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Left: Alan Weiss, S.V.P Right: Richard Roderick, E.V.P/Partner

Companies involved in M&As understand the importance of financial due diligence to ensure knowledge of assumed obligations, the nature and extent of a target’s contingent liabilities, real and intellectual property issues, litigation risks and more.

Many businesses are unaware of other risks that may alter the terms of—or derail—a transaction. Insurance due diligence helps financial and strategic buyers assess prior, current and future risk as well as post-closing insurance expense prior to close, ensuring financial implications are understood and included in negotiations, or modeled where appropriate. Risk diligence also optimizes structuring of insurance and identification of savings, unlocking previously unrecognized prospective value.

Here’s a look at a few ways qualified insurance diligence can add value to your next transaction.

UNCOVERING BLIND SPOTS

In a stock deal, a buyer assumes all past liabilities, including the seller’s prior acquisitions. Buyers benefit from surviving indemnities and undisclosed insurance contracts discovered during diligence. Targets frequently have hidden liabilities surface during diligence. For example, when reviewing a Products Liability policy, Lockton found an exclusion for claims arising from manufacturing or distributing a specific surgically implantable product. The seller represented that it discontinued making the product, but the risk of future medical problems presented an uninsured current liability. In another scenario, any buyer would want to know before closing that millions of dollars of improvements were previously recommended to a warehouse fire suppression sprinkler system to avert a total loss of a critical supply chain facility. Without diligence, these potential liabilities would have been overlooked.

QUALITY OF EARNINGS

Insurance diligence contributes to the quality of earnings assessment for potential adjustments in purchase price. Purchase price adjustments are often made in corporate carve-outs to compensate for differences between subsidized allocated P&L expenses and the budget for a new stand-alone program. Large parent companies often retain significant risk, which reduces fixed costs of insurance. A Newco’s inability to take risk (e.g. large retention), coupled with the loss of a parent’s purchasing power, tends to escalate costs for stand-alone entities.

Other quality of earnings adjustments come from a seller’s understated retained liabilities. For example, a company with a $250,000 workers’ compensation deductible must reserve for future development of claim values in addition to the insurer’s case reserves. If projected losses used for an earnings budget are based on understated historical claims reserves, there will likely be a purchase price adjustment. Carriers also require collateral for these insurance reserves to backstop their exposure should a business fail. Collateral—typically a letter of credit—is frequently overstated in the carrier’s favor, but LCs can be mitigated with adroit negotiation. Buyers ignoring this risk diligence may miss the opportunity to negotiate millions in purchase price savings.

MANAGEMENT LIABILITIES

Because buyers are assuming liabilities for sellers’ pre-closing wrongful acts, parties in a stock purchase routinely require a six-year “tail” policy for D&O, employment practices and fiduciary liability insurance.

Asset purchase agreements typically do not stipulate the terms of this extended claims (“tail”) coverage because there is usually no assumption of liability. There are business reasons, however, for buyers to suggest that sellers purchase a “tail.” As an example, in situations where the seller becomes part owner of the new company through an equity rollover, buyers want to avoid the distraction and encumberment of uninsured litigation against the selling principal for pre-closing wrongful acts.

MITIGATING M&A RISKS

Insurance designed to cover loss or liability arising from unknown or undisclosed matters (breaches of representations and warranties) can reduce M&A risks and provide indemnity for financial loss. Representation & Warranty Indemnity Insurance is commonplace and advocated by legal counsel in the deal stream. This coverage is now readily available with competitive pricing, a more streamlined underwriting process and broader terms and conditions. Other attributes include the potential reduction of buyer holdbacks, supplementing the seller’s indemnity package, extending survival periods, providing coverage beyond the seller’s indemnity cap, and improving auction bids.

Inevitably, many insurance related issues will arise in every M&A transaction. Leveraging the expertise of a trusted risk management advisor will provide buyers and sellers greater reliance on insurance during the diligence process, uncover hidden liabilities and even potentially identify opportunities to save buyers millions of dollars prior to closing.

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