In response to the insurance industry's recent profitability challenges and increased commitment to creative risk management techniques, many insurers are now offering three types of new insurance products that can provide significant benefits to a company. Each are briefly described below.
A. Loss Mitigation Underwriting.
Many insurers are now willing to issue policies insuring existing or imminent litigation or loss which is otherwise uninsured or inadequately insured. Frequently referred to as Loss Mitigation Underwriting ("LMU"), this type of risk transfer arrangement presents to insurers and insureds both significant underwriting challenges as well as tremendous potential benefits.
Examples of situations where LMU insurance may be useful to a company include the following:
Strategic Transaction. A desirable strategic transaction (such as an acquisition of the company, a securities offering or a debt restructuring) may not be possible unless the company conclusively contains a potentially catastrophic lawsuit or loss exposure. But the company may not be able to negotiate and finalize a settlement with plaintiffs or to quantify the loss within the limited time frame of the strategic transaction. LMU insurance can contain the risk exposure, thus allowing the strategic transaction to proceed.
Stock Price. When a company faces a potentially catastrophic lawsuit or loss, the market price of its stock may be suppressed, thereby creating discontent among shareholders, impairing the company's financing alternatives, and projecting a false image of fundamental financial distress. This market response frequently is an over-reaction based on a false impression that the claim is worse than it really is. An LMU can provide comfort to the securities market that the perceived catastrophic exposure is quantified and contained, thereby allowing the company's stock price to return to its true value.
Unreasonable Plaintiff. The plaintiffs in a lawsuit may have grossly unreasonable expectations regarding the value of the claim, thus forcing defendants to defend the case up to and perhaps through trial. In large cases, plaintiffs frequently use the threat of a "runaway" jury verdict to coerce an excessive settlement from defendants. An LMU can allow defendants to contain their financial exposure from the claim sooner rather than later and can potentially assist in settlement negotiations with plaintiffs by showing that the defendants are no longer concerned about a large jury verdict. In addition, in some instances the LMU insurer may be able to assert greater leverage over plaintiffs and may be able to more persuasively negate plaintiffs' threat to take the claim to trial. For example, the insurer may have a large number of cases with the plaintiffs' counsel and may be able to more convincingly say "no" to an unreasonable settlement offer from plaintiff.
Tax Issues. Insurance premiums generally are deductible for federal income tax purposes. However, many settlements, judgments and other losses are not deductible. For example, costs incurred to resolve a shareholder class action arising out of the company's sale of securities may be a capital expenditure which cannot be fully deducted in the year incurred. In some instances, an LMU may enable a defendant to convert a non-deductible loss into a deductible insurance premium.
Although there is an infinite number of LMU variations, the most frequent LMU structures include:
1. Additional insurance coverage directly excess of the company's existing insurance. Because this structure simply increases the total amount of insurance available for the subject claim without creating any structural barriers to accessing the new coverage, this approach is at times less attractive to insurers than other alternatives.
2. High level additional insurance coverage that is excess of both the company's existing insurance and a large self-insured retention ("SIR")which applies once the existing insurance is exhausted. By placing a large SIR between the existing coverage and the new coverage, the Insureds retain a strong economic incentive to minimize loss from the subject claim and the plaintiff cannot directly reach the new insurance without first exhausting the large SIR through recovery from the Insured's own assets. Insurers typically favor this structure because it minimizes the risk of the LMU changing the Insureds' and the plaintiffs litigation settlement strategies, expectations, and behavior.
3. The Insurer's complete assumption of the entire claim, including full claims control. The Insurer's rationale for this extraordinary assumption of risk is the belief that the Insurer can successfully negotiate an acceptable settlement with the plaintiff by utilizing the Insurer's vast resources, experiences and perceived leverage over the plaintiff. Unlike the Insureds, the Insurer probably has a large "inventory" of claims with plaintiffs' counsel, thereby potentially giving the Insurer greater credibility and leverage in settlement negotiations. obviously, because this structure involves the greatest amount of risk transfer, this structure typically involves the largest amount of premium.
4. Insurance coverage only for judgments, not settlements or defense costs, in the lawsuit. Because the vast majority of claims which are subject to LMUs are settled rather than tried to judgment, this structure arguably transfers to the Insurer less risk while still providing the Insureds with desirable catastrophic loss protection in the event of a large judgment. This structure may also facilitate more reasonable settlements by showing to plaintiffs that defendants are not afraid to try the case if necessary. As a practical matter, this structure may also afford coverage for large settlements since the Insurer may conclude that it is in the Insurer's best interest to make a voluntary contribution to a settlement in order to facilitate such a settlement, thereby eliminating the risks associated with a trial of the claim.
LMU policies are usually manuscripted to address the unique features of each situation. Typically, an LMU provides very broad coverage for the specified claim(s) or loss, frequently subject to a co-insurance provision, and either a return premium or additional premium provision depending on whether the Insurer ultimately pays any loss under the LMU. The LMU coverage can be either following form to existing underlying insurance or broader than existing underlying insurance. Typically, LMUs have relatively few exclusions. The most common include fraud, illegal profit, costs to comply with non-monetary relief, fines and penalties and, with respect to professional liability coverage, bodily injury, property damage and claims by Insureds.
