Authors: Aaron Zeid, Celeste Owens, Chris Murphy
Surviving market turmoil characterized much of 2022, the first full year in which much of the world fully transitioned from COVID-19 era lockdown lifestyles. Employees returned to the office for much of the week, creating a shift in consumer behavior that burst the bubble of certain industries once considered pandemic proof. In the US, inflation hit consumers, and private capital providers grappled with perplexingly high industry valuations.
To the chagrin of many, both the global stock and bond markets suffered historic losses in the trillions of dollars.1 In what many regard as the Federal Reserve's most aggressive interest rate policy in decades, interest rates rose with four consecutive three-quarter percentage point hikes.
News of a recession loomed heavy, but one didn't materialize. Nevertheless, mergers and acquisition (M&A) activity and the use of Representations and Warranties Insurance (RWI) persisted, albeit at a slower pace compared to the two prior years.
In the US, private equity and strategic corporate investors alike proceeded with caution, focusing more on add-ons and protecting their investments with RWI. In anticipation of disruptive supply chain issues created by the geopolitical conflicts in Ukraine and a looming conflict in Asia, some focused on industries like renewable energy or alleviating specific supply chain issues like computer processing chips. As a result, the RWI market, buttressed by its strong claims paying reputation as well as its improved underwriting process, remained strong. In fact, one industry veteran recorded the highest submission and policy binding volumes for the month of December in its history.2
What we saw in the 2022 Representations and Warranties Insurance market
New competition
In 2021 and 2022, new insurers, including a few led by RWI market veterans, entered into the RWI marketplace. Some of these markets have specific industry niches and slightly less restrictive appetites than their competitors, making it easier to place RWI for more deals than in years prior. Overall, their presence also translated into better terms for RWI insureds, driving down retentions and premiums and forcing Insurers to adapt and get creative.
Appetite for smaller deals
As M&A activity surged in the COVID-19 pandemic era, some markets limited by their team size instituted a minimum enterprise value of $200 million and declined submissions for M&A deals below a certain amount. This limitation drove many brokers to specific markets, which then gave those markets leverage to price coverage as they wished. As of 2022, the minimum enterprise value was no longer prevalent throughout the market. In fact, our team was routinely able to place RWI coverage for smaller deals and expects to be able to do so in 2023.
RWI retentions
As we noted in last year's update, retentions in general remained unchanged. An initial retention of 1.0% of enterprise value that drops to 0.5% (usually 12 months after closing) is still standard for most deals valued between $50 million and $250 million; however, initial retentions have been trending downward as insurers attempt to distinguish their terms in an extremely competitive market. Initial retentions for deals valued at more than $250 million are still commonly 0.75%. For relatively smaller deals ($25 million or less), minimum retentions apply — typically, $250,000 dropping to $200,000.
RWI premium rates
RWI premium Rate on Line (ROL) abated in early 2022, and by Q2, we began to receive quotes for rates not seen since before the COVID-19 pandemic. Given the current marketplace dynamics, we don't expect transactions to warrant ROLs of 4% or more, unless the nature or jurisdictional nexus of the target business warrants such a rate.
RWI claims
Overall, claims data shows a slight decrease in the frequency of notification of claims. Interestingly enough, for deals that involve a named insured domiciled in the US, Canada, and parts of Latin America, notification of claims increased approximately 55%.3 Claims data also shows that high-severity claims result from deals of all sizes, but are more common on larger deals that originate out of the Americas region. Notably, the medium- and high-severity claims are mostly in the life sciences, biotechnology and pharmaceutical space.3
For the first time, the most frequently cited representations in a RWI claim notice are tax-related, although these claims are largely precautionary (i.e., related to a routine tax audit).3 In an interesting departure from years prior, financial and accounting matters don't even make the top five in the Americas, although financial and accounting matters do account for the highest-severity claims. In the Americas specifically, breaches of tax representations are followed by the following types of rep breaches: employee matters, compliance with laws, material contracts, and Intellectual Property (IP). As mitigation measures for cyber risk have become the norm, cyber breaches now rank low on the list.3
RWI underwriting implications
In recent years, we saw underwriters more critically assess contract administration, contract terms with third parties and accounting issues. Specifically, customer calls became 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.
Similarly, we expect recent claims studies to inform underwriting decisions. In particular, because RWI was never intended to be a substitute for other commercially available insurance products, we expect insurers to limit their exposures for areas where other insurance is available or can be readily obtained.
For example, for high-stakes tax matters excluded under a RWI policy but for which an insured anticipates successful challenge by a tax authority, tax liability insurance may be a suitable solution. While we expect RWI to sit excess of and no broader than underlying environmental coverage on certain targets in the manufacturing space for Errors and Omissions (E&O) on companies that provide professional services, we also expect cyber to be a focus on most transactions. However, in contrast to recent years, the market no longer takes a restrictive approach to cyber matters.
Looking ahead at the 2023 Representations and Warranties Insurance market
Trends in recession or geopolitical conflict-proof buyout or growth-stage investments that started in 2022 are expected to continue. Investments in renewable energy, fintech or asset-heavy Latin American opportunities are ripe for RWI underwriting. Of course, we expect to support industries that have been widely supported historically, such as manufacturing, technology and healthcare. Despite cautious expectations for M&A, more generally during the first half of 2023, we expect RWI to remain the norm and will continue to monitor trends as the market continues to mature.
Conclusion
The RWI market continues to evolve and adapt to larger M&A market activity. RWI terms have become more competitive over the last year, in part due to the slow pace of deals and because new MGAs drove down the overall cost. RWI underwriting teams remain ready to support your M&A transaction.
Because of the highly nuanced nature of this market, it's imperative that you're 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.
