensive, and time consuming. Representation and Warranty Insurance can cover costs and prevent legal disputes in a way that benefits both the buyer and the seller.

What are Representations and Warranties?

Representation refers to any statements that the seller makes before entering into an agreement of sale that the other party is expected to rely upon. Example: “Our company made a profit of $25 million last year.” A warranty is a promise that the statements are true. Example: “Our company made a profit of $25 million last year, and I will reimburse you if I am wrong.” In mergers and acquisitions, both the buyer and the seller are required to disclose relevant information and make representations. If either of the parties misrepresents or fails to share key information, they may be held liable for inaccurate representation or a breach of warranty.

• You own a large beverage manufacturer and plan to purchase a smaller soft drink company. The smaller company makes 90% of its revenue from a special crystal-clear soda that tastes like lemonade. They promise to disclose the highly guarded secret recipe to you as the new owner, so that you can continue to manufacture it and continue with business as usual. After the sale goes through, everything appears to be fine. After your first batch ships, however, you start to receive feedback from customers that the special crystal-clear lemonade soda tastes different, and you suspect you were not given the correct recipe. Sales drop, and consumers say they don’t intend to buy the soda anymore. You sue the seller of the soft drink company for breach of representation and warranty.

What is Representation and Warranty Insurance?

Representation and Warranty Insurance is used in mergers and acquisitions to protect against damages and losses stemming from breaches of warranty or inaccurate representation on the part of the seller. Policies can be purchased by the buyer, seller, or both parties, and commonly, a policy purchased by the buyer will also contain coverage for the seller. Representation and Warranty Insurance offers protection for the buyer in the form of monetary compensation for losses relating to a seller’s breach of representation or warranty. For the seller, Representation and Warranty Insurance provides liability coverage and may reduce or eliminate the need for an escrow.

In the past, the buyer in an M&A deal relied on money that was previously set aside in escrow. In severe cases, the buyer directly negotiated with or sued the seller long after the deal was finalized. Representation and Warranty Insurance greatly reduces the need for the buyer or seller to pursue legal action against one another after the merger or acquisition has finished. This means that both parties have a cleaner exit.

Representation and Warranty Insurance vs Traditional Escrow Process

Representation and Warranty Insurance is increasingly being used as an alternative to the traditional escrow process that companies have historically used in a merger or acquisition. With a traditional escrow approach, a portion of the M&A purchase price is held back for a period of time in order to ensure the seller fulfills all obligations and commitments according to the sale agreement. Representation and Warranty Insurance, however, allows buyers and sellers to potentially forgo this process, giving the seller 100% of the purchase price when the deal closes and transferring liability onto the insurance company.

A typical escrow approach to M&A would generally proceed as follows:

• The seller agrees to reimburse the buyer if the buyer discovers a breach of warranty or inaccurate representation after the merger or acquisition is finished.
• The buyer sets aside 10-15% of the final price and gives it to a third party (referred to as “escrow”). The seller only receives 85-90% of the agreed final price when the deal closes.
• The money in escrow is used to cover the buyer for damage or losses if they discover a breach of warranty or inaccurate representation. If there is no breach of warranty or inaccurate representation, the seller receives the remaining 10-15% of the agreed upon purchase price after an established period of time, usually 12 to 24 months.

There are usually exceptions and limitations in the form of caps, time limits, and exclusions (e.g. your business must declare the breach of warranty within 2 years of the deal and can collect no more than $3 million).

• Your startup company is bought by a much larger software company. They decide to complete the transaction through a traditional escrow process. The larger company pays your smaller company $10 million. As part of the sales process, the larger company puts aside $1 million as an escrow holdback from the sale. Your company only receives $9 million of the $10 million they were promised when the sale closes. Under the terms of the deal, your startup will receive the final $1 million it is owed after two years have passed and the larger company is sure there hasn’t been a breach of warranty or inaccurate representation. You and your co-founder want to invest this money in new ventures but aren’t able to do so because $1 million is tied up in the escrow holdback account.

In some cases, the buyer has the right to seek reimbursement beyond what was set aside in escrow. This means that the seller is still liable and might be forced to engage with the buyer years after the merger or acquisition has been finalized. This is a major negative point for many sellers and one of the reasons Representation and Warranty Insurance has become more popular in recent years. When the companies have Representation and Warranty Insurance, all payment and liability is assumed by the insurer, and sellers can receive 100% of the agreed upon purchase price immediately at deal close.

Benefits of Representation and Warranty Insurance for Buyers

Usually, the party in an M&A deal with the most to gain from R&W Insurance is the buyer. Benefits for the buyer side of Representation and Warranty Insurance include:

• Better protection and coverage – In the case of breaches of warranty or inaccuracies in representation, buyers can be compensated through a reputable insurer, rather than relying on the seller. Sellers may also be more willing to offer broader warranties and representations, given the liability is being taken on by an insurer.
• Looks appealing to the seller – A seller may be more likely to pursue a deal with a buyer that offers reduced or no escrow or holdback because the seller will be able to receive more of the purchase value at deal close.
• More time to discover problems – R&W Insurance increases the length of time that buyers have to uncover problems, usually beyond the two year limit that is common with escrow.

Benefits of Representation and Warranty Insurance for Sellers

Benefits for the seller side of Representation and Warranty Insurance include:

• Clean exit – With a removal of escrow or holdback, sellers are able to receive the proceeds from a sale immediately after the deal is closed and avoid dealing with any contingent post-closing liabilities.
• Liability protection – If there are unforeseen complications like a breach of warranty, R&W Insurance can provide for defense and settlement costs.
• Passive seller protection – Any minority or passive investor that was not in direct control of the business but may be liable under joint and several liability can be protected under R&W Insurance.

What triggers Representation and Warranty Insurance?

Representation and Warranty Insurance is triggered by a breach of warranty or representation. These breaches may include:

• Problems with customer contracts
• Issue with employment agreements
• Inaccurate or missing information about a “secret recipe” for a product
• Undisclosed pending litigation
• Large unpaid bills

Limitations of Representation and Warranty Insurance

Though Representation and Warranty Insurance can offer your business more protection, it comes with limitations. The following are considered standard exclusions for Representation and Warranty Insurance:

• Availability of R&D or Net Operating Loss tax credits
• Sales projections and other forward-looking warranties
• Adjustment of the purchase price or working capital
• Underfunded or unfunded pensions or benefit plans
• Any breaches of which the buyer had actual knowledge at the time of closing

Policy terms are usually limited to between three and six years. This is, however, longer than the standard indemnity period under the traditional escrow process.

How much does Representation and Warranty Insurance cost?

Representation and Warranty Insurance policies generally include a deductible or self-insured retention. While the amount may vary depending on the risk of the deal, it is usually between 1% and 3% of the overall transaction price.

In terms of the premium, pricing varies based on the insurer’s risk assessment, coverage limit, length of coverage, and deductible or retention amount. Most insurance companies charge between 1.5% and 3.5% of the coverage limit, and the premium is usually a one-time payment made for the entire policy duration.

For example, if the policy’s coverage limit is $20 million, the premium will be between $300,000 and $700,000. The floor for premiums is generally a minimum of $150,000. The policy coverage of most policies is usually 10% of the total value of purchase price.

In M&A deals, Representation and Warranty Insurance offers a compelling alternative to the traditional escrow approach. As a buyer, you are essentially purchasing a protection plan against breaches of warranty or representation, backed by a reputable insurer. And as a seller, you are able to forego escrow and receive full payment at the time of close. R&W Insurance has become increasingly popular in recent years, and as it becomes more widespread, premiums will continue to drop. If you are buying, selling, or merging a private company, you might want to consider Representation and Warranty Insurance.

Small Business Resources

• Business Insurance Basics
• Business Insurance Types
• Insurance Industry Guides
• Data Analyses & Studies

About AdvisorSmith

• Leadership Team

• Management Liability
• Property & Casualty
• Employee Benefits
• Private Client
• Cyber Liability
• Life Sciences
• Private Equity & Venture Capital
• SPACS: Special Purpose Acquisition Companies
• Financial Services
• Construction
• Real Estate
• Manufacturing
• Our Leadership
• Insuring Innovation TM

Client Access

Guide to Representations & Warranties Insurance

Emily Maier Senior Vice President, Head of Transactional Insurance Editor, M&A Notebook

June 28, 2023

/ Mergers & Acquisitions

Over the past decade, representations and warranties insurance (RWI or R&W) has become an established tool in the merger and acquisition (M&A) toolbox for both private equity and strategic buyers . In fact, RWI is used in an estimated 75% of private equity transactions and 64% of larger strategic acquisitions.

We have good news for buyers: Broad coverage and competitive pricing are the keywords for RWI in 2023.

Learn more in Woodruff Sawyer’s updated Guide for this evolving coverage.

Read the full Guide to R&W Insurance:

What Is Reps & Warranties Insurance?

R&W insurance is a breach-of-contract coverage designed to enhance or replace the indemnification given by the seller to the buyer. In short, R&W covers loss caused by any breaches of the seller’s representations, whether it involves issues with their customer contracts, employment agreements, or the secret recipe of their product (i.e., intellectual property or IP).

The indemnity package is usually the most contentious part of any merger or acquisition negotiation. R&W steps in to eliminate contention and provide everyone with a cleaner, faster, and safer deal.

The RWI Underwriting Market Has Grown Significantly

The RWI underwriting market has grown substantially in the last two years. It was not too long ago that there were only three or four markets writing this type of risk. By mid-2023, there were 26 markets, with one new market already this year and two new markets last year. We believe this growth will level off, but there is certainly a thriving and competitive marketplace.

Changes in Premiums From 2022 to 2023

The changes we saw at the end of last year are eroding further as 2023 progresses. As of June, standard rates are now running 2%–3% of the limit bought. (For analysis, read our blog post, M&A Insurance: 2023 First Quarter Roundup .)

We see this trend as very good news for our clients and those needing RWI. The average number of quotes went through the roof, and the premium prices are on par with the beginning of 2018, if not slightly more competitive.

The lowest quote we have seen so far this year is 2%, a return to 2018 in terms of pricing.

How Does Reps & Warranties Insurance Work?

The typical policyholder.

While either buyer or seller can be insured, 97% of the policies placed are buy-side, protecting the buyer from any breaches of the seller’s representations. Here are five buy-side details:

• Buy-side policies have additional fraud coverage that sell-side policies can’t provide.
• The insured buyer can pick a coverage limit and survival period (i.e., the period for which the policy is in place) beyond what the seller is willing to give.
• With this coverage, the buyer can avoid suing their newly acquired management team. If any breaches or misrepresentations come up, they can go directly to the carrier.
• Buy-side policies allow the buyer to offer lower escrows or more competitive terms in an auction.
• The insurance can replace distressed company indemnification with A+ rated indemnification.

