transaction liability insurance: a strategic approach to

Prepared by Aon Strategic Advisors and Transaction SolutionsAon Transaction Solutions

Transaction Liability Insurance:A Strategic Approach to Deal Risk Management

Prepared by Aon Strategic Advisors & Transaction SolutionsProprietary & Confidential

Aon ContactMatthew B. WienerSenior Vice President

Matthew Wiener is the head of Aon’s’ Transaction Liability team for the Southwest region. Inthis role, Mr. Wiener is responsible for the development and implementation of transactional-based risk solutions, including the deployment of insurance capital for M&A transactionsthrough representations and warranties, litigation, tax and other contingent liabilities insurance.Mr. Wiener is based in Houston and is further supported by a New York-based team of 20professionals in North America and colleagues in London, Hong Kong, Sydney and Bermudawho focus exclusively on transactional risk transfer. Prior to joining the Aon Team, Matthewwas an attorney at Vinson & Elkins LLP, where he specialized in corporate finance andsecurities law matters, including mergers and acquisitions, private equity, public and privatesecurities offerings, divestitures, and general corporate representation.

Matthew is a graduate of The University of Texas with a BBA in Finance and GeorgetownUniversity Law Center with a Juris Doctorate degree.

Contact InformationOffice: 713-470-9794Email: [email protected]


Insurance Capital Overview

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Transaction Liability Insurance Capital — The PrincipleThe availability of insurance capital designated for transaction liability has expanded significantly over the last five years. The most substantial use of this capital is through the deployment of Representations & Warranties (R&W) insurance. R&W insurance covers liabilities arising out of a breach of one or more of the R&W in an M&A transaction (including financial statements, intellectual property, taxes, and compliance with law). Policies are tailored to address a client’s specific indemnity and risk and exposure allocation needs on any given transaction.

• Policies are negotiated and drafted to replicate the traditional indemnity/escrow found in most transaction agreements, with an aim to put Buyer in the same (if not better) position regarding financial loss exposure.

• R&W insurance policies can cover all R&W contained in the transaction agreement, including both general and fundamental R&W, as well as pre-closing tax indemnities.

• Structure (including Seller indemnity and Buyer deductible) depends on objectives of parties and policies can be designed to back-stop Seller indemnification obligations and/or function as Buyer’s sole source of recovery.

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Transaction Liability (TL) Insurance — A GrowingMarket

The use of Transaction Liability Insurance has grown dramatically over the past four years

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Transaction Liability Insurance Market and Players


Representations and Warranties Insurance

Representations and Warranties Insurance

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Sell-Side Strategies and Value Enhancement -Overview R&W insurance serves to significantly reduce (or in some cases replace) the typical indemnity/escrow arrangement that a Buyer will generally require a Seller to agree to in an M&A transaction.

• In the absence of a R&W policy, a Buyer often requires that a Seller place 10% or more of the purchase price in escrow (or contractually agree to be liable for such amounts) to satisfy any losses incurred as a result of a breach of the R&W that the Seller makes under the transaction agreement.

• The R&W policy can significantly reduce (or in some cases eliminate) this indemnity obligation, thus allowing the Seller to immediately substantially all of the proceeds from the transaction and effectuate a cleaner exit.

• Sellers will frequently arrange to implement R&W insurance as an option at the start of a sales process such that the Seller can introduce a more favorable indemnity structure from the outset of the process, ensuring that the overwhelming majority of purchase price received by the Seller from the sale is unencumbered by potential future obligations.

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Representations and Warranties InsuranceRepresentations and Warranties insurance allows sellers to close a deal with limited or no indemnity and can make a buyer’s bid more attractive.

Traditional Deal Structure

*Seller may cover a share of policy premium

$90MMNet Proceeds

at Closing

$10MMProceeds at

Risk

$99.5MMNet Proceeds

at Closing

$0.5MMProceeds at

Risk

Representations & Warranties Policy


Sell-Side Strategies and Value Enhancement —ConsiderationsPrivate Equity Utilization and Benefit• Private Equity use of “seller-flip” model has dramatically increased over the last two years.

– Greater acceptance by corporate/strategic buyers as well as familiarity by law firms and financial advisors has played a significant factor

• R&W structure enables PE to return more capital immediately to LPs upon fund exit (as opposed to significant funds being subject to an indemnity period), reducing equity claw-back exposure and mitigating post-close transaction liabilities.

• PE ability to redeploy escrow capital into high-return investments (as opposed to a low-interest escrow account).

• Exclusion of subrogation of claims against Seller, absent fraud.

Seller Engagement• Broker engaged by Seller prior to marketing to solicit preliminary carrier interest in underwriting

transaction.

• Carriers provide initial pricing terms and coverage in 2-4 days.

• Broker prepares Process Letter providing overview of R&W Insurance coverage from carriers which is provided to buyers participating in auction process.

• Winning bidder engages Broker to implement and negotiate R&W insurance policy.

– Nothing further is needed or required from Seller.

