Famed British motivational speaker and business coach Rasheed Ogunlaru once said, “Unlike sport, in business the win-win is the best possible score.” In an M&A transaction, representation and warranty insurance can provide a buyer and seller a win-win by giving the buyer adequate financial security for any indemnification claims while minimizing the seller’s exposure and opportunity cost related to such claims.

Given the array of competing forces in any given transaction, it is sometimes hard to fathom, let alone put into practice, Ogunlaru’s philosophy that business transactions can and should be a win-win for all parties. M&A negotiations are inherently contentious, partly due to the risk allocation dance inherent in the representations and warranties in any purchase agreement. This delicate waltz causes both parties to expend much time, energy, and money negotiating the breadth of seller’s representations against the size, procedures, and limitations of Buyer’s indemnity. Further complicating these negotiations is seller’s dual role as both interested party and surety within the transaction. Seller’s duality inherently causes it to reject or delay Buyer’s claims for indemnification, no matter how legitimate, sometimes resulting in protracted and expensive litigation between the parties after closing.

Representation and warranty insurance is a useful tool to bridge this gap by replacing the traditional seller indemnification and surety structure within purchase agreements. Instead of making a claim against a seller, the buyer makes its claim against an insurance policy after the retention, or deductible, is reached, thus transferring risk from the seller to the underwriter.

The recent increase in competition within the insurance industry, coupled with an increase in the number of issued policies, has driven down the costs for these policies and allowed for more customization of policy terms. On average, industry premiums are currently at or below 3% of the coverage limits, while deductibles, known as “retentions,” are typically at or below 1% of the purchase price. Sometimes, through negotiation, the retention is split evenly between buyer and seller. Policy coverage limits are generally 10% of the purchase price, which is comparable to a typical escrow arrangement in an M&A transaction. Because of the costs associated with these policies, both premiums and due diligence fees charged by the underwriter, representation and warranty insurance may only be economical for deals valued at $20 million and above.

From the seller’s standpoint, representation and warranty insurance minimizes the seller’s overall liability for any inaccurate representations and allows the seller nearly complete access to the purchase price at closing. In a typical $100 million deal, under the traditional seller escrow surety structure, the seller may be required to deposit $10 million, or 10% of the purchase price, into escrow for up to two years. With representation and warranty insurance, the seller’s exposure is limited to the amount of the retention plus the amount of the policy premium. In this example, using the industry averages, the retention would be $1 million and the premium would be about $300,000, for a total “cost” of $1.3 million at closing. (If there are no claims, the seller will ultimately receive the $1 million escrow.) If the seller is able to convince the buyer to split the retention, which is fairly common, the total cost at closing would be only $800,000. One possible caveat to the seller’s benefits is that while purchasing an insurance policy costs the seller $300,000, there is a possibility that no indemnification is ever made, and the seller would have paid nothing. However, a savvy seller will likely be able to invest the $9 million (or $9.5 million) more it receives at closing to more than compensate it for the cost of the insurance policy. This is one of the reasons why insurance is only economical for deals above a certain size.

From the buyer’s standpoint, representation and warranty insurance provides adequate financial security for indemnification while making the indemnification process easier, more efficient, and less adversarial. In particular, as the insurance product has matured and insurers have paid more claims in recent years, buyers may find it easier to make claims with the underwriters than with sellers. Buyers may also be able to obtain greater coverage, e.g., longer survival periods or higher coverage limits, than sellers are typically willing to give. In addition, buyers willing to consider, or even pay for, representation and warranty insurance may make their bids more attractive in an auction process.

Representation and warranty insurance has become an integral tool for resolving sometimes difficult negotiations in M&A transactions and can provide both parties the best possible score as a win-win.