How Underwriters Assess M&A Risk

When drawing up the R&W policy, underwriters evaluate:

• The nature of the sale purchase agreement (SPA) terms and conditions
• The nature of the specific warranties being given in the context of the transaction
• The quality of the due diligence

While the insurance is designed to cover all warranties, certain exclusions are standard:

• Forward-looking warranties (sales projections, etc.)
• Purchase price adjustments
• The availability or usability of net operating losses or R&D tax credits
• Areas of coverage that are difficult to get, such as Foreign Corrupt Practices Act (FCPA) violations, union activity, underfunding of pensions, wage and hour violations, etc.
• Known issues

Placement Process and Timing

Placing R&W coverage is a two-part process:

• The initial non-binding indication occurs one week after receiving the target financials, draft sale and purchase agreement, and any information memorandum that has been prepared by the seller. Underwriters provide initial indications on premium, retention, areas of concern, or heightened risk. This costs nothing.
• Underwriting requires a $30,000–$45,000 up-front “diligence fee.” Underwriters and their counsel are granted access to the data room and begin reviewing the diligence reports and the disclosure schedules. It involves a two- to three-hour diligence call with underwriters, deal team members, and third-party diligence providers. Twenty-four hours after the call, underwriters provide a draft policy and follow-up questions, if any.

How Pricing Is Determined

The policy retention or deductible is expressed as a percentage of overall transaction size. The minimum for mid-size deals is 0.75% of the transaction.

For larger deals above $500 million in enterprise value (EV), it’s more common to see a 0.5% retention, which can be in the form of a seller’s escrow, the buyer’s deductible, or a combination of the two. A 0.75% retention drops down to 0.5% after 12 months, regardless of the size of the transaction. Those starting at 0.5% may not see a further drop.

Premium is expressed as a percentage of the limit of coverage bought and is not related to transaction size. As of June, premiums range from 2%–3% of the limitation of coverage. It’s worth noting that minimum premiums are running around $100,000 for ordinary deals with $3–$5 million of limits requested.

Claims Trends

Halfway through 2023, we’ve found the rate of claims has been relatively consistent with previous years, while the number of claims has increased. This increase is largely attributable to the surge of M&A activity in 2021. However, we have seen interesting shifts in claims, including:

• Claims are being noticed later than usual, between 12 and 18 months post-close.
• First-party, or indemnification, claims (where the insured brings a claim directly to the carrier) remain more common than third-party claims. However, third-party claims are on the rise for 2023 and will likely continue to uptick.
• Data security/privacy breach is a top RWI claim. Carriers are increasingly concerned about the adequacy of cyber coverage, and buyers should expect this to be an area of heightened diligence.

Find out more about RWI claims trends in an upcoming blog.

Choosing a Specialty Broker

R&W insurance is a complex and fast-growing marketplace. It requires a dedicated insurance broker who understands this type of coverage and is backed by the resources to handle all insurance lines and questions that come out of a transaction.

Woodruff Sawyer believes that clients are best served by a team dedicated to reps and warranties insurance, with access to broader resources that can review all your organization’s insurance needs and present a holistic solution.

Read the full guide for additional details about retentions, exclusions, program structure, and limits below:

FEATURED VIDEO

Related Blog Posts

Transactional Risk in 2023: A Guide to Insurance Trends and Due Diligence

Read more for insight into the state of the M&A and Private Equity market and why insurance due diligence is more important than ever.

R&W Claims 101: Types of Loss

If you’re facing a breach in your M&A agreement, your reps and warranties insurance policy may step in to cover the loss.

Was this post helpful?

• Insights & Events

About McDermott

• Firm Overview
• Vision & Values
• Our Approach
• Justice, Diversity, Equity & Inclusion
• Pro Bono & Community Service

Representations & Warranties Insurance: Understanding the Underwriting Process, Timeline, and Key Coverage Terms

• Representations & Warranties Insurance: Understanding t...

The use of representations and warranties insurance is becoming increasingly commonplace in M&A transactions, particularly in competitive auction processes where use of the product has become almost ubiquitous. While much has been written about the deal terms of M&A transactions that make use of representations and warranties insurance, there is little practical guidance available that addresses either the underwriting process and timeline, or the negotiation of key policy terms. These areas can be challenging for parties using a representations and warranties policy for the first time, and this commentary is intended to provide a high-level overview of representations and warranties insurance to help demystify an otherwise imposing process.

The Insurance Timeline and Process

When working on a transaction where a representations and warranties insurance policy will be used, it is critical to understand the timeline and process considerations and to calibrate expectations accordingly. Given that the vast majority of underwritten policies are buyer-side policies rather than seller-side policies, this discussion assumes that the parties have selected a buyer-side policy.

Underwriting Process Timeline . Underwriters typically state that they need 7-10 business days from the date they are engaged to underwrite a policy, although this timeline can be shortened in certain circumstances. The following steps are prerequisites to commencing the underwriting process:

• Broker selection . Selecting a broker is generally the first step in the process. Most of the large insurance brokerages have individuals that specialize in brokering representations and warranties insurance policies, and many of these brokers are former practicing M&A attorneys or other deal professionals who understand M&A transactions and their often fast-paced timelines. Brokers can provide invaluable assistance in managing the insurance underwriting process, negotiating with underwriters and providing substantive comments to draft policies.
• Underwriter selection . Once the initial draft of the transaction agreement is available, the broker will typically seek nonbinding premium indications from prospective underwriters. These indications will be based upon the representations and warranties in the draft agreement provided to the underwriters, so if there are substantial changes in the scope of the representations and warranties in the final definitive agreement, the indicated premiums may end up being adjusted when the insurer provides the final, binding quote. In addition to the estimated premiums, the indications will set forth expected coverage exclusions and areas of heightened diligence scrutiny. The “insured” (the party purchasing the insurance, presumed to be the buyer for purposes of this guide) then selects the insurer offering the most favorable terms by executing the underwriting proposal and paying the insurer’s underwriting fee. Note that this underwriting fee is distinct from the premium and typically is a relatively inexpensive fee that the underwriter charges as compensation for incurring the time and expense of the underwriting process.
• Substantial Completion of Diligence, the Definitive Agreement and Disclosure Schedules . The 7-10 business day clock doesn’t start running until the underwriter has received substantially complete third-party diligence reports, including reports from the company’s legal, financial/accounting and tax advisers. Similarly, underwriters will require substantially complete copies of the acquisition agreement and related disclosure schedules to kick off the underwriting diligence process. Although negotiations between a buyer and seller (and related changes to the acquisition agreement and disclosure schedules) will often continue until the signing date, the acquisition agreement is ready for purposes of beginning the underwriting process once the general scope of the representations and warranties is settled and the draft disclosure schedules have been updated accordingly.

Underwriter Diligence Considerations . Once engaged, the underwriter must complete its diligence in order to finalize the policy prior to the signing date. Set forth below are a few key considerations for buyers and sellers with respect to the underwriter’s diligence process.

• Sharing of diligence materials . An underwriter typically requires the buyer to share its third-party diligence reports with the underwriter in order to jump-start the underwriter’s diligence. These reports are provided on a non-reliance basis, and third-party diligence providers will need to prepare and enter into non-reliance letters with the underwriter before the buyer is able to share the reports. A buyer should make sure that its advisors are aware that an underwriter will be reading their diligence reports, and should carefully read the diligence reports to look for any red flags that will likely draw the attention of the underwriter: Does the report satisfactorily address any issues uncovered? Does it convey to the reader that the diligence process was robust? Does it provide in-depth analysis of significant issues? Failure to adequately address key issues or to convey the robust nature of the diligence review can lead to deeper probing by the underwriter, which can in turn delay the process and/or lead to coverage exclusions or limitations. The underwriter typically will convene a diligence call with the buyer and its advisers to review diligence findings as a final step in its diligence, and proper preparation for such a call can go a long way in assuring a successful underwriting.
• Risk-Sharing Dynamics . Although the underwriter diligence process in some ways parallels the lender diligence process in a leveraged transaction ( e.g., the tight diligence timeline and the sharing of diligence materials on non-reliance basis), the risk-sharing dynamics are quite different in the underwriter diligence context. Lenders are generally accepting of a buyer’s decision to limit the scope of its diligence review, as the lender is protected by its higher position in the capital structure vis-à-vis the equity-holding buyer, and so the buyer is properly incentivized to analyze material diligence issues given that it bears the primary risk for issues not uncovered. In contrast, in a transaction using a representations and warranties policy, the underwriter bears the primary risk for issues not uncovered in due diligence, and so an underwriter will be highly focused on the quality and depth of the diligence review conducted by the buyer. Failure to look into a material issue may result in the underwriter insisting upon a deal-specific exclusion for claims related directly to that issue.
• Dealing with Diligence-Based Exclusions . Inevitably, the diligence process will uncover some issues that will be excluded from coverage under the policy—whether due to the fact that any known risks are automatically excluded from coverage, or because the underwriter is uncomfortable with a risk due to an insufficient diligence review (in the opinion of the underwriter) or an ambiguity in the diligence findings. This often results in the need for buyers and sellers to address these carve-outs at a very late stage in the negotiation, likely only days before signing the definitive acquisition agreement. There are myriad ways for buyers and sellers to solve such issues, e.g., special indemnities, separate escrows, etc., and such solutions will depend upon the particular facts at hand, but as a general matter, buyers and sellers should anticipate the need to address quickly such issues late in the process.

The Insurance Framework

The policy form usually is finalized concurrently with the underwriter due diligence process.

As a starting point, the insuring agreement of the typical policy obligates the insurer to pay on behalf of the insured “Loss” on account of a “Claim” for the “Breach” of any of the designated representations and warranties in the acquisition agreement. From here, coverage is tailored to the specific transaction based upon the definitions of key terms, and policy conditions and exclusions.

The definition of Loss (sometimes referred to instead as “Net Provable Damages”) describes the damages that the policy will cover, and some that it will not. In general, covered Loss should be defined to encompass the damages that the buyer would be entitled to under the acquisition agreement. But the insurer may propose initially a definition that carves out key categories of damages, as discussed below.

Consistent with the term “representations and warranties insurance,” a Breach is the failure or inaccuracy of any representation or warranty contained in the acquisition agreement. In contrast, covenants are not insured, and neither are post-transaction price adjustments or earn-outs based upon future revenue targets or other metrics.

Insurers usually require the parties to share some liability in the event of a Breach, typically in the range of 1–2.5 percent of the transaction value. This “retention” can vary depending upon the deal holdback negotiated by the parties (among other factors), but in a transaction where the seller has escrowed a portion of its proceeds to secure its indemnification obligations, the retention is often an amount equal to twice the amount of the seller’s initial escrow. Once the escrowed funds are released to the seller pursuant to the terms of the acquisition agreement, there is a corresponding reduction in the retention (taking into account both the amount of the escrowed funds released to the seller and the amount of any escrow payments previously made by the seller to the buyer). This structure avoids an unanticipated “gap” in the buyer’s protection.

