May 2004

During the late 1990’s and 2000, while private equity firms were doing deals at record rates, insurance due diligence was often secondary to business, legal and accounting due diligence and, in some cases, just getting the transaction closed was the only focus. Today, an increasing number of equity sponsors are focusing on insurance and risk management due diligence. For many target companies, property and casualty insurance premiums are a significant expense item. Also, challenges faced by equity sponsors in recent years, such as bankruptcies and increased litigation, have heightened awareness of insurable exposures and increased motivation to ensure adequate protections are in place. It is important that private equity investment professionals understand the ownership of target company insurance policies and the issues associated with assigning some or all of the rights of those policies.

In this article, we focus on several key issues of particular concern to private equity professionals and their portfolio companies:

• What is involved in a policy assignment?
• When is an assignment appropriate and advantageous?
• What steps are required to avoid problems?

What is a Policy Assignment?

An insurance policy is an asset that conveys certain rights to indemnification or reimbursement to the entity that owns it. As with other assets, under certain circumstances, ownership rights can be transferred or assigned. Policy assignment can be divided into two types: Legacy Coverage and Go-forward Coverage. Legacy Coverage involves liabilities resulting from claims that occur pre-close that may not be reported until after the close. Assigning Go-forward Coverage involves a transfer of ownership of the insurance policy post-close, allowing that policy to remain in force and respond to claims that occur between the close and the policy’s expiration.

When Can Policy Assignment Be a Problem?

Until recently, it was a fairly common practice for acquisition candidates that had bought and paid for occurrence-based insurance coverage to transfer the rights associated with those policies to an acquirer. Except in cases where the policy contained a specific prohibition or change in control provisions, the “operation of law” theory allowed the policy holder (target) to transfer the right to indemnity to the successor company. Courts had ruled that just because the alleged claim took place prior to the transfer of the insurance policies, the insurance company is not exposed to any greater risk with the successor company. However, on February 3, 2003, the California Supreme Court ruled in Henkel vs. Hartford Accident & Indemnity Co., that insurer consent is required before insurance coverage can be assigned to an acquirer in a merger or acquisition. This decision affects all companies that conduct business in California, not just those headquartered in the state. Although there are only two other states that have ruled on the transfer of insurance policies (Colorado and Massachusetts), California law tends to attract visibility and could serve as precedent in other states.

There are a variety of reasons a carrier might refuse its consent for a policy assignment.

• Poor claims history / lack of carrier profitability on the account
• Concerns about the companies increased debt leverage post-close
• The carrier desires to discontinue writing business in a particular line of coverage or geographic region

The Assignment Decision

While on the surface, it may seem attractive to take advantage of existing, in-force (and paid for) coverage, there are some important factors to consider.

• Is the policy subject to audit or retrospective rating that could result in significant additional premium being assessed?
• Does the policy contain deductibles or a self-insured retention (SIR) that could lead to uncovered claims?
• Does the insurance carrier’s financial rating indicate any doubt that the company will be there to pay claims when needed?
• Is better coverage available?

These and other questions should be answered before a final decision is made.

How to Approach Policy Assignment

The Henkel decision forces private equity firms to exercise added care when evaluating the insurance programs of potential investments. There are several steps that can be taken to increase the chances the insurance carrier will agree to an assignment as well as meet its future obligations:

1. Review all of the target’s old property and casualty insurance policies;
2. Identify the insurance carriers that provided the target company with coverage during the previous five year period;
3. Provide carriers ample written notice (2 weeks or more) of the pending transaction;
4. Obtain pricing, terms, and conditions for post-close replacement coverage and determine availability and pricing of prior-acts coverage;
5. If policy assignment is indicated, obtain written confirmation from the carrier;
6. Ensure the Purchase & Sale Agreement clearly defines the seller’s obligations and liabilities in the event the policies cannot be assigned.

Proper evaluation and execution of a policy assignment can greatly reduce the chances of any claim disputes arising out of the acquisition of another entity. We hope this research is informative and we welcome your questions and comments.

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Christopher J. Veber is a Director at Equity Risk Partners, the only full service insurance brokerage and risk management advisory firm dedicated exclusively to the needs of the private equity industry and its portfolio companies. For more information, visit www.equityriskpartners.com. Mr. Veber can be reached at 312-558-4872 or cveber@equityriskpartners.com.

James Riddle is a partner at Thelen Reid & Priest LLP, a full-service law firm, whose practice concentrates on various insurance matters. Mr. Riddle can be reached at 415-369-7302 or jriddle@thelenreid.com.