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Buy-Side Implementation and Risk Allocation —OverviewBuyers are incorporating insurance capital into their bids, reducing Sellers’ indemnity obligations, and insuring up to more market levels.

• The use of insurance capital in M&A transactions has increased exponentially primarily as a result of two key factors:• “Mandated” by seller via Seller-Flip process or through indemnity structure built into the draft

transaction agreement• Used as a bid a differentiator in competitive auction processes.

• In a sales process “mandate”, Seller will introduce a limited/no-indemnity structure in the transaction agreement and instruct prospective buyers to seek R&W insurance to cover losses incurred as a result of R&W breaches.

• Buyers frequently look to utilize R&W insurance at the start of a sales process to facilitate enhancing a buy-side bid. In the event, a limited/no-seller indemnity structure how not been incorporated from the outset, a Buyer is often able to either shut down an auction process or offer a reduced valuation given the benefit the Seller is receiving through this structure.

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Buy-Side Implementation and Risk Allocation —ImplementationThe implementation of R&W insurance can be broken-down into a three-step process consisting of (i) initial Underwriter quoting, (ii) underwriter diligence and (iii) policy negotiation and execution.

• Initial Underwriter Quoting• Broker and underwriters enter into Confidentiality Agreement with prospective Seller/Buyer.• Broker submits documentation to underwriting syndicate to obtain high-level quotes and interest in

underwriting transaction. Requested documentation to provide initial terms usually consists of:» Sell-side marketing materials (CIM/CIP/Management Presentation)» Audited financials (if available); QofE Report» Buyer/Seller draft of transaction agreement.

• Initial quotes are generally obtained within 3 days, and Broker prepares a Summary comparing pricing, coverage and other terms from each quoting underwriter

• Underwriter Diligence• Upon engagement of an underwriter, formal diligence begins and typically lasts 2-4 days.• Underwriters engage outside counsel to review diligence performed by Buyer and its advisors on a non-

reliance basis.– No additional diligence is required of Buyer beyond what has already been performed.

• The diligence process culminates in an underwriter call with Buyer and its advisors to walk through any outstanding questions/issues the underwriter may have.

• Underwriter Diligence• Once diligence has been complete, underwriter will prepare and submit an initial draft of the policy.• Broker and Buyer’s counsel will negotiate the R&W insurance policy.• Policy is generally finalized within 1-2 days and signed concurrent with the execution

of the transaction agreement.

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R&W Insurance – Process and Timing

1 2 3 4 5 6 7 8 9 10 11 12+

Day 1Engage broker early in processBroker and potential Insurers execute (joinder to) NDA

Day 5Select Insurer• Insurer due diligence fee payable before underwriting ($10K-$40K)

Day 3 - 5Obtain quotes from Insurers• Submission includes recent draft agreement, offering memorandum, schedules,

and audited financials• No cost to obtain quotes

Day 5 to 12+Insurer Underwriting (7-10 days process), Policy Negotiation• High-level review of due diligence process• Access to legal, financial, tax due diligence reports, subject to non-reliance letters• As with providing legal reports to lenders, loss of attorney-client privilege• Telephone conference(s) with deal team

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Representations and Warranties Insurance: Enhanced Indemnity

Survival Period

Limits Materiality Scrape

Definition of Loss

A buyer-side representation & warranties insurance policy may enhance a buyer’s potential for recovery rather than simply replace the typical seller’s indemnity.


Corporate/Strategic Acquirer UsageAon placed 94 R+W policies for strategic acquirers in 2016. 95% were buy-side and 5% were sell-side policies. Two-thirds of the 94 policies were purchased by public companies.

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Value Creation in Distressed Transactions

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Value Creation in Distressed Transactions - OverviewR&W Insurance can make a significant impact in distressed deals by providing indemnification protection to a buyer where none would otherwise be available:

Increase competition and return to creditors

Protect buyer against loss of value based on misrepresentation

Provide buyer with a creditworthy counterparty where indemnification is available, but effectively meaningless

Given the current dislocation in the energy markets and the increase in bankruptcies and distressed deal flow as the market reconfigures, the synergies between the deployment of insurance capital and the allocation of risk away from parties engaged in the distressed deal marketplace are now more pronounced.

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As with non-distressed deals, the R&W Insurance would protect the insured for liability resulting from unknown breaches of the company’s or seller’s R&W in the transaction agreement

Coverage would match traditional, non-distressed M&A indemnity structure, with limits available up to 100% of enterprise value

Policy period would be three years for general reps; six years for fundamental and tax reps

Cost could range from 3% to 5% of the limit purchased, based on deal and target specifics

Self-insured retention is typically 1-2% of enterprise value, and buyers may be able to negotiate seller’s retention of a portion of the retention risk

Carriers can also entertain underwriting transactions where no seller indemnity is required (i.e., the self-insured retention would be borne solely by buyer)