Opportunities for Improvement

Many of the key policy provisions are negotiable, some for payment of additional premium but many at no cost to the insured. Insureds should inquire about potential coverage enhancements, including the following:

• Diminution in Value/Multiplied Damages . Some policies restrict the definition of Loss to exclude the diminished value of the target company due to the Breach, including damages calculated by using any multiple on which the purchase price was based, such as earnings, revenue, etc. This is a significant limitation on coverage that should be removed if possible. Some insurers may require a small increase in premium to do so.
• Consequential Damages . All policies include within Loss “actual” and “general” damages that flow naturally and directly from a Breach. But some policies expressly exclude from Loss “consequential” damages, which are reasonably foreseeable damages incurred due to the special circumstances of the buyer. This exclusion likely narrows the coverage from what the seller would have been required to indemnify, and usually is negotiable with the insurer. With respect to both this exclusion and that for diminution in value/multiplied damages or similar measures of damages, the underwriter is often willing to omit such express exclusions if the underlying acquisition agreement is likewise silent on the topic. On the other hand, if the acquisition agreement expressly excludes recovery for such categories of damages, then the policy will almost certainly exclude such damages as well.
• Materiality Scrape . The seller’s representations and warranties usually are qualified by acquisition agreement terms such as “material’ or “material adverse effect.” Just as it is common to include a “materiality scrape” provision in an acquisition agreement—which removes such qualifications when determining both whether a Breach has occurred and the amount of covered Loss attributable to a Breach—policies can be negotiated to include a materiality scrape. Note, however, that underwriters typically are willing to include a materiality scrape only if the underlying acquisition agreement includes one.
• Loss Adjustments . Policies typically reduce covered Loss to account for collateral benefits received by the insured, such as amounts obtained under other insurance policies, tax benefits, etc. But these adjustments are not always net of the insured’s costs to obtain them, such as legal fees, policy deductibles, increased premium, etc., and this point should be negotiated with the insurer.
• Actual Knowledge . Policies only insure against claims unknown to the buyer at closing, but committing this principle to writing often is subject to negotiation. “Actual Knowledge” should be defined as actual conscious awareness, with the definition stating clearly that constructive or imputed knowledge of a fact is insufficient.
• Closing Letter . All buyer-side policies bar coverage if it is discovered that the buyer’s representative falsely stated at the time of closing that he or she did not know of any Breach by the seller. But this exclusion can be limited to claims related causatively or logically to the statement, and only if the insurer is materially prejudiced by the statement.
• Mitigation . All policies require the insured to take reasonable steps to mitigate Loss caused by a Breach. This issue arises most often in the context of a potential claim by the buyer against the seller, however, and it is possible to negotiate an express statement that mitigation steps against the seller are not a pre-condition to the buyer making a claim or receiving payment for Loss under the policy.

Understanding the underwriting process and timeline, and the opportunities for negotiating the most favorable policy terms, will pave the way for successfully implementing representations and warranties insurance in a transaction. Consult counsel and an insurance broker experienced with these concepts for the best results.

Stay Connected

Insurance Representations & Warranties

Representation is made by the proposer to the insurer relating to a proposed risk. A warranty is an undertaking by the insured.

Insurance Representations

A representation is a statement made by the proposer to the insurer relating to a proposed risk. Such a representation may pertain to both material and immaterial facts.

If material, then the representation must be substantially true. Any false statement on the material portion of the fact would render the contract voidable.

Insurance Warranties

A warranty is an undertaking by the insured to the effect that he shall or shall not do a certain thing or that some conditions shall be fulfilled or whereby he affirms or negatives the existence of a particular state of affairs.

Warranties may be either express or implied. Express warranties are those mentioned in the policies, e.g., warranted no smoking inside the premises.

Implied warranties are those which would apply even though not mentioned in the policy, e.g., warranty of sea-worthiness in marine insurance .

Distinction Between Representations and Warranties in Insurance

It is necessary to understand the difference between representation and warranty, and in this regard, making a mistake is quite likely.

Such a mistake would be indeed fatal, particularly keeping in view that a breach of either warranty or representation would have a different bearing on the insurance contract .

The differences are:

• A representation is required to be substantially true, i.e., the material portion of the statement must be literally true even though the immaterial portion of the statement need not be true or correct. On the other hand, a warranty must be strictly and literally complied with.
• With regard to representation, if the insurers want to avoid the contract on the grounds of misrepresentation, it has to be proved by the insurers that the misrepresentation relates to a material fact. On the other hand, with regard to warranty, any breach, whether material or immaterial, is enough for the insurers to avoid the contract.
• A representation does not appear in the policy, but a warranty must appear in the policy either expressly or by way of reference.

Following our deep dive into insurance representations & warranties; use our total guide on insurance and it's concepts .

• Documents Required for Marine Insurance
• Insurance Proposal Form: Example, Format, Importance, Purpose, Elements
• Life Insurance Surrender Value
• Types of Insurance Organizations [A Comprehensive Guide]
• How Facultative Reinsurance Works [Explained with Example]
• Types of Marine Losses: Total & Partial Loss Explained!
• Marine Insurance: Meaning, Types of Policies, Elements
• Principles of Fire Insurance Policies
• Life Insurance Bonus: Definition, Features, Types
• How & Why Insurance Is Not Gambling?
• Reinsurance: Definition, Types, Importance, Examples

• News & Events
• Diversity & Inclusion
• Women's Initiative
• Payment Portal

Key considerations for representation and warranty insurance

Michele   kloeppel september 26, 2016.

The allocation of risk through representations and warranties and the accompanying indemnification obligations is a primary source of contention in almost every private merger and acquisition transaction. Buyers aim to negotiate an expansive indemnification package as a means to cover the majority of post-closing losses (and may seek an escrow to facilitate recovery). Whereas sellers seek to limit their post-closing indemnification exposure by narrowing the scope of the representations and warranties, negotiating for short survival periods and inserting indemnity deductibles, caps and other limitations.

Representation and warranty insurance helps resolve this conflict by, in exchange for insurance premiums, shifting a majority of the risk from the transacting parties to a third-party insurance provider. 

Representation and warranty insurance comes in two flavors: seller-side policies and buyer-side policies. Seller-side policies are purchased by or for the seller, and coverage terms generally track the survival periods and indemnification cap outlined in the underlying purchase agreement. A seller-side policy reimburses the seller for losses it incurs if it has to pay the buyer for a breach of a representation or warranty. 

Buyer-side policies are purchased by or for the buyer, with coverage terms potentially being extended beyond the survival periods and indemnification cap. Buyer-side policies are more common in transactions, as they allow coverage to extend beyond the contracted limitations agreed upon by the parties and may cover the seller’s fraud. These policies allow the buyer to recover its losses for breach of a representation or warranty directly from the insurer. 

Who should use representation and warranty insurance?

Representation and warranty insurance may not be suitable for every transaction. For example, insurance is generally not suitable for smaller transactions (e.g., transactions of less than $20 million), as the premium costs and other expenses quickly outweigh the benefits. Therefore, careful consideration should be given to the specifics of each individual transaction when considering representation and warranty insurance. 

Common situations where representation and warranty insurance may be beneficial include the following:

• Buyer’s inability to obtain satisfactory indemnification coverage. Whether because of the seller’s superior bargaining leverage, a nominal purchase price with a corresponding low indemnification cap, or some other reason, certain transactions impose little to no indemnification obligations on the seller. Even when indemnification coverage appears sufficient on paper, pragmatic factors (such as the seller’s financial distress or the difficulties of enforcing indemnification obligations in a foreign jurisdiction) may render unsatisfactory a buyer’s rights under the acquisition agreement. In these situations, a buyer-side policy to supplement or replace the limited or non-existent indemnification coverage may be desirable to buyer. 
• Protecting continuing business relationships. A buyer often relies on the target’s management to continue to run the daily operations of the acquired business following the closing. The retained management often includes the business’s founders or others who were involved in the negotiation of the acquisition agreement, and these individuals may be responsible to the buyer for post-closing indemnification claims. Indemnification claims can quickly sour the relationship between the buyer and retained management. By shifting the indemnification obligations to an insurance provider, representation and warranty insurance can preserve the relationship between the parties.
• Seller certainty as to purchase price. Lengthy survival periods combined with escrows, holdbacks, and other mechanisms may prevent a seller from making a clean break from the business and may limit the amount of cash available to the seller following the closing. These problems are magnified when a venture capital/private equity firm is the seller and its investors expect a return on investment or funds available for distribution or re-investment.  Representation and warranty insurance allows the seller to negotiate shorter survival periods and reduce or even eliminate escrows, both of which free up the seller’s cash post-closing.
• A competitive advantage in a competitive bid process. A seller may rely on the competitive nature of an auction process to maximize the sale price while simultaneously negotiating more favorable deal terms. Obtaining representation and warranty insurance may give a buyer a competitive advantage in the bid context by allowing it to limit the indemnification package it requests from the seller and causing more sale proceeds to be delivered to the seller at closing. Thus, a buyer’s bid that takes into account representation and warranty insurance may be more attractive to a seller.

Accordingly, with regard to your M&A transaction, consider whether representation and warranty insurance may be worthwhile. 

Michele Kloeppel  is an attorney in Thompson Coburn’s Corporate Finance & Securities group. 

ED’s Evolving State Authorization and Professional Licensure Requirements

Corporate transparency act (cta) resources, david kaufman, nathan viehl discuss reddit’s initial stock performance, bipa update: another amendment attempt for illinois privacy law, staying above board: what employers need to know about recent developments from the national labor relations board, update: it’s the final countdown h-1b registration closes march 25, david kaufman discusses truth social trading debut with ny post, california ag announces second settlement under the california consumer privacy act, how privacy requirements impact ai, 5 things to watch out for in a retail lease agreement, kayla siam receives dei award from governors state university, california chamber seeks state supreme court review of privacy act enforcement.

• Client Access
• Disclaimers
• Attorney Advertising
• Los Angeles
• Southern Illinois
• Washington, D.C.

Please read before continuing

NOTICE . Although we would like to hear from you, we cannot represent you until we know that doing so will not create a conflict of interest. Also, we cannot treat unsolicited information as confidential. Accordingly, please do not send us any information about any matter that may involve you until you receive a written statement from us that we represent you (an ‘engagement letter’).

By clicking the ‘ACCEPT’ button, you agree that we may review any information you transmit to us. You recognize that our review of your information, even if you submitted it in a good faith effort to retain us, and, further, even if you consider it confidential, does not preclude us from representing another client directly adverse to you, even in a matter where that information could and will be used against you. Please click the ‘ACCEPT’ button if you understand and accept the foregoing statement and wish to proceed.

Utmost Good Faith — Representations, Concealments, and Warranties

Because the insured usually has a much greater knowledge about the thing insured, and because insurance companies need to know this information to decide whether they want to insure it, and, if so, at what rate, the insurance company depends on the insured for this vital information. If a loss occurs, and the insurance company finds that material information was false, it can deny coverage. Utmost good faith (sometimes encountered in legal texts as the Latin uberrimae fidei ) is complete and total honesty — all statements must be true and all material facts must be revealed; otherwise, insurance could not be provided economically.

The principle of utmost good faith also makes the application for insurance easier, since most insurance companies do not check the facts before they issue the policy. Since losses are rare, it is more economical to investigate a loss when it actually occurs. If a material fact listed in the insurance application is false or was not revealed, then the insurance company will usually be able to void the contract and deny the payment of any claims. Thus, for insurance applicants, honesty is the best policy, since dishonesty could lead to no compensation for losses even though premiums were paid.

Utmost good faith is usually divided into 3 components: representations, concealments, and warranties.

Representations

Representations are the statements made by the insured on the insurance application. Many of these representations are responses to questions to determine whether the applicant is insurable and how much should be charged. For instance, for auto insurance , insurers will ask how far you travel to work, whether you had any accidents or citations, and other items potentially measuring risk.

An insurance contract is voidable by the insurer if any representation is

• was relied upon by the insurer,
• and was known to be false by the insurance applicant.

A material representation was relied upon by the insurer when issuing the policy. If the truth were known, the insurer either would not have issued the policy, or would have issued it with different terms, and probably would have charged higher premiums. However, the insurance company cannot deny a claim for a false representation unless it can prove that the applicant lied and intended to deceive the company — not because the applicant merely expressed an opinion that later turned out to be false.

