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.
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