R&W Insurance – Application in Distressed Transactions

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R&W Insurance – Section 363 SalesDebtor-Seller negotiates asset purchase agreement (“APA”) with proposed stalking horse bidder-buyer

Broker prices ‘stapled’ RWI to be available to winning bidder, subject to completion of underwriting

Bankruptcy Court approves stalking horse bidder and payment of RWI policy costs at closing of sale

Debtor-seller selects highest/best bid at auction and carrier completes underwriting with winning bidder

Based on insurer underwriting results and negotiated R&W language in final APA, final terms of policy are negotiated and policy is bound at closing, with policy costs paid at or shortly after closing

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R&W Insurance – Chapter 11 Plan SalesSeller-Plan proponent includes asset purchase agreement (“APA”) in proposed chapter 11 plan


Bankruptcy Court approves payment of RWI policy costs following plan proposal at closing of sale

Plan proponent-seller selects highest/best bid at plan auction and carrier completes underwriting with winning bidder


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R&W Insurance – Prepackaged PlansSeller-Plan proponent includes asset purchase agreement (“APA”) with or without pre-selected buyer in proposed chapter 11 plan


Bankruptcy Court approves payment of RWI policy costs following plan proposal at closing

Plan proponent-seller selects highest/best bid at plan auction and carrier completes underwriting with winning bidder


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Tax Insurance

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Tax Insurance Protection in Distressed TransactionsWhat is tax insurance?

Tax liability or tax opinion insurance can help a company reduce or eliminate an unwanted or contingent liability arising from a successful challenge by the I.R.S. or a foreign or state and local tax authority of a company’s tax treatment of a current, pending or historical transaction or investment

What is covered?

Failure of the insured to achieve the expected tax treatment in a transaction (M&A, lease, partnership or financing transaction) or an existing/ongoing corporate tax issue

U.S., state, local or foreign taxes

Tax, contest costs, interest, penalties and gross-up

Policy limits available from $10million to ~$1billion

Policy term typically 6 years; claims made

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Advantages of Tax Insurance Tax Liability or Tax Opinion Insurance protects buyers against a successful challenge by the IRS or other foreign, state or local tax authority and can help sellers close their deal more quickly.

Manages counterparty

exposure

Achieves economic certainty

Protect tax positions from

challenges

Eliminates the need

for escrow

Reduces uncertainty

in cross-border deals

Streamlines negotiations by eliminating deal-breaking issues

Challenges from U.S., state, local

or foreign tax authorities

Failure to achieve

expected tax treatment

Recovery for tax, contest

costs, interest, penalties and

gross-up

Retroactive change in

tax law

What is CoveredKey Benefits


Tax Insurance

S corporations

Tax-free reorganizations/mergers

Section 355 spin-offs

REITs/real estate acquisition/sales

Partnership issues

Employee benefits issues

NOLs

Federal and State Tax credits (e.g., solar ITC, low income housing)

*Tax Shelters (listed transactions) are not insurable

Tax neutral reorganizations Availability of degrouping relief Debt for equity tax relief Substantial shareholdings

exemption (SSE) Offshore and residency issues REITs

When to Consider Tax Insurance

USA UK/Europe


Litigation and Specialty Insurances

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Litigation InsurancePending or potential litigation can expose buyers to significant risks and financial liability. Litigation insurance can offset that risk or limit the liability buyers will be responsible for once the deal is complete.

When to consider Litigation Insurance

Possibility of a catastrophic outcome

Likely attachment point or retention due to potentially large range of damages

Pending litigation is preventing a deal from closing

Litigation arguments are well developed

M&A Deals Helps sellers avoid substantial escrow

requirements Allows buyers to ring fence the cost of

damages from an adverse judgement

Ongoing Business Risk Management Protects companies from catastrophic loss

from an adverse judgement


CFIUS Reverse Break Fee InsurancesChinese buyers may be subject to review by the Committee on Foreign Investments in the US face placing them at greater risk that their acquisition of a US asset will not be approved. CFIUS Reverse Break Fee Insurance helps Chinese buyers stay on an equal footing with US and other foreign bidders.

What is Covered

CFIUS Reverse Break Fees

(less self-insurance retentions or deductible)

Landscape Increased appetite for foreign

investment in the US Seller requests for buyer to

pay reverse break fees when deals fail

Inability of non-US investors to absorb the risk of paying out break fees

Broken Deal Costs(legal and banking

fees and expenses)


Transaction Liability: Claims

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R&W Insurance — Claims History

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R&W Insurance – Frequency and Timing of Claims

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Aon Strategic Advisors and Transaction Solutions | Aon Transaction Solutions 31

Transaction Liability Insurance & Claims: Aon Policies

*More claims for policies that incepted in 2015 and 2016 are likely forthcoming

Percent of Aon policies that resulted in claims

When to consider Litigation Insurance

14

119

87

665

3.92016*

%

12.62015*

% 17.62014

%

Prepared by Aon Strategic Advisors & Transaction SolutionsProprietary & Confidential32

transaction liability insurance: a strategic approach to

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