Any misrepresentations after a loss can also void an insurance contract . A common example of this type of misrepresentation is when the insured suffers the loss of property, but files a claim for much more than the property was actually worth.

In most jurisdictions, an insurance company can also void a contract if there was an innocent misrepresentation of a material fact.

Concealments

Concealment is closely related to misrepresentation — it is the failure to disclose material information. However, before an insurance company can deny payment for concealment it must prove:

• the insured knew that the fact was important in regard to the insurance being applied for;
• and defrauding the insurer was intended.

Misrepresentations and concealments are common strategies used by people with higher risks, and leads to adverse selection by insurance companies, which, in turn, raises premiums for everyone else.

A warranty is a promise by the insurance applicant to do certain things or to satisfy certain requirements, or, it is a statement of fact that is attested by the insurance applicant. The warranty becomes part of the insurance contract. If the insured breaches the warranty, the insurer can void the contract and deny payment of a claim. An affirmative warranty is a statement of fact, which is like a representation, while a promissory warranty is a promise to do something or that something will be done in a specific way. An express warranty is specifically stated in the contract, while an implied warranty is presumed.

Years ago, if a warranty was breached even a little, it allowed the insurer to void the contract and deny coverage, which lessened the value of insurance, and led to great financial losses by the insured for a slight breach of the warranty, many times due to facts that were not material. The states and courts have since lessened the harshness of this doctrine: application statements are considered representations and not warranties; a warranty is not breached if the increase in risk is temporary or minor; in some states, there is no breach of warranty unless it increases the hazard of an insurable loss, and some states require that the breach in warranty actually contributed to the loss.

Advertisement

Representations and warranties insurance in mergers and acquisitions

• Open access
• Published: 10 September 2022
• Volume 29 , pages 423–450, ( 2024 )

Cite this article

You have full access to this open access article

• Omri Even-Tov   ORCID: orcid.org/0000-0003-1448-0765 1 ,
• James Ryans 2 &
• Steven Davidoff Solomon 3  

5034 Accesses

2 Altmetric

Explore all metrics

To mitigate information asymmetry in acquisitions, the seller makes contractual representations and warranties (referred to as “R&W” or “reps”) about the state of the target, such as attesting to the accuracy of the target’s financial statements. While seller indemnities allow buyers to impose costs due to breaches in the reps discovered after the deal’s close, these indemnities involve significant contracting costs. To mitigate these costs, the acquisition parties have increasingly turned to purchasing representations and warranties insurance. Using a proprietary and novel sample of R&W insurance policies issued worldwide for acquisitions of non-public targets, we find that the demand for R&W insurance, the premium charged for it, and the likelihood of a claim being filed are correlated with industry metrics for valuation uncertainty, the type of acquirer and seller, and the target’s legal regime. In particular, we find higher demand for R&W insurance and a higher R&W insurance premium charged when the target belongs to an industry with weaker internal controls. We also find that a higher premium is charged when the target is in an industry with relatively high levels of R&D to sales, indicating that the insurance company expects unrecognized intangible assets to have a greater risk of future claims. Our study adds to our understanding of how parties reduce target valuation uncertainty and the role of disclosures and R&W insurance policies in private mergers and acquisitions transactions.

Similar content being viewed by others

The role of the external auditor in managing environmental, social, and governance (ESG) reputation risk

Bright Asante-Appiah & Tamara A. Lambert

Spillover Effects from the Volkswagen Emissions Scandal: An Analysis of Stock and Corporate Bond Markets

Florian Barth, Christian Eckert, … Hendrik Scholz

How pervasive is corporate fraud?

Alexander Dyck, Adair Morse & Luigi Zingales

Avoid common mistakes on your manuscript.

1 Introduction

Information asymmetry between an acquirer and a target is an underlying issue in merger and acquisition (M&A) discussions and outcomes and derives from the acquirer’s incomplete knowledge of the target’s value. It is more pronounced for private targets, which, unlike public targets, are not subject to securities regulations, disclosure requirements, and public shareholder oversight. To mitigate the increased information asymmetry surrounding private targets, these sellers provide representations and warranties (referred to as “R&W” or “reps”) regarding the state of the seller’s business that are more extensive than those provided by public sellers. Through these reps, a seller promises that a set of facts about the target in the acquisition agreement are true. If the reps are found to have been breached following the closing of the deal, then the buyer’s remedies include pursuing damages under applicable law or including an indemnity provision in the merger agreement, usually accompanied by a holdback or escrow amount used to adjust the purchase price post closing. Alternatively, the parties may purchase an R&W insurance policy, and the value of damages can be recovered through an insurance claim. In this paper, we use a proprietary sample of R&W insurance policies to investigate the factors that affect the decision to purchase a policy (the decision to transfer risk to the insurer), the factors that determine the premium charged by the insurance company (the market measure of the risk), and the factors that are correlated with the likelihood of a claim (the realized risk).

Representation and warranties insurance transfers indemnification risk to a third-party insurer for an up-front premium payment. Footnote 1 These policies were first introduced in the 1990s but have only gained significant traction over the past ten years (Griffith 2020 ). These products arose because reps and indemnities introduce significant contracting costs for both buyers and sellers and are among the most difficult and time-consuming aspects of the acquisition agreement to negotiate (e.g., Freund 1975 ; Gallozi and Phillips 2002 ; Hill et al. 2016 ). Footnote 2 These costs arise because the seller may not have, or may not want to disclose, a complete and accurate picture of the state of the business, including the true value of its assets and liabilities. In this case, it may limit the types of warranties and the amount of indemnification it provides. In addition, risk aversion on the part of the buyer or the seller may preclude agreement on the amount or duration of an indemnity to guarantee the R&Ws. Lastly, if a seller maintains a relationship with the buyer post acquisition—e.g., the buyer retains the seller as a manager—any attempt to recover an indemnity from the seller/manager represent a direct principal-agent conflict.

In this paper, we obtain a proprietary sample of R&W insurance policies issued by a global insurance company for acquisitions of private targets between January 2011 and December 2016, representing 1,690 acquisitions and $470 billion in enterprise value. Footnote 3 For each policy, our data from the insurance company includes, among other items, the premium and liability limit. For the acquisition parties, we observe deal size (enterprise value), buyer and target ownership type, target region, and target industry. We also observe claims reported for each policy and the type of reps breached, if any, as of September 2017.

Using this sample, we first investigate variables that are associated with the decision to purchase R&W insurance policies. The first set of variables we examine are industry metrics for valuation uncertainty, which follow along the lines of Datar et al. ( 2001 ) and Cain et al. ( 2011 ) who examine the role of earnouts in valuation uncertainty in private firms and who also lack the buyer and seller identities. The second set of variables are the acquirer and seller types—private equity (PE), strategic, or individual. Footnote 4

We find that there is a higher likelihood of purchasing R&W insurance when acquisition targets belong to industries with higher target valuation uncertainty, such as greater return volatility and lower-quality financial reporting, as measured by the level of internal control weakness. We also provide evidence of lower demand for R&W insurance in industries where there are more growth opportunities, as captured by the target industry Tobin’s Q, consistent with the fact that the value of high-growth firms is predicated more on future prospects than on existing assets and liabilities, making R&W insurance less valuable. We also show that PE acquirers are more likely to purchase R&W insurance than are strategic buyers, consistent with the notion that an acquisition by a private-equity buyer exposes the buyer to more firm-specific financial risk than would a similar acquisition by a large diversified public acquirer. This is because PE buyers’ funds usually consist of a concentrated set of portfolio companies, held over a relatively short period of time. Demand for R&W insurance is also higher among PE sellers. PE sellers are more likely than strategic sellers to want to limit their post-closing indemnification liabilities on the sale of a portfolio company so as to be able to fully distribute sales proceeds to the limited partners of the PE fund at the time of the sale, thereby providing higher internal rates of return to investors (Griffith 2020 ). Last, we find that demand is significantly higher if the target is in a common law regime (as opposed to civil or other legal regimes), consistent with greater expected indemnity contracting costs in these legal environments.

We then examine variables associated with the premium charged by the insurance company. Our analysis reveals that the insurance company charges higher premiums for targets in industries with poorer financial statement quality, which are perceived to be associated with a greater risk of loss. We also find that a higher premium is charged when the target is in an industry with relatively high levels of research and development (R&D) to sales, indicating that the insurance company expects unrecognized intangible assets to have a greater risk of future claims. In contrast, we find that premiums are lower in targets in industries with more growth opportunities, consistent with our prior evidence of a lower likelihood of purchasing R&W insurance for high-growth targets, given their greater reliance on future prospects. We do not find differences between the premium that the insurance company charges to private equity buyers and strategic buyers. In contrast, we find that PE sellers and individual sellers pay a higher premium than do strategic sellers.

We conclude by investigating the factors that are correlated with the likelihood of a claim, which reflects the realized risk. Somewhat surprisingly, we find that most industry-related factors are not associated with the likelihood of a future claim (with the exception of R&D to sales), but that these industry factors are related to the demand for R&W insurance or the premium charged. We also find that private equity buyers are less likely to file claims. A finding that is consistent across our three analyses is that deals with private-equity sellers are more likely to involve the purchase of R&W insurance than are deals with other types of sellers, have higher premiums, and are more likely to result in a claim. Overall, the results suggest that the ex ante risks inherent in the demand and premium charges are, to a large extent, not consistent with the realized incidence of breaches.

Our study contributes to several strands of the accounting and finance literature. First, we add to research on target valuation uncertainty in acquisitions (Shleifer and Vishny 2003 ; Rhodes-Kropf and Viswanathan 2004 ; Officer 2004 ) and on the impact of contracting on reducing valuation costs (Cain et al. 2011 ). We extend this literature by demonstrating the prevalence of R&W insurance as a replacement for the seller indemnity, which is a contracting mechanism to allocate risk and reduce information asymmetry and valuation uncertainty between buyers and sellers. Second, we add to literature that examines contractual mechanisms used to allocate risk in acquisitions. Some studies examine the determinants and effects of earnout provisions—contractual mechanisms that allocate post-transaction performance risk and create value in mergers and acquisitions (Bates et al. 2018 ; Cadman et al. 2014 ; Cain et al. 2011 ; Datar et al. 2001 ; Kohers and Ang 2000 ). Other studies of risk allocation in acquisitions explore material adverse change or event clauses (Denis and Macias 2013 ; Gilson and Schwartz 2005 ; Talley 2009 ). Our study extends these papers by being the first empirical paper to explore R&W insurance, which has only been explored theoretically (e.g., Gallozi and Phillips 2002 ; Griffith 2020 ; Hill et al. 2016 ). Last, we contribute to the body of research on disclosures in mergers and acquisitions by extending the analysis to private targets, which constitute the majority of M&A targets (Cain et al. 2011 ); most studies to date have focused on the effect of disclosures on the valuation of publicly traded target companies (e.g., Raman et al. 2013 ; McNichols and Stubben 2015 ; Skaife and Wangerin 2013 ).

2 Background

2.1 representations and warranties insurance.

Representations and warranties insurance transfers the risk of losses incurred due to breaches in the reps of an acquisition by compensating the policyholder in the event that such losses do occur. R&W insurance is issued either as a “buy-side” or a “sell-side” policy, depending on whether the policyholder is the acquirer or the seller, respectively. In a buy-side policy, the seller indemnity is not required, since the value of a breach is claimed directly from the insurance company. When the seller purchases the policy, the indemnity provision is retained, and R&W insurance compensates the seller for any subsequent indemnity claims made by the buyer.

