Authors: Aaron Zeid, Matt Chodosh, Chris Murphy
The year 2021 may be described in one word: change. The year commenced with the inauguration of President Joe Biden. We saw the widespread distribution of the COVID-19 vaccine. Unemployment rates began the year at 6.4% in January and steadily trended downward, ending at a low of 3.9%.1 U.S. gross domestic product increased 5.7%, in contrast with a decrease of 3.4% in 2020.2 The Federal Reserve kept the federal funds rate to almost zero, resulting in extremely low interest rates; however, the Fed announced monetary tightening measures towards the end of the year. The nation experienced the new COVID-19 strains, Delta and Omicron. Inflation was the hot topic towards the end of the year. The 2021 annual change in the cost-of-living as measured by the Consumer Price Index was 7.0%.3
These economic factors created a ripe environment for merger and acquisition (M&A) activity. M&A deal value reached an all-time high of $5.9 trillion globally.4 Deal volume benefited from deals planned for 2020 that were postponed due to COVID-19 uncertainty, as well as deals planned for 2022 brought forward due to potential tax-related changes. Because of supply chain disruptions and a tight labor market, buyers focused on operationally sound companies and pandemic-related dislocation in some markets.5
Explosive M&A activity fueled the Representations and Warranties Insurance (RWI) market, which saw its highest demand on record. Some carriers experienced nearly 60.0% greater client requests for RWI policies compared to prior years.6 High valuations led to bigger deal sizes, resulting in larger RWI policies. RWI policy volumes reflect the growing use and acceptance of the product. Further, large claim payments have proven the effectiveness of RWI in managing and mitigating transactional risk.
What we saw in 2021
Below are some observations of what we saw in 2021 as it relates to the RWI insurance market.
High demand for RWI led many markets to hit their budgets much earlier in the year than usual. Combined with a crunch on human capital, this trend resulted in fewer quotes and higher pricing across the board. Opportunities in the healthcare and financial services spaces felt this impact harder than others due to their perceived risk profile. In response to high demand, labor shortages and underwriting constraints, existing markets are staffing up, and new insurers are entering the market. Despite these factors, capacity has remained ample to get large deals done.
Retentions in general remained unchanged, though it is worth noting a continued increase in public-style, no-seller indemnity transactions where the buyer is solely responsible for the policy's retention. An initial retention of 1.0% of enterprise value, dropping to 0.5% (usually 12 months after closing) is still standard. Initial retentions for larger deals are commonly 0.75% of deal value. For smaller deals, minimum retentions often apply, typically around $300,000, then dropping to the $200,000 to $250,000 range.
RWI premiums increased materially in 2021. Rate-on-line (ROL) pricing steadily decreased over the prior few years, hitting lows of 2.5% ROL in 2019. The reversal in ROL began in the latter half of 2020 and continued throughout 2021. Rates have abated in early 2022, and we expect ROL to remain in the 4.0% to 6.0% range, depending on the nature of the target's operations.
Claims frequency and severity held steady into 2021. The rate of claim notification frequency mirrored recent years, with an average of one in five policies. AIG's annual Claims Intelligence report indicates average material claim sizes remained constant across AIG's portfolio: $19 million for the largest claims over $10 million, $4 million for claims between $1 million and $10 million, and $380,000 for smaller claims between $100,000 and $1 million, where material claims are those with incurrent losses greater than $100,000.7
Types of policy breaches mirrored prior years. As a percentage of incidents reported by breach, breaches of financial statements accounted for 21.0% of claims, tax for 19.0% and compliance with laws for 16.0%.
Claims for breaches of material contracts representations constitute the fourth largest breach type at 12.0% of all breaches and are among the largest claims.8 The top 6.0% of material contracts claims account for 63.0% of loss dollars paid on those claims.9 Material contract breaches are indiscriminate, occurring in all industry classes; however, they occur more frequently in the manufacturing and technology sectors.
The influx in deal volume in 2021 caught many parties scrambling to keep pace. The RWI market was no exception. Decreasing unemployment combined with robust M&A activity created a human capital squeeze, in what is being called "The Great Resignation." As industry experts hire and train additional personnel, longer lead times are required for underwriters to handle the demand.
Initial concerns that COVID-19 would result in a barrage of claims activity has thus far been unfounded. Claims notifications did not jump due to COVID-19.10 Carriers continued to tailor COVID-19 exclusions to specific known impacts on the target company. COVID-19 has created significant challenges to traditional due diligence. Completing physical due diligence such as inventory checks and site inspections or meeting with company personnel and management were difficult to impossible in some cases.
Attributable to losses paid for material contracts claims, underwriters are taking a more critical assessment of contract administration, contract terms with third parties and accounting issues. Customer call are becoming commonplace, and due diligence is more focused on the target's internal controls around the administration of contracts, in addition to reviewing the contracts themselves.
Lastly, RWI insurers continue to take a close look at the target's underlying insurance programs, as RWI was never intended to be a substitute for other commercially available insurance products. While we expect RWI to sit excess of and no broader than underlying environmental coverage on certain targets in the manufacturing space or Errors & Omissions E&O) on companies that provide professional services, we also expect cyber to be a focus on most transactions. Given the hardening in the cyber market, RWI policies may contain a separate retention for cyber and privacy matters to the extent the target is uninsured or underinsured for those exposures.
In light of rising interest rates and historic valuations in the capital markets, M&A activity shows no sign of slowing down. Massive fundraising efforts by private equity and large alternative asset managers indicate there is significant capital waiting on the sidelines to be deployed.
Buyers face macroeconomic complications, including supply chain disruptions, inflation, labor shortages/greater competition for talent, and rising wages.11 Geopolitical tensions continue to escalate — most recently in the Ukraine, which is an evolving situation. These concerns will continue to keep markets on edge.
Robust M&A activity and expanding claims history will keep RWI pricing elevated in 2022, although new markets and additional labor should help alleviate some pain points. Eventually, claims experience will likely create variable pricing based on industry, transaction size, diligence quality and deal complexity.
Because of the highly nuanced nature of this market, it is imperative that you are working with an insurance broker who specializes in your particular industry or line of coverage. Gallagher has a vast network of specialists who understand your industry and business, along with the best solutions in the marketplace for your specific challenges.
Please note: A client's risk profile is the primary variable dictating renewal outcomes. Loss experience, industry, location and individual account nuances will also have a significant impact on these renewals.
1U.S. Bureau of Labor Statistics, "The Employment Situation - January 2022," Feb 4, 2022.
2Bureau of Economic Analysis, US Department of Commerce.
3U.S. Bureau of Labor Statistics, "Consumer Price Index Summary," CPI for all urban consumers, Jan 12, 2022.
4Bain & Company, "Global M&A Report 2022," 2022.
6Euclid Transactional, "Thriving in Uncertain Times," Feb 28, 2022.
7AIG Claims Intelligence Series, "M&A: Elevated Claim Levels Put Focus on Due Diligence," 2022.
10Liberty Global Transaction Solutions, "2021 Claims Briefing," 2021.