The mergers and acquisitions market sustained an immediate impact from the rapid spread of the novel coronavirus (COVID-19), including swift changes from the representations and warranties (R&W) insurance industry in an effort to adjust underwriting policies to the new risks presented by the pandemic. The impact on R&W insurance is continuing to change on a daily basis, but there have been significant developments and key market considerations that should be weighed as merger and acquisition (M&A) transactions consider the use of R&W insurance.

R&W insurers initially developed a handful of responses to COVID-19 including, but not limited to, specific exclusions related to the impact of COVID-19 and heightened diligence of a target’s business. As we enter into the summer months, those responses appear to be evolving in order to adapt to the reactions of clients and deal counsel. Initially, the reactions of certain R&W insurers disproportionately placed the risk on the policyholders, but as COVID-19 has progressed we have seen that R&W insurers are attempting to balance the risk posed by COVID-19 and are more willing to share in at least a portion of that risk with policyholders.

I. The Balance of COVID-19 Exclusions

One of the most immediate and greatest impacts on the R&W insurance market has been the development of underwriting protocols that require exclusions for COVID-19 related exposures from the policy. While there is a reasonably wide disparity with respect to the application of these exclusions by insurance carriers, the use of some form of exclusion is the new normal facing clients and deal counsel. At the outset of COVID-19, the COVID-19 related exclusions in R&W policies were being applied broadly and, in some cases, were so broad that they threatened to undermine the purpose of the policy itself. However, as time has progressed and more deals are seeking R&W insurance following the COVID-19 outbreak, these exclusions are becoming more focused on the specific risks posed by the target in relation to COVID-19 rather than utilizing a broad-based approach. Craig P. Warnke, Managing Director of the Transactional Risk Practice at Marsh USA, Inc., recently noted that when COVID-19 first began, insurance underwriters were excluding any risk presented by COVID-19 from policies, but insurers are now becoming more thoughtful about the application of COVID-19 related exclusions and tailoring the exclusions to the actual risk presented by each target on a case-by-case basis.

While there is only a small sample size of transactions entered into in the post-COVID-19 landscape, we have seen that the majority of COVID-19 exclusions no longer seek to allocate all risk to the policyholders and, instead, seek to balance the risk by focusing on the vulnerabilities of the specific target. In certain circumstances, the COVID-19 exclusions have even been limited to failures by the target company to protect employees or customers, rather than a broad exclusion relating to the general impact by COVID-19 on all aspects of the target’s business. In fact, in some circumstances, the underwriters have agreed to forgo COVID-19 exclusions altogether. For example, William M. Monat, the Transactional Risk Leader for Willis Towers Watson’s Mergers & Acquisitions Group, described a recent transaction in which the underwriter was able to gain comfort through the diligence process that the target’s supply chain and operations were not subject to enhanced risk due to COVID-19 and that the target’s sales had actually increased as a result of COVID-19, so the underwriter was able to offer R&W insurance without any COVID-19 exclusion.

Overall, while the majority of R&W insurance carriers will include some form of policy exclusion related to COVID-19, carriers are generally no longer insistent that policyholders bear all COVID-19 risks. Instead, there is anecdotal evidence that insurance carriers are striving to balance the risks of these exclusions between the policyholders and insurers.

II. Due Diligence Expectations for Clients

The COVID-19 related exclusions from coverage previously discussed are informed through a customary diligence process conducted by the insurer on the target as a whole. Insurers have always identified heightened focus areas of due diligence based on the target’s business, and most recently those heightened areas consistently include the impact of COVID-19. Specific diligence questions related to COVID-19 are being added to underwriting protocols, including, but not limited to, requests for recent financials and projections, the collection of accounts receivable since COVID-19, functionality of the target company’s facilities, the target’s efforts to protect employees and the direct impact on those employees, disruptions to customer or supplier relationships, business continuity plans, and insurance claims or coverage changes. Since the beginning of COVID-19, insurers continue to include general diligence questions regarding the effects of COVID-19 on the target, but targets should also expect focused questions that dig into areas where the target may be vulnerable. The heightened diligence by insurers will also be focused on defined terms in the definitive agreement such as “Material Adverse Effect” and whether the target will be able to properly make certain bring-down representations at the closing in two-step transactions. Targets should expect certain diligence requests related to the impact of COVID-19 on the target’s business in between signing and closing to ensure that pre-signing diligence remains current.

III. Anticipating the Impact of COVID-19 on Future R&W Insurance Offerings

As expected, since the beginning of the COVID-19 pandemic, insurers saw a substantial decrease in the number of deals submitted. As we began the month of June, insurers reported a slight increase in the total number of deal submissions, but submissions remain small in terms of overall transaction value when compared to pre-COVID-19 expectations.

Prior to COVID-19, there was a substantial trend towards “walkaway” deals without any form of seller indemnity obligations. Some commentators have speculated if seller-friendly clauses such as these will become less prevalent in the post-COVID-19 market, which many expect to be buyer-favorable, at least initially. However, as Scott Wolf of Willis Towers Watson’s Mergers & Acquisition Group notes, one driver behind this trend toward “walkaway” deals is the increased availability and awareness of excess R&W insurance covering buyers for losses from a breach of a fundamental and/or tax representation or warranty.¹

COVID-19 is unlikely to alter the risk of a breach of fundamental representations, which means that the costs of this excess R&W insurance are not expected to be materially impacted by the pandemic. As such, we anticipate that certain sellers, particularly financial sellers, will continue to resist agreeing to indemnify the buyer for losses in excess of the R&W policy’s coverage limit, and instead suggest the buyer purchase excess R&W insurance. However, other factors such as loss experience may impact the rates of the R&W insurance market, which could cause buyers to push back on obtaining excess R&W insurance. While it is too early to determine the impact on the overall market, one major R&W insurer recently announced a 20% rate increase due to loss experience. Overall, we anticipate that the trend towards “walkaway” deals will continue apace despite the presence of COVID-19.

Lastly, with an expected meaningful increase in restructuring activity and distressed M&A, we anticipate a significant increase in the demand for R&W insurance as a way for buyers to recover damages in situations where it is anticipated that the seller will not be creditworthy post-closing.

IV. Take-Aways

• The use of COVID-19 related exclusions is the new norm for R&W insurance; however, underwriters are beginning to focus on the actual vulnerabilities of the target and tailor the exclusions more narrowly as a result, which more appropriately balances the risk between policyholders and insurers.

• Clients and deal counsel need to ensure that COVID-19 related exclusions do not overlap coverage areas that are merely incidental to the risks posed by COVID-19 and would otherwise be covered under a typical R&W policy.

• Targets should expect heightened due diligence related to the impact of COVID-19, as well as follow up diligence to ensure representations and warranties remain accurate between signing and closing.

¹ In transactions involving buy-side R&W insurance, there is typically either limited seller indemnity (often capped at or around 0.5% of the purchase price) or no seller indemnity. Instead, sellers expect buyers to look to a buy-side R&W insurance policy as a substitute for a buyer’s traditional indemnification rights. However, most R&W insurance policies only provide coverage to the buyer for coverage limits ranging from 5% to 20% of the purchase price. Traditionally, without R&W insurance, a buyer would negotiate higher indemnification caps for losses arising from a breach of a fundamental or tax representation or warranty. When a buyer purchases excess R&W insurance for losses arising from a breach of a fundamental or tax representation or warranty, the buyer first looks to its primary R&W insurance policy up to the coverage limit. If the buyer incurs losses in excess of the primary R&W insurance policy’s coverage limit, and such losses arise from a breach of a fundamental or tax risk, the buyer would then look to the excess R&W insurance policy.