In recent years, the use of R&W insurance has become significantly more widespread. Although first introduced in the 1990s, developments in the underwriting process, expansion of coverage, and the prevalence of PE participants in the acquisition market have dramatically expanded R&W insurance usage over the past ten years (Griffith 2020 ). Industry reports estimate that the US market for R&W insurance was less than 100 policies in 2011 and grew to more than 2,500 policies in 2018. Footnote 5 It is now estimated that R&W insurance is obtained in the majority of significant private deals.

2.2 R&W insurance policy terms

There are four key terms in an R&W insurance policy: liability limit, retention, policy period, and premium. The liability limit is the maximum amount that the insurance company will pay for all claims made under the policy. The limit usually, but not always, matches the indemnification amount included in the merger agreement; indeed, the limits are sometimes synthetic, in that the policy provides coverage even in the absence of a contractual seller indemnity. The retention represents the initial amount of losses that the insured must pay before insurance coverage applies. Retentions mitigate moral hazard by guaranteeing that the insured bears some of the economic cost of losses. In addition, since the insurer incurs significant administrative overhead, broker commissions, and premium taxes, it is not efficient to insure small or frequent losses. The retention eliminates these costs because the insured pays small claims directly (e.g., Grossman and Hart 1983 ; Holmstrom 1979 ; Mirrlees 1999 ). The policy period begins at the acquisition’s closing and ends at an agreed upon expiration date. In order for a claim to be paid, the insurance company must be notified of the loss during the policy period. The premium is the amount paid to the insurer for providing coverage when the policy is bound, generally prior to the deal’s close.

3 Literature review

There is a rich literature on valuation uncertainty in acquisitions (Shleifer and Vishny 2003 ; Rhodes-Kropf and Viswanathan 2004 ; Officer 2004 ). In order to reduce this uncertainty, parties to the acquisition agreement apply different contractual mechanisms of risk allocation. One mechanism is the inclusion of material adverse change or event clauses, which are used to protect parties against the risk of unforeseen events or circumstances (Denis and Macias 2013 ; Gilson and Schwartz 2005 ; Talley 2009 ). Another mechanism is the inclusion of earnout provisions, which allocate post-transaction performance risk. Earnouts allow the seller to insure future growth and earnings prospects (e.g., Cain et al. 2011 ; Datar et al. 2001 ). A third, more significant mechanism is the inclusion of reps, which are a set of promises, made by the seller, warranting that statements made about the target are true, and of indemnities, which are financial guarantees to the buyer against breaches discovered in reps after the closing of the deal. Several theoretical studies have explored the role of reps and indemnities to allocate risk and to reduce information asymmetry and valuation uncertainty (e.g., Gallozi and Phillips 2002 ; Griffith 2020 ; Hill et al. 2016 ). However, despite reps and indemnities being more common and more fundamental to the acquisition process than other contractual features, there has not been any empirical research into their economic magnitude, most likely because information about reps, indemnities, and breaches is rarely, if ever, publicly disclosed.

We contribute to the existing literature by empirically examining R&W insurance policies, which effectively replace the seller indemnity and thereby decrease contracting costs associated with negotiating the indemnity and subsequently litigating indemnity disputes. Using a novel dataset, we investigate three key issues with respect to R&W insurance. First, we examine the factors that affect the demand for R&W insurance. Second, we explore the factors that determine the premium charged by the insurance company. Third, we examine R&W insurance claims data in order to identify the factors that are associated with the likelihood of a claim.

4 Sample and data description

4.1 m&a transaction sample.

We examine a proprietary sample of 1,690 R&W insurance policies issued worldwide by a global insurance company for acquisitions of non-public targets between January 2011 and December 2016. The sample represents $470 billion in enterprise value acquired. Our data does not include the acquisition of public targets, because R&Ws for public targets typically do not survive the closing and because it is impractical for the acquirer to seek indemnification from or make holdback payments to a large number of public shareholders (Hill et al. 2016 ). Footnote 6 However, our data does include the acquisition of subsidiaries or units of public companies. For all policies, our data from the insurance company includes liability limits, duration, retention, and premium. For the acquisition parties, we observe deal size (enterprise value), buyer and target ownership type, target region, and target industry. We also observe claims reported for each policy through September 2017.

To understand how acquisition parties who purchase R&W insurance differ from those who do not, we compare our sample to similar acquisitions from the same time period in the Mergers and Acquisitions database of the Securities Data Corporation (SDC). Note that some of the acquisitions in the SDC sample may also have R&W insurance policy coverage; this will only serve to weaken our results. In order to align our sample with the SDC’s, we exclude, from the SDC database, observations in which (1) the acquirer did not purchase full ownership in the target, (2) the target is a public company, (3) the acquirer and the target are the same firm, (4) the transaction value is missing from the SDC database, or (5) the target company is located in Central America. We remove Central American targets because our R&W insurance sample does not include policies written in this region. After applying these filters, the SDC sample consists of 36,769 completed acquisitions.

In Panel A of Table 1 we report the number of deals with R&W insurance coverage by year and compare them with the SDC population. As depicted in this panel, the 1,690 acquisitions in our sample reflect 4.6% of the total number of deals in the SDC population. Over the course of our sample period, the number of R&W insurance policies as a percentage of the number of firms in the SDC sample for a given year increases from 1.9% in 2011 to 7.7% in 2016. Panel B of Table 1 reports the industry classifications for targets in our sample and compares them to the SDC population. In Appendix B Table 8 we show the mapping between the insurance company’s industry classification and that of the Securities Data Corporation. Although the target companies in our sample represent a range of industries, they exhibit some significant differences relative to the SDC population. Of the total R&W insurance sample, 37.3% of the industries possess large amounts of intangible assets, drawn from the consumer (15.6%), technology (12.5%), and healthcare (9.2%) industries. In comparison, the same three industries combined account for only 18.1% of the SDC population.

Panel C of Table 1 reports the region classifications for targets in our sample and compares them to the SDC population. Again, we note a key difference with respect to regional representation. In our sample, 73.4% of the targets are either in the United States (46.4%), the United Kingdom (14.7%), or Australia (12.3%), whereas in the SDC population these regions account for only 45.3% of the sample. The descriptive statistics in Panel D of Table 1 indicate that R&W insurance policies in our sample are more likely to be issued on large deals and to involve a private equity acquirer than are those in the SDC population. The mean deal size of our R&W insurance sample is $278 million, compared with $175 million for the overall SDC population. These univariate differences are consistent with minimum fixed underwriting costs, which discourage R&W insurance acquisition for smaller deals. With respect to the acquirer type, we document that PE firms represent 40.9% of the acquirers in our sample, compared to only 20.1% in the SDC population.

4.2 Descriptive statistics of deals, R&W insurance policies, and claims for breach of reps

Panels A and B of Table 2 provide descriptive statistics of the deals and R&W insurance policies in our sample, respectively. Panel A highlights the diversity of deal characteristics. For example, 40.9% of deals involve a PE acquirer, and 22.9% involve a seller who is an individual seller. Panel A shows that the mean (median) deal size is $278.3 ($120.0) million and that 74.37% of deals are negotiated under common law. The mean (median) premium is $0.54 million ($0.38 million).

Figure 1 illustrates the characteristics of claims filed for breach of reps for the policies in our sample through September 2017. Panel A of Fig.  1 reports the frequency of claims for breach and specifies the number of policies issued during each year of our sample period, the number of claims made on these policies as of September 2017, and the percentage of policies issued that incurred a claim. Each policy represents a specific acquisition or deal. As shown, 26.6% of all policies issued in 2011 resulted in a breach claim by September 2017. The percentage of policies issued that had claims against them in 2012, 2013, 2014, 2015, and 2016 were 24.2%, 23.5%, 20.1%, 16.2%, and 11.6%, respectively. The monotonic decrease over the years is likely due to the fact that claims can be filed for several years after the closing of the deal; consequently, fewer of the breaches of reps made in the more recent years will have occurred by the end of our sample period. These figures highlight the significant number of alleged breaches of reps in acquisition deals and provide evidence of the importance of R&W insurance. While most claims are generally reported within two years of the acquisition, some—e.g., those that are tax-related—may take six or more years to be filed after the applicable tax audit window expires. In our regression analysis, we add year fixed effects to account for this claims development pattern. Panel B of Fig. 1 indicates that approximately 95.9% of total claims are filed within 24 months, meaning that the discovery of the breach occurs during this time period. However, the value of the claim may not be known for some time thereafter.

Breach of representations and warranties: frequency and type. The following figures provide information on the frequency and types of claims for R&W breaches in our sample. Our sample includes 1,690 mergers and acquisitions involving R&W insurance policies procured between January 1, 2011, and December 31, 2016. Panel A shows the number of deals by year and the number of deals with a breach claim submitted by September 30, 2017. Panel B shows the number of claims by type and Panel C enumerates their distribution. Panel A: Claim for breach of representations and warranties: frequency by year. Panel B: Distribution of average time to claim for breach of representations and warranties. Panel C: Frequency of representation and warranty claims by type.

The insurance company that provided our sample classifies claims into 10 different categories. Panel C of Fig. 1 illustrates the distribution of breach by type. The four largest categories account for 65.2% of all breaches: financial statement errors (21.3%), material contract issues (15.1%), tax issues (14.4%), and regulatory compliance issues (14.4%). Footnote 7 The remaining breaches stem from intellectual property, employment, fundamental, operational, litigation, and environmental issues. Footnote 8 , Footnote 9 The insurance company further classifies financial statement claims into five subcategories, which, in an untabulated analysis, we find to be roughly evenly distributed. These subcategories include accounting rules breach, misstatement of accounts receivable/payable, undisclosed liabilities, misstatement of inventory, and overstatement of cash holdings or profit. In Appendix D Table 10 , we list the reps and provisions associated with each of the 10 main breach types.

Table 3 presents the frequency of the different types of claims by industry and by region. Panel A shows how the incidence of claims varies with the industry classification of the target. For example, in technology industry acquisitions, the most common breaches are of intellectual property reps. This is consistent with the fact that companies in this industry likely rely heavily on intangible assets, such as patents, to propel future growth. Additionally, in both the consumer and healthcare industries, the most common breaches are of compliance with laws reps. This is consistent with the fact that companies in these industries likely rely heavily on legal compliance and regulation issues. Lastly, in the financial industry, the most common breaches are of financial statements. In this industry there are 10 financial statement breaches, consisting of four accounting rule breaches, four misstatements of accounts receivables/payable breaches, one undisclosed liability breach, and one misstatement of inventory breach.

Panel B of Table 3 shows how the incidence of claims varies with the geographical region in which the target is located. Most claims are concentrated in the areas where R&W insurance is common (the US, Europe, Australia, and the UK). Among these four regions, tax breaches are the biggest driver of reported claims in Europe (28.57%) and the UK (33.33%), which reflects the greater frequency of cross-border deals among European acquisitions and the complexity of Europe’s multi-jurisdictional tax system (e.g., Erel et al. 2012 ). Almost all intellectual property claims take place in the US, consistent with untabulated evidence, in our sample, that most of the R&W insurance policies for technology companies are concentrated in the US (about 64%). Lastly, similar to Panel A, in all industries, one of the most common breaches is of financial statements.