LMUs are difficult, time-consuming and expensive to evaluate and negotiate. Insurers must conduct a thorough due diligence investigation, which frequently includes retaining outside experts, extensive document review and interviews of various key witnesses. An underwriting fee is often charged by Insurers even if the LMU is never bound, both to offset the Insurer's large transactional cost and to confirm at an early date the Insureds' level of interest in the proposed policy.
Insureds who have an interest in exploring a potential LMU should understand and commit to the following principals at the beginning of the process:
- Retain the services of insurance brokers, financial advisors and legal counsel knowledgeable and experienced in this type of unique insurance product.
- Be prepared and willing to provide to the Insurer full access to all relevant documents, material information and company officers, employees and outside advisors.
- Allow significant time for the Insurer's due diligence and the negotiation of the policy terms.
- Do not treat the LMU as a commodity by shopping it to numerous Insurers. Select the Insurers like any other strategic partner, not through an auction of the policy.
- Establish a relationship of trust, candor and full cooperation with the Insurers.
- Thoughtfully structure the insurance program to address both the needs of the Insureds and the interests of the Insurers.
LMUs involve high costs to Insureds and high risk to Insurers, but under the right circumstances can deliver enormous benefit to the Insureds and a healthy profit for Insurers. The challenge for all parties to an LMU is to determine when and how this classic win-win scenario can be achieved.
B. Representation and Warranty Insurance.
Representations and Warranties Insurance covers loss resulting from breaches of representations and warranties made by the parties to a variety of business transactions, including mergers, acquisitions, stock or assets sales and leases. The insurance is most frequently purchased in connection with mergers and acquisitions ("M&As"). Like LMUs, this is a relatively new and creative insurance product that can provide valuable benefits to both parties to the business transaction.
What are Representations and Warranties? The Buyer in an M&A transaction cannot identify and evaluate before the acquisition every potentially material fact or circumstance relating to the purchased assets or their value. Therefore, Buyers typically request from the Seller and the Seller typically gives to the Buyer in the Purchase Agreement ("Purchase Agreement") various representations and warranties ("R&Ws"), in which the Seller in essence promises to the Buyer that various facts about the purchased assets are true. These R&Ws are usually the subject of extensive negotiations between the parties and therefore each transaction has its own unique set of R&Ws.
Some of the topics frequently addressed by R&Ws include the accuracy of the company's financial statements; compliance with various laws, including tax, employee benefit and employment laws; existence of threatened or pending litigation; lack of environmental hazards; and ownership and non-infringement of specified intellectual property.
If the R&Ws are subsequently shown to be materially false, the Buyer may be entitled to assert a claim against the Seller for damages incurred by the Buyer as a result of the false R&W. In order to assure the Buyer that a source of recovery for such a claim will exist, the parties frequently agree to escrow or holdback at closing a portion of the purchase price for a period of time or agree to an offset provision in the Buyer's promissory note. The Buyer can apply that escrow or holdback or can invoke that offset if there is a material breach of the R&Ws. Although not common, claims for breach of R&Ws can be significant and can materially change the economic results of a transaction.
What is Covered? An R&W Insurance Policy generally affords coverage for legal fees and the amount owing for breach of the insured R&Ws. Each of the insurers who offer this coverage have their own unique insurance policy form and many of the policy provisions are negotiable under certain circumstances. The following summarizes some of the more important provisions of a typical R&W Insurance Policy:
Insured. The Policy can be purchased by and can insure either the Seller or the Buyer in the M&A transaction. If the Insured is the Seller, then the Policy affords liability coverage for claims by the Buyer alleging breaches of the covered R&Ws, thereby protecting the Seller from paying back to the Buyer some of the purchase price due to R&W breaches. If the Insured is the Buyer, the Policy affords first-party coverage, reimbursing the Buyer for damages caused by the R&W breaches, thereby enabling the Buyer to recover its losses without having to locate and pursue the Seller and its assets.
Exclusions. Typically, the R&W Insurance Policy contains a minimal number of exclusions. Some of the exclusions contained within the standard R&W Insurance Policy form include tax liability; closing or balance sheet adjustments; breaches about which the Insured had actual knowledge at closing; projections; environmental matters; and failure of the Insured to fulfill a condition precedent in the Purchase Agreement.
Deductible. The deductible can be a rather modest amount, thereby providing coverage for most of the loss incurred by the Insured, or can be quite large, thereby providing more catastrophic coverage for the Insured. Generally, as the deductible gets significantly larger, the premium becomes smaller and the coverage terms become broader (i.e. fewer and narrower exclusions).
