By Greg Cushard and Charles Sternberg, Lockton
Transactional risk insurance products are increasingly being accepted by the merger and acquisition community as a strategic alternative to traditional negotiation tactics. The convenience and gas retailing industry is one of those sectors seeing growth in M&A opportunities. Today, the market demands that financial buyers invest more of their own capital into their investments at closing and use operational gains to drive increases in the EBITDA of individual investments. A financial buyer must prove that its investment thesis yields attractive returns to compete effectively for the monies that fuel this sector.
From an insurance and employee benefits perspective, there are several key processes in place to assist a buyer in achieving its financial objectives. First and foremost, is a due diligence process in which financial, legal and operational aspects of the target are closely reviewed to vet the quality of earnings and identify exposures to the target’s financials. Second, is the maintenance of a solid relationship with insurance and benefits experts to assist the buyer in identifying ways to reduce expenses and increase EBITDA.
The use of portfolio purchasing strategies offers the buyer a significant opportunity to achieve these cost savings while improving the quality of insurance coverage. Further, these processes allow buyers and sellers with reduced appetites for risk to complete transactions.
In addition, greater awareness of the applicability of the products available on the part of legal and tax advisors has led to an increase in the use of transactional risk insurance. Following their initial development, transactional risk products such as representations and warranties, legal contingency, and tax liability insurance were not viewed as an attractive means of risk transfer to backstop the indemnification provided in a purchase agreement or to ring-fence an exposure with potentially significant impact to the financials of a buyer. Many of the products failed to catch on due to narrow coverage grants, high premiums and high retention levels. Now, the products are maturing. With more than a decade of underwriting results and legal precedent to which to defer, insurance companies are now more comfortable with broadened coverage terms and reduced rates. Finally, the underwriting process has become simpler. A cadre of experienced transactional attorneys specializing in litigation, tax liability, product liability and environmental liability has supported the products’ growing popularity by reducing the time and cost associated with underwriting.
Deal Case Study
The sell-side party to a transaction wished to divest itself of the majority of its c-stores, and return the proceeds of the transaction to its limited partners. The seller’s version of the purchase agreement offered zero funds to remain in escrow to pay for environmental remediation obligations. The seller purchased an insurance policy that would indemnify the buyer in the event the seller defaulted on its financial obligations to the environmental remediation contractor. This was unlike a cost cap policy that would have paid out if the remediation costs exceeded the contract. As such, a transaction was completed where it may not have been in the absence of a transactional risk product.
Types of Transactional Risk Insurance
Many transactional risk products have gained popularity as the market has matured and the alternative investment community has faced new challenges, including:
- Representations and warranties insurance
- Tax liability insurance
- Legal contingency insurance
- Environmental liability insurance
Representations and Warranties Insurance
The most popular of these products is representations and warranties (R&W) insurance. It provides coverage for financial loss associated with an unanticipated breach in a representation or warranty within the executed purchase agreement. Eligible transactions include mergers, acquisitions, mezzanine financings, other forms of capital infusions and divestitures. Policies may be purchased by both the buy-side and the sell-side. A sell- side policy provides indemnification and risk transfer, excess of a retention, in the event that the seller is sued for an alleged breach of a representation or warranty. A buy-side policy also provides coverage for an alleged breach of a representation or warranty, but it is a first- party contract that allows the buyer to claim proceeds directly from the insurer.
There are several benefits derived from purchasing a representation and warranties policy. From a buyer’s perspective, the policy provides a means to guarantee the collection of the indemnity in the event that the indemnitor is unwilling or unable to pay. The policy also can be used in lieu of an escrow or other holdback. As such, it can be structured to allow a buyer to offer a more attractive bid to a seller since the seller may receive virtually all of the proceeds of the sale at closing. Finally, for both parties to the transaction, the policy helps to eliminate post-closing surprises. All this being said, representations and warranties insurance is not bad deal insurance and should not be considered a substitute for conducting a thorough due diligence process.
Tax Liability Insurance
Tax liability insurance provides coverage for unpaid taxes, interest and penalties incurred when a covered tax position is successfully challenged by a taxing authority. Defense and gross-up costs (income tax on the receipt of insurance proceeds) may be covered as well.
Tax liability insurance is particularly effective in transactions for which there is no clear precedent established by a taxing authority, the amount of a potential tax liability creates a need to transfer the risk to another party, and when it is not possible to obtain a private letter ruling from a taxing authority prior to closing. Current concerns encountered on transactions include:
- Will there be taxable cancellation of debt (COD) income?
- Will prior interest deductions/net operating losses be challenged?
Deal Case Study
Buy-side party wishes to ensure that the net operating losses (NOLs) incurred by a target company will be available to offset post-closing earnings. The buyer purchases a tax liability policy to provide coverage against a financial loss in the event that a taxing authority disallows the use of the NOLs because of a prior change in control. The policy facilitates the transaction by providing coverage for taxes, interest, fines, defense and gross-up in the event of an adverse ruling.