5 Risk allocation and demand for R&W insurance

We begin our analysis by examining the determinants of the decision to purchase R&W insurance. As mentioned earlier, we explore two sets of variables to assess the demand for reps. Our first set of demand variables are industry metrics for valuation uncertainty and follow along the lines of Datar et al. ( 2001 ) and Cain et al. ( 2011 ), who examine the role of earnouts in valuation uncertainty in private firms. The first proxy reflects the target’s growth prospects using the target industry median Tobin’s Q ratio ( target industry Tobin’s Q) . The second is an indicator variable equal to one if the target’s industry has above-median standard deviation of daily returns over the prior year ( target industry STD returns ). The third is the industry ratio of R&D to sales ( target industry R&D to Sales ). We use an indicator variable equal to one if the target’s industry has an above-median ratio, which reflects both uncertainty about future prospects (Officer et al. 2009 ) and the extent to which there are unrecorded assets on the balance sheet (Lev and Sougiannis 1996 ). The financial statement reps signal the value of a firm’s recorded assets and liabilities, but most internal research-related assets are not recorded on financial statements. Therefore, these reps are a less likely source of breach for R&D-intensive firms. We add a fourth proxy, for target riskiness—the target’s industry mean rate of internal control weakness prevalence ( target industry ICW ). Inferences about internal control weakness are likely to signal other aspects of general management and target quality. This is consistent with prior findings that show a correlation between internal control deficiencies and information uncertainty, higher audit fees, lower financial reporting quality, and fraud (e.g., Amiram et al. 2018 ; Beneish et al. 2008 ; Doyle et al. 2007 ; Hogan and Wilkins 2008 ; Hoitash et al. 2009 ).

To examine the effects of target industry characteristics on R&W insurance demand, we use the following logit regression specification, where the dependent variable is an indicator variable equal to one if R&W insurance has been purchased:

We include two control variables. The first is deal size ( Log(Deal Size) ). We expect this variable to be positively associated with R&W insurance demand since the complexity and difficulty of conducting adequate due diligence during the acquisition timeline for larger deals may generate more breach claims. The second control variable is the target’s legal environment. We create an indicator variable ( common law ) that takes the value of one if the target is in a predominantly common law jurisdiction, and zero otherwise (La Porta et al. 1997 ). We predict that common law will be positively associated with the demand for R&W insurance, consistent with prior research that shows greater levels of investor protection and property rights in common law countries and that indicates that the enforcement of these rights often involves costly litigation efforts (e.g., La Porta et al. 2008 ). Since our R&W insurance data lists the target country for the US and the UK and the region for targets located in other countries, we consider a region to be common law if the majority of its acquisition activity by deal volume occurs in common law countries, using the SDC sample as a guide. In Appendix C Table 9 , we provide further detail about each region’s common law classification.

Our second set of variables are the type of acquirer and seller, since these parties may assess target riskiness and the need for reps differently. While our sample includes an indicator variable if the seller is an individual, the SDC database does not record this category. Therefore, our purchase decision analysis is limited to examining PE and non-PE deal participants, wherein the non-PE participants consist of both individuals and corporate entities. Footnote 10 To examine the relationship between PE firm involvement and R&W insurance purchase, we include an indicator variable equal to one if the acquirer is a PE firm ( acquirer PE ), and zero otherwise; and an indicator variable equal to one if the seller is a PE firm ( seller PE ), and zero otherwise. We examine the effects of seller and acquirer identity on R&W insurance demand by using the following logit regression specification, where the dependent variable is an indicator variable equal to 1 if R&W insurance has been acquired:

To account for industry-invariant factors, we also include industry fixed effects (based on the industry classification described in Appendix B Table 8 ). Table 4 presents the results of different specifications of the regressions described in Eqs. ( 1 ) and ( 2 ). For this test, we merge the SDC acquisition data used in Table 1 with our R&W insurance sample, and each observation, i , represents an acquisition in the combined sample. The SDC sample comprises 33,442 observations with the required control variables. Note that some of the acquisitions in the SDC sample may also have R&W insurance policy coverage; this will only serve to weaken our results. Footnote 11

As shown in Column (1) of Table 4 , firms in industries with more growth opportunities (labeled by target industry Tobin’s Q ) are less likely to purchase R&W insurance, consistent with the fact that the value of high-growth firms is predicated more on future prospects than on existing assets and liabilities, making R&W insurance less valuable. The coefficient on target industry STD returns is positive and significant for targets in industries with greater market volatility. The coefficients on R&D intensity ( target industry R&D to Sales ) and financial reporting risk (represented by target industry ICW ) are not significantly associated with the purchase of R&W insurance.

The results in columns (2) and (4) show that PE acquirers are more likely to purchase insurance ( acquirer PE ). This result is consistent with the notion that an acquisition by a private-equity buyer exposes the buyer to more firm-specific financial risk than would a similar acquisition by a large diversified public acquirer. This is because PE buyers’ fund structure usually consists of a concentrated set of portfolio companies, held over a relatively short period of time. The coefficient on seller PE is positive and significant, consistent with PE sellers’ greater desire, relative to strategic sellers, to limit their post-closing indemnification liabilities on the sale of a portfolio company. Doing so allows them to fully distribute sales proceeds to the PE funds’ limited partners and show higher internal rates of return to investors (Griffith 2020 ). In Column 5, we pool all variables of interest from Eqs. ( 1 ) and ( 2 ) into one regression and find results similar to those in columns (1) through (4). Moreover, when we add the type of acquirer and seller, the coefficient on target industry ICW becomes positively and significantly associated with R&W insurance purchase, which suggests that the addition of these independent variables is important and is consistent with the significantly higher adjusted R 2 .

Finally, in all columns, we find positive and significant coefficients on Log(Deal Size) and Common Law , consistent with our expectations. Overall, we find that R&W insurance demand is correlated with both target industry characteristics and type of acquirer and seller.

6 Third party assessment of potential breaches of representations and warranties

In this section, we examine the variables that are associated with the premium charged by the insurance company. This premium is based on the insurance company’s expectation of breach-related losses, plus administrative overhead and profits. Therefore, we expect premiums to be higher in industries with greater valuation uncertainty. Our R&W insurance sample allows us to add two additional variables that were made available to us by the insurance company but were not included in the previous analysis because they are not available in the SDC database. The first is an indicator variable ( Seller Individual ) that takes the value of one if the seller is an individual, and zero otherwise. The second is an indicator variable equal to one if the acquirer is the named insured (a buy-side policy), and zero if the seller is the named insured (a sell-side policy). We expect higher premiums to be charged on acquirer policies, as buyers suffer from a greater information disadvantage and more valuation uncertainty compared to sellers.

In order to draw clearer inferences regarding the association between the R&W insurance premium and target industry metrics and the type of acquirers and sellers, we follow prior studies and also control for the abnormal amounts of insurance coverage purchased ( Abnormal Limit ), defined as the residual coverage limit (Lin et al. 2013 ; Cao and Narayanamoorthy 2014 ; Chalmers et al. 2002 ). The residual coverage limit is obtained from a limit prediction model similar to Core ( 2000 ), in which the dependent variable is the logged policy limit and the explanatory variables include target industry characteristics , acquirer and seller type, an indicator variable for acquirer policy, an indicator variable for seller individual, logged deal size, and legal environment. Footnote 12 We then estimate the following two regressions:

Table 5 reports the results of estimating Eqs. ( 3 ) and ( 4 ), where the dependent variable is the logarithm of the policy premium. Focusing on target industry characteristics in Column (1), we find that the coefficient on target industry Tobin’s Q is negative and marginally significant. This result is consistent with that of the previous section, where it was shown that there is a lower likelihood of purchasing R&W insurance for high-growth firms, given their reliance on future prospects. The positive and significant coefficient on target industry R&D to Sales indicates that the insurance company expects unrecognized intangible assets to have a greater risk of future claims and takes that into account in determining the premium. Footnote 13 The coefficient on target industry ICW is positive and significantly associated with premiums, indicating that industries with poor financial statement quality are perceived to have a greater risk of loss. This inference is supported by Panel C of Fig. 1 , which illustrates that financial statement breaches are the main source of R&W insurance claims, accounting for more than 21% of all claims. Focusing on acquirer and seller type in Columns (2) to (4), we find positive and significant coefficients on seller PE and seller individual , relative to a strategic seller. In comparison, the coefficient on the acquirer’s identity, represented by acquirer PE , is not significantly associated with the premium. Our results remain qualitatively unchanged when we pool all variables of interest from Eqs. ( 3 ) and ( 4 ) into one regression (Column 5).

Across all columns, we find that the coefficient on acquirer policy is positive and significant, illustrating the insurer’s perception of heightened risk of losses for buy-side policies, consistent with buyers’ information asymmetry and the exclusion of fraud claims if the seller is the policyholder. The coefficient on abnormal limit is also positive and significant in all regressions, indicating that the insurer recognizes and charges increased premiums when the insured demands abnormally high limits, thereby countering potential adverse selection. The coefficient on common law is positive and significant, consistent with those regions’ higher levels and costs of litigation, which affects both expected losses and R&W insurance contracting costs. In all columns, larger deals result in higher premiums, given their greater degree of overall complexity and valuation uncertainty. Overall, we conclude that the insurance underwriting process takes into consideration valuation uncertainty measures as well as the type of the seller.

7 Breaches of reps

In this section, we investigate the factors that are correlated with the likelihood of a claim, which reflects the realized risk incurred by the insurance company. We do so by estimating the following logit regressions:

The variable Premium-to-Limit captures the insurance company’s ability to predict the likelihood of a claim being filed that is not controlled for by our other variables. Table 6 reports the results of estimating Eqs. ( 5 ) and ( 6 ), where the dependent variable is an indicator variable equal to 1 if an R&W insurance policy resulted in a breach claim. Footnote 14 Focusing on target industry characteristics in Column (1), we find that only the coefficient on R&D intensity ( target industry R&D to Sales ) is positive and significant, a result that is in line with our earlier documentation that the insurance company charges higher premiums to firms in R&D-intensive industries (Table 5 ). Additionally, whereas the insurance company charges higher premiums to firms in industries with more internal control weaknesses and lower premiums to firms in industries with higher Tobin’s Q, we do not find any association between these factors and the probability of a claim for breach of reps.

Focusing on the type of acquirer (columns 2 and 4), we find that, compared to strategic buyers, private equity buyers are less likely to submit a breach-related claim. A reason offered by Griffith ( 2020 ) as to why the insurance company might not charge lower premiums to PE buyers even though they are less likely to submit a claim is that the insurance company may not have enough historical information to realize that this is the case. Footnote 15 In columns 3 and 4, we document that the coefficient on Seller PE is positive and significant. In column (5), when we pool all measures into one regression, the coefficient on Seller PE remains positive and significant. This result is consistent with our previous finding that the demand for insurance and the premium charged are higher when the seller is a PE firm, compared to a strategic seller.

We also find that claims are more likely to be filed in larger deals, supporting our earlier finding that higher R&W insurance premiums are charged in larger deals. Moreover, we find that the coefficient on Premium-to-Limit is positive and significant, meaning that claims are more likely when the insurance company charges higher premiums. This finding suggests that the insurance company is able to identify other areas of potential risk not captured by the other independent variables. Last, we find that claims are more likely under common law, consistent with these regions’ higher levels and costs of litigation (e.g., La Porta et al. 2008 ), which affect both expected losses and contracting costs and are thus more associated with the frequency of breaches in the reps (Ramseyer and Rasmusen 2010 ; Browne et al. 2000 ). Overall, the results suggest that the ex ante risks perceived by the demand and premium charges are, to a large extent, not consistent with the realized incidence of breaches.