Subrogation. The Insurer will be subrogated under the Policy to any rights of recovery which the Insured may have for the loss paid by the Insurer. For example, if the Insured is the Buyer, the Insurer may be able to assert a subrogation claim against the Seller for the R&W breaches. Similarly, if the Insured is the Seller and the R&Ws which were breached were made by the Seller based on advice from its lawyers, accountants or other professionals, then the Insurer may be able to assert subrogation claims against those professionals.
When considering the value of an R&W Insurance Policy, one should primarily focus upon the strategic and economic advantages which this type of Policy can afford the Insured. A simple cost/benefit analysis which compares the likelihood and magnitude of a covered loss with the Policy premium will usually result in the erroneous conclusion that the Policy should not be purchased. R&W losses infrequently occur, but can be very large when they do occur. Accordingly, Insurers must charge a premium for these types of policies which may initially appear excessive in light of the perceived risk being insured.
The true value of an R&W Insurance Policy to the Insured is realized only if the Policy becomes a part of the Insured's overall strategy for the subject transaction, and the cost of the Policy is built into the negotiated purchase price so that the other party to the transaction effectively funds the Policy's premium. The following summarizes some of the strategic and negotiating advantages available to either the Seller or the Buyer from an R&W Insurance Policy:
Advantages of Seller Policy. An R&W Insurance Policy purchased by the Seller can afford true closure for the Seller regarding the transaction. For example, the Policy can:
- Virtually eliminate the Seller's contingent liability exposure for potential breaches of R&Ws;
- Eliminate the need for the Buyer to hold back or place into escrow a portion of the purchase price, thereby allowing the Seller unlimited use of the full purchase price immediately after closing.
Advantages of Buyer Policy. An R&W Insurance Policy purchased by the Buyer can create the following benefits:
- Afford to the Buyer a competitive advantage over other bidders for the Seller's assets by enabling the Buyer to pay the full purchase price to the Seller at closing (without any hold back or escrow);
- Create for the Buyer an easily accessible source of collection for future breaches of R&Ws in lieu of pursuing the Seller.
In other words, an R&W Insurance Policy can facilitate the negotiation of a transaction by bridging a gap between the parties and can allow the Seller to immediately access the full purchase price. Therefore, the cost of such a Policy should be evaluated primarily based on the Policy's importance to the transaction and the Seller's cost of capital.
The scope of the Insurer's underwriting analysis for an R&W Insurance Policy varies depending upon the Insurer, and the type of transaction and R&Ws which are being insured. Because the facts underlying the insured R&Ws exist at the time the Policy is underwritten, Insurers can, with sufficient due diligence, quantify to a large extent the risks being assumed under the Policy. Therefore, like LMUs, the underwriting process for this type of insurance policy is frequently more comprehensive than under many other types of insurance policies.
Because the Insurer's underwriting process can be quite extensive, a prospective Insured should begin discussions with the Insurer about a potential R&W Insurance Policy at an early stage of the underlying transaction and should be willing to fully cooperate and share information with the Insured and its counsel throughout the underwriting process. Like LMUs, a R&W Insurance Policy should not be viewed as a commodity which is auctioned to the lowest bidder. Instead, Insureds should select, through the assistance of experienced insurance brokers, an appropriate Insurer with whom a mutually beneficial partnership arrangement can be established.
C. Contingent Tax Liability Insurance.
A Contingent Tax Liability Insurance Policy potentially can address one or both of two different tax exposures.
First, the Policy can serve as a type of R&W Insurance Policy by covering a breach of tax-related representations and warranties in a transaction agreement. Frequently, Insurers underwrite and insure tax-related R&W's separate from other types of R&W's because of the unique nature of the tax exposure and the need for special Policy terms and conditions.
Second, the Policy can cover loss resulting from the taxing authority denying the Insured's tax treatment of a particular transaction. For example, if a company attempts a tax-free spin-off of a subsidiary but is unable for a variety of reasons to obtain a revenue ruling from the IRS prior to closing, the company may be able to purchase a Contingent Tax Liability Insurance Policy to cover the risk that the IRS subsequently determines the spin-off did not qualify for tax-free treatment.
Because this type of Policy is similar in many respects to a R&W Insurance Policy, the same cautions and guidelines discussed above for R&W Insurance equally apply to this type of policy. Some of the specific aspects of a Contingent Tax Liability Insurance Policy include the following:
- Coverage frequently applies to the Insured's liability for taxes, interest and penalties if there is a final determination that the intended tax consequences are unavailable. Costs incurred in contesting the challenge by the taxing authority may also be covered, as well as any "gross up" payments (i.e. any payments which are necessary to reimburse the Insured for its additional tax liability associated with receipt of payments under the Policy).
- Frequent exclusions include (i) the inability of the Insured to benefit economically from the intended tax benefit, (ii) application of an alternative or minimum tax, (iii) the Insured's failure to follow proper tax procedures, and (iv) state or local taxes.
- Often, the Policy is premised upon and indirectly insures the accuracy of a tax opinion obtained by the Insured from its outside tax advisors. In those situations, the Insurer may have a subrogation claim against those advisors if the opinion is wrong.