8 Conclusion

Drawing from a large and unique sample of R&W insurance policies, we document that industry measures of valuation uncertainty, as well as the type of acquirers and sellers, play a role in the demand for R&W insurance, the premium charged by the insurance company, and the likelihood of filing a claim. While the reps and indemnities are an effective mechanism to encourage information production to facilitate M&A, the significant contracting costs associated with seller indemnities have bolstered the purchase of R&W insurance policies in recent years. Our evidence shows that the demand for R&W insurance is increasing in proxies for indemnity contracting costs, including those associated with valuation uncertainty, risk aversion, litigation costs, and institutional features that do not favor seller indemnities. Given the rising trend in transferring indemnity risk to an insurer, there is concern that R&W insurance reduces the incentives for acquirers to perform due diligence and for sellers to produce efficient information about the state of the target, which should be a topic for future research.

Acquisitions involve many trillions of dollars. Our results attest to the demand for R&W insurance and extend the theoretical literature by documenting the use of R&W insurance in risk allocation, reduction of information asymmetry, and promotion of valuation certainty. Understanding the effect of private target disclosures on the demand and pricing of R&W insurance policies is an interesting topic for future research. Another potential future research question is whether there is a relation between the purchase of insurance and the success of acquisitions or the purchase price of targets.

A limitation of our empirical analysis is that we do not know the identities of the insured parties and do not have access to detailed financial information about them. We only have access to a limited set of buyer and target characteristics. These include geographic region, industry sector, type of entity (private equity, strategic, or individual), and acquisition value. We use industry-based proxies based on these observable characteristics, as reflected in prior literature (e.g., Cain et al. 2011 ; Datar et al. 2001 ), to make inferences about the acquisition participants. An additional limitation of our study is that we have a single source of R&W insurance data for our analysis. Without being able to observe the entire population of R&W insurance policies, the extent to which our results are generalizable is not clear. Even with these limitations, our paper provides a contribution to the nascent literature on the value of disclosures in private M&A transactions.

Outside the US, R&W insurance is commonly known as warranties and indemnities (W&I) insurance.

Coates ( 2015 ) notes that they constitute 43% of the words in the average acquisition agreement, a greater percentage than any other type of provision.

Betton et al. ( 2008 ) estimate that non-public targets represent more than 63% of all acquisition targets. R&W insurance is more commonly utilized in acquisitions of private companies than of public companies. This is primarily due to the fact that the reps in public deals typically do not provide for post-completion indemnification for breaches.

Private equity is composed of funds and investors that directly invest in private companies . A strategic buyer is a company that acquires another company in the same industry to capture synergies . A strategic seller is a company (not a PE) that sells a subsidiary or a business unit. An individual seller is a company being sold that is privately owned by a single person.

Risk and Insurance Magazine ( https://riskandinsurance.com/the-value-of-reps-warranties/ ). Retrieved November 2019.

R&Ws in public acquisitions generally serve to provide grounds to terminate the transaction prior to the closing for material breaches in the R&Ws, rather than to provide compensation to the buyer for breaches discovered post closing. Akorn, Inc. v. Fresenius Kabi, AG (Del.Ch. 2018) illustrates a case where the violation of representations regarding regulatory compliance was determined by the court to be grounds to terminate the merger agreement.

Of the 448 claims submitted, 143 have yet to be fully investigated and categorized; thus, we omit these when tabulating the distribution of claim types.

It is important to know that not all R&W insurance policies will cover environmental reps and warranties—especially if the environmental liabilities are potentially significant. In such cases, the parties would be better off obtaining an environmental insurance policy. However, even where a buyer insists on an escrow or indemnity for environmental liability, an R&W insurance policy can still be utilized to reduce valuation risk. By covering claims for breaches of other reps and warranties, an R&W insurance policy could enhance the chances that the escrow will not be exhausted by non-environmental claims. Moreover, in some cases, R&W insurance may be more cost efficient in addressing environmental liabilities than an environmental risk policy would be (Gallozi and Phillips 2002 ).

According to the insurance company, many regulatory compliance claims are filed by third parties. These claims include allegations of violations of employment, consumer protection, and competition laws. Typical employee-related breach cases involve claims by employees with respect to harassment or contractual obligations.

In the R&W insurance sample, the seller type is 47.8% strategic (corporate) entities, 29.3% PE, and 22.9% individuals.

While our sample includes an indicator variable if the seller is an individual, the SDC database does not record this category. Therefore, our purchase decision analysis is limited to examining PE and non-PE deal participants, wherein the non-PE participants consist of both individuals and corporate entities.

In untabulated results, we find that higher coverage limits are selected in buyer-purchased policies, when deals are larger, and when the buyer is a strategic acquirer.

This inference is supported by Panel A of Table 3 , which shows that IP-related claims represent a major source of R&W insurance losses, accounting for more than 23% of claims for targets in the technology industry.

Our results are qualitatively unchanged when we use the number of claims as our outcome variable instead of as an indicator variable.

An interesting example provided in Griffith ( 2020 ): “One insurer illustrated this point with an analogy to the sale of worker’s compensation insurance to contractors during the Iraq war. There was no actuarial data available, at least at the start of the war, on the risk of worker’s compensation claims in a war zone. Yet an insurance company was willing to sell the coverage, but only at a significantly higher price than ordinary policies. The contractor, who simply passed the cost on to the US government, was happy to pay the inflated price, and the insurance company made significant profits on the coverage. The moral of the story: ‘you don’t need a mountain of actuarial data to sell coverage profitably’.”

Amiram, D., Z. Bozanic, J. Cox, Q. Dupont, J. Karpoff, and R. Sloan. 2018. Financial reporting fraud and other forms of misconduct: A multidisciplinary review of the literature. Review of Accounting Studies 23 (2): 732–783.

Article   Google Scholar  

Bates, T., J. Neyland, and Y. Wang. 2018. Financing acquisitions with earnouts. Journal of Accounting and Economics 66: 374–395.

Beneish, M., M. Billings, and L. Hodder. 2008. Internal control weaknesses and information uncertainty. The Accounting Review 83 (3): 665–703.

Betton, S., B.E. Eckbo, and K. Thorburn. 2008. Corporate takeovers. In Handbook of corporate finance: Empirical corporate finance , ed. B.E. Eckbo. Elsevier.

Google Scholar  

Browne, M.J., J. Chung, and E.W. Frees. 2000. International property-liability insurance consumption. Journal of Risk and Insurance 67 (1): 73–90.

Cadman, B., R. Carrizosa, and L. Faurel. 2014. Economic determinants and information environment effects of earnouts: New insights from SFAS 141(R). Journal of Accounting Research 52 (1): 37–74.

Cain, M.D., D.J. Denis, and D.K. Denis. 2011. Earnouts: A study of financial contracting in acquisition agreements. Journal of Accounting and Economics 51 (1): 151–170.

Cao, Z., and G.S. Narayanamoorthy. 2014. Accounting and litigation risk: Evidence from directors’ and officers’ insurance pricing. Review of Accounting Studies 19: 1–42.

Chalmers, J., L. Dann, and J. Harford. 2002. Managerial opportunism? Evidence from directors’ and officers’ insurance purchases. The Journal of Finance 57 (2): 609–636.

Coates, J. (2015). M&A contracts: Purposes, types, regulation, and patterns of practice. In research handbook on mergers and acquisitions . https://www.elgaronline.com/view/edcoll/9781784711474/9781784711474.00010.xml .

Core, J. 2000. The directors’ and officers’ insurance premium: An outside assessment of the quality of corporate governance. Journal of Law Economics and Organization 16: 449–477.

Datar, S., R. Frankel, and M. Wolfson. 2001. Earnouts: The effects of adverse selection and agency costs on acquisition techniques. Journal of Law, Economics, & Organization 17 (1): 201–238.

Denis, D., and A. Macias. 2013. Material adverse change clauses and acquisition dynamics. Journal of Financial and Quantitative Analysis 48 (3): 819–847.

Doyle, J., W. Ge, and S. McVay. 2007. Accruals quality and internal control over financial reporting. The Accounting Review 82: 1141–1170.

Erel, I., R. Liao, and M. Weisbach. 2012. Determinants of cross-border mergers and acquisitions. Journal of Finance 67 (3): 1045–1082.

Freund, J. 1975. Anatomy of a merger: Strategies and techniques for negotiating corporate acquisitions . Law Journal Press.

Gallozi, M.s., and E. Phillips. 2002. Representation and warranties insurance. Environmental Claims Journal 14 (4): 455–467.

Gilson, R., and A. Schwartz. 2005. Understanding MACs: Moral hazard in acquisitions. Journal of Law, Economics, and Organization 21: 330–358.

Griffith, S.J. 2020. Deal insurance: Representation and warranty insurance in M&a contracting. Minnesota Law Review 104 (4): 1839–1920.

Grossman, S.J., and O. Hart. 1983. An analysis of the principal-agent problem. Econometrica 51 (1): 7–45.

Article   MathSciNet   Google Scholar  

Hill, C., B. Quinn, and S. Davidoff Solomon. 2016. Mergers and acquisitions: Law theory, ad practice . West Academic Publishing.

Hogan, C., and M. Wilkins. 2008. Evidence on the audit risk model: Do auditors increase audit fees in the presence of internal control deficiencies? Contemporary Accounting Research 25 (1): 219–242.

Hoitash, U., R. Hoitash, and J. Bedard. 2009. Corporate governance and internal control over financial reporting: A comparison of regulatory regimes. The Accounting Review 84 (3): 839–867.

Holmstrom, B. 1979. Moral hazard and observability. The Bell Journal of Economics 10 (1): 74–91.

Raman, K., L. Shivakumar, and A. Tamayo. 2013. Target’s earnings quality and bidders’ takeover decisions. Review of Accounting Studies 18: 1050–1087.

Kohers, N., and J. Ang. 2000. Earnouts in mergers: Agreeing to disagree and agreeing to stay. Journal of Business 73 (3): 445–476.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R.W. Vishny. 1997. Legal determinants of external finance. Journal of Finance 52 (3): 1131–1150.

La Porta, R., F. Lopez-de-Silanes, and A. Shleifer. 2008. The economic consequences of legal origins. Journal of Economic Literature 46 (2): 285–332.

Lev, B., and T. Sougiannis. 1996. The capitalization, amortization, and value-relevance of R&D. Journal of Accounting and Economics 21: 107–138.

Lin, C., M. Officer, R. Wang, and H. Zou. 2013. Directors’ and officers’ liability insurance and loan spreads. Journal of Financial Economics 110: 37–60.

McNichols, M.F., and S.R. Stubben. 2015. The effect if target-firm accounting quality on valuation in acquisitions. Review of Accounting Studies 20 (1): 110–140. https://doi.org/10.1007/s11142-014-9283-x

Mirrlees, J. 1999. The theory of moral hazard and unobservable behavior: Part I. Review of Economic Studies 66 (1): 3–21.

Officer, M. 2004. Collars and renegotiation in mergers and acquisitions. Journal of Finance 59: 2719–2743.

Officer, M., A. Poulsen, and M. Stegemoller. 2009. Target-firm information asymmetry and acquirer returns. Review of Finance 13: 467–493.

Ramseyer, J., and E. Rasmusen. 2010. Comparative litigation rates. Harvard Law School . http://nrs.harvard.edu/urn-3:HUL.InstRepos:30064400 . Accessed Nov. 2010.

Rhodes-Kropf, M., and S. Viswanathan. 2004. Market valuation and merger waves. The Journal of Finance 59 (6): 2685–2718.

Shleifer, A., and R.W. Vishny. 2003. Stock market driven acquisitions. Journal of Financial Economics 70 (3): 295–311.

Skaife, H., and D. Wangerin. 2013. Target financial reporting quality and M&a deals that go bust. Contemporary Accounting Research 30 (2): 719–749.

Talley, E.L. 2009. On uncertainty, ambiguity, and contractual conditions. Delaware Journal of Corporate Law 34: 755–812.

Download references

Acknowledgements

We are grateful to the insurance company that provided us with the data used in this study and to several individuals in the company’s M&A insurance group for valuable comments. We also appreciate the comments of David Aboody, Mary Barth, Matthew Cain, Brian Cadman, Keith Crocker, Kimmie George, Sean Griffith, Thomas Joraanstand, Emily Maier, Michelle Hanlon, John Hughes, Lukasz Langer, Jennifer Maxwell, Panos Patatoukas, Peter Pope, Yihan Song, Brett Trueman, Young Yoon, and seminar participants at Cass Business School and the Tilburg Winter Accounting Camp 2020. Omri Even-Tov acknowledges the support of the UC Berkeley Haas School of Business. James Ryans acknowledges the support of the London Business School Research and Materials Development fund.

Author information

Authors and affiliations.

Haas School of Business, University of California at Berkeley, 545 Student Services #1900, Berkeley, CA, 94720, USA

Omri Even-Tov

London Business School, Regent’s Park, London, NW1 4SA, UK

James Ryans

Berkeley Law, University of California at Berkeley, 693 Simon Hall, Berkeley, CA, 94720, USA

Steven Davidoff Solomon

You can also search for this author in PubMed   Google Scholar

Corresponding author

Correspondence to Omri Even-Tov .

Additional information

Publisher’s note.

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Rights and permissions

Open Access This article is licensed under a Creative Commons Attribution 4.0 International License, which permits use, sharing, adaptation, distribution and reproduction in any medium or format, as long as you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons licence, and indicate if changes were made. The images or other third party material in this article are included in the article's Creative Commons licence, unless indicated otherwise in a credit line to the material. If material is not included in the article's Creative Commons licence and your intended use is not permitted by statutory regulation or exceeds the permitted use, you will need to obtain permission directly from the copyright holder. To view a copy of this licence, visit http://creativecommons.org/licenses/by/4.0/ .

Reprints and permissions

About this article

Even-Tov, O., Ryans, J. & Solomon, S.D. Representations and warranties insurance in mergers and acquisitions. Rev Account Stud 29 , 423–450 (2024). https://doi.org/10.1007/s11142-022-09709-w

Download citation

Accepted : 01 August 2022

Published : 10 September 2022

Issue Date : March 2024

DOI : https://doi.org/10.1007/s11142-022-09709-w

Share this article

Anyone you share the following link with will be able to read this content:

Sorry, a shareable link is not currently available for this article.

Provided by the Springer Nature SharedIt content-sharing initiative

• Information asymmetry
• Representations and warranties
• Valuation uncertainty
• Mergers and acquisitions
• Seller indemnities
• Find a journal
• Publish with us
• Track your research

Guide to Representations & Warranties Insurance - 2023 Edition

The use of representations and warranties insurance (RWI or R&W) has become increasingly mainstream; it is used in an estimated 75% of private equity transactions and 64% of the time by larger strategic acquirers. Woodruff Sawyer’s R&W team presents this comprehensive look at this facet of coverage.

9 Reasons to Use Representations & Warranties Insurance RWI is now a well-established tool in the merger and acquisition (M&A) toolbox for both private equity and strategic buyers. Broad coverage and competitive pricing have been the theme for 2023. RWI has been widely adopted because it can be used to...

Please see full publication below for more information.

LOADING PDF: If there are any problems, click here to download the file.

Latest Posts

• We Are Living in a Material World: Ways for Companies to Mitigate Insider Trading Risk
• Risk Mitigation and Due Diligence Tips for Global Growth
• 2024 Compliance Hot Topics
• Guide to D&O Insurance for De-SPAC Transactions, 2024 Edition
• Building Defenses Against Cyber Risk in the Construction Sector

See more »

Refine your interests »

Written by:

Published In:

Woodruff sawyer on:.

"My best business intelligence, in one easy email…"

Trending News

Related Practices & Jurisdictions

• Real Estate
• Insurance Reinsurance & Surety
• Financial Institutions & Banking
• All Federal

Insurance is coming to real estate in new and important ways. Investors in real estate have long had a variety of structuring options when acquiring real estate assets, including buying real estate directly, buying interests in entities that hold real estate, and investing in REITs or private equity funds. While the underlying asset in each case is real estate, the choice of structure introduces varying degrees of complexity in purchase agreement negotiations and risk allocation. As the size of real estate funds continues to grow, more investors are seeking much larger transactions, often through “platform” acquisitions and other equity-level transactions.

To address new issues around post-closing risk, tools that have long been prevalent in corporate mergers and acquisitions (“M&A”) are being used in the real estate context. One such tool that is of particular value in these transactions is representations and warranties insurance (“RWI”). RWI is used in M&A transactions to allocate to a third-party insurer a buyer’s risk of loss in connection with a breach of the seller’s representations and warranties and to mitigate a buyer’s collection risk with respect to a seller that may have no assets by the time that the breach of a seller representation and warranty has come to light. RWI can provide similar benefits to buyers in complex commercial real estate transactions and facilitate the closing of deals.  

Representations and Warranties Generally

Seller representations and warranties (“R&Ws”) are used in purchase agreements to provide assurance to buyers that they are getting exactly the assets that they are paying for and that the acquisition of those assets will not result in the imposition of unforeseen liabilities. Such R&Ws typically fall into four categories: (i) R&Ws regarding a seller’s right to transfer the assets in question (such as good standing, due authorization, enforceability and ownership); (ii) R&Ws related to the condition and status of the assets (such as environmental, “no violations or liens”, contracts, and litigation); (iii) R&Ws regarding the revenue associated with the assets (such as financial statements, rent roll, and leasing); and (iv) R&Ws related to the potential liabilities that may arise in connection with the acquisition of the interests or assets (such as “no undisclosed liabilities”, tax, and compliance with laws representations). In a commercial real estate transaction, these R&Ws may survive for only a short period of time, typically 6-12 months and include caps based on a percentage of the purchase price. In a M&A transaction, however, these R&Ws may last significantly longer (12-24 months for “general” R&Ws and 6 years or longer for certain “fundamental” representations) and have much higher caps. Traditional real estate industry methods of risk allocation and risk management, including post-closing guaranties, holdbacks or even escrows often are insufficient or uneconomic in most of these “corporate-real estate” transactions.

Understanding RWI Coverage

Like traditional real estate post-closing indemnities, RWI protects parties against financial losses arising from inaccuracies in the R&Ws made by the seller in a purchase agreement. RWI policies provide coverage for breaches of a broad range of R&Ws, such as:

Organization and Good Standing;

Title to Property/Shares;

Capitalization/Authority;

Financial Statements;

Absence of Undisclosed Liabilities;

Litigation;

Compliance with Laws; and

Tax Matters.

Also like traditional indemnities, RWI insures breaches of R&Ws as long as the breach was not “actually known” by the key members of the buyer’s deal team at the closing and does not otherwise fall into any of the policy’s exclusions. Standard RWI exclusions include R&Ws regarding pension underfunding, asbestos and PCBs, R&Ws that constitute projections or are otherwise forward-looking, and so-called “10b-5” representations. 

RWI policies, however, allow for longer R&W survival periods than in commercial real estate transactions and standard M&A transactions. Coverage typically extends for 3 years in the case of general representations and warranties and up to 7 years in the case of fundamental representations and warranties. 

In terms of size, RWI has been used to insure transactions with total enterprise values ranging from $5 million to well over $1 billion. Current RWI markets have the capacity to insure limits of liability from $1 million to over $300 million. 

RWI coverage is subject to a deductible equal to approximately 1% of the total enterprise value of the transaction, which typically drops by 50% after the first year of coverage. The deductible is often split 50/50 between the buyer and the seller (with the seller’s portion normally funded into escrow at closing), although, in some cases, the buyer may agree to bear the entire deductible. RWI typically costs between 3% and 4.5% of the total amount of coverage purchased, although the cost can be slightly above or below this range depending on the size and nature of the transaction, current market conditions, etc. Who pays for the coverage is negotiable, but the costs are most often either split 50/50 between the parties or borne entirely by the buyer. These material terms should be addressed at the outset of any transaction.

RWI Coverage in Commercial Real Estate Transactions

In commercial real estate transactions, RWI can be an effective tool to mitigate a buyer’s risk of loss in connection with a breach of the seller’s R&Ws. This is especially true in transactions that involve the purchase of equity interests in entities that hold real estate. In addition to R&Ws regarding the underlying real property itself, such transactions typically contain the full suite of R&Ws common to non-real estate M&A transactions. The R&Ws in such transactions are generally very compatible with the coverage offered by RWI. 

Not all transactions are well-suited for RWI. Direct sales of real estate, for example, may involve a simple purchase agreement, with limited, if any, representations and warranties. Risks that are allocated to the buyer in such transactions are usually managed through a combination of due diligence and title insurance. The benefits of RWI in such transactions tend to be limited and do not ordinarily warrant the cost. But in a deal where the buyer is acquiring equity rather than real estate and is seeking meaningful recourse for “M&A-style” R&Ws over a longer period of time, RWI can be extremely helpful.

RWI markets have become very efficient over the years. Insurers in the RWI space have deep experience with M&A transactions and are able to provide coverage quickly and efficiently in “M&A-style” commercial real estate transactions. The entire underwriting process, including due diligence by the insurer and the negotiation of the RWI policy, can normally be completed in 1-3 weeks.  

While the market has evolved to the point where RWI policies now have many terms that have become industry standards, the policies are bespoke and negotiable. In order to obtain the strongest insurance coverage available, the purchase and sale agreement must be customized to align with the coverage provided by the RWI policy. For example, RWI insurers will typically provide broader coverage of R&Ws when the purchase agreement contains a so-called “materiality scrape” and is silent on the availability of consequential damages. Experienced legal counsel and insurance brokers are necessary to insure that the purchase agreement and RWI policy are drafted and negotiated so as to maximize available coverage and minimize the potential for out-of-pocket loss to the buyer. 

Real estate investors, funds, and institutions who invest in platform deals and acquire equity in entities owning large portfolios of properties rather than purchasing individual assets may be taking on exposures that are broader than in a traditional acquisition of real estate. To help mitigate the risks associated with these sophisticated commercial real estate transactions, purchasers and investors in such transactions should consider the use of RWI. RWI provides buyers with meaningful protection from R&W breaches at a price point that is reasonable in the context of a significant M&A transaction. Experienced M&A, real estate, and risk management attorneys can provide critical assistance to buyers and sellers who seek to effectively navigate the complexities of sophisticated real estate transactions and mitigate their exposure for post-closing liabilities through the use of RWI.     

Current Legal Analysis

More from goulston & storrs, upcoming legal education events.

Sign Up for e-NewsBulletins