Deal Documents and Insurance Diligence
When conducting due diligence on a prospective acquisition, we focus the majority of our time analyzing the target's insurance policies, loss history, reserves/accruals, risk management practices, and other information that our private equity clients would naturally associate with insurance. However, we believe it is almost as important for us to review drafts of key deal documents, including the Purchase Agreement (with schedules) and Credit Agreement.
From an insurance perspective, the purchase agreement ("PA") will address a number of important questions:
- Is the transaction structured as a subsidiary stock or an asset purchase? In both of these situations, it may be necessary to place entirely new insurance programs for the target at the closing of the transaction. Subsidiaries are typically covered pre-closing by their parent companies' insurance programs, and thus, will require a separate, stand-alone program. In a sale of assets, the historical policies may remain with the seller. If desired by both the buyer and seller, it may be possible to assign the target's insurance policies to the buyer, subject to carrier approval.
- Will the target undergo a change of control? Typically, upon a change of control, "claims made" liability policies such as Directors' & Officers', Employment Practices, and Fiduciary, will automatically go into "run-off," ceasing to cover any claims made following the change of control for the rest of the policy period. Unless the change of control provisions in these policies are waived by the carriers, new, prospective, policies for these coverages will have to be placed at closing. For reference, claims made policies cover claims made during a given policy period irrespective of when the alleged act giving rise to the claim occurred (subject to retroactive or "prior acts" dates imposed by the policy).To complicate matters, the new, prospective policies do not usually cover claims made post-closing that relate to pre-closing alleged acts. Thus, we typically recommend the purchase of a "tail" policy, providing an extended period (three to six years post-closing) in which to report such claims. The PA should specify whether the buyer or seller is responsible for purchasing the tail policies, since each party may benefit from them. Occurrence policies, such as Workers' Compensation ("WC"), General Liability ("GL"), Property, and Auto Liability ("AL"), cover claims that arise from events which occur during the policy period regardless of at what point in the future a claim is made. These policies generally do not go into "run-off" upon a change of control, but may have provisions that enable carriers to reevaluate certain terms and conditions, such as the level of collateral supporting high deductible programs.
- Which liabilities will be assumed by the buyer in the transaction and which will be retained by the seller? If any pre-closing, insurance related liabilities are accompanying the target, the potential magnitude and variability of these liabilities should be assessed by Equity Risk Partners and the buyer. Examples include open claims/reserves within high deductible WC, GL or AL programs, claims within self-funded medical benefits programs, and known environmental exposures.Even if the seller is providing indemnification for some or all of the known or potential liabilities associated with pre-closing acts, it is still suggested that they be quantified (to the extent possible) because (i) the total amount of indemnification available to cover these liabilities and breaches of reps and warranties may be insufficient, (ii) the survival period of such indemnification may not be long enough given the expected duration of the liabilities, and (iii) the seller may not have the financial wherewithal to fulfill indemnification obligations.
- What are the details of the representations and warranties made and indemnification provided with respect to insurance and otherwise? If the seller is representing that the company has certain insurance coverages in place, we need to review the insurance schedule to the PA to confirm that it matches the target's policies we reviewed during due diligence. If the magnitude and survival period of indemnifications being provided and/or the amount placed in escrow by the seller to guaranty the indemnification may not be adequate to address pre-closing insurance related liabilities/exposures, the incremental exposure needs to be factored into the buyer's purchase analysis. There may also be insurance market alternatives to transfer risk for these exposures. Examples include loss portfolio transfers, representations and warranty policies, environmental liability policies, etc. These solutions may also allow for smaller escrows, possibly facilitating smoother negotiations between buyer and seller.
The insurance sections inserted into credit agreements by lenders are often "boilerplate," remaining unchanged from deal to deal. As such, they frequently contain requirements that are not applicable to and/or onerous for a particular transaction. Private equity firms should make sure that Equity Risk Partners has adequate time to review, negotiate, and ensure compliance with lender requirements.
Lenders will typically indicate which types of coverage are required (e.g., Property, GL, AL, Environmental) as well as the scope of coverage (e.g., products and completed operations within GL, "all perils" Property coverage). Minimum limits of insurance purchased, maximum retentions/deductibles, and minimum claims paying/financial strength ratings for the borrower's insurance carriers are generally specified as well.
Given the lack of customization applied to credit agreement insurance sections as referenced above, we often find that the requirements are not relevant to or achievable for the target. For example:
- The target has no products, completed operations, or environmental exposures, but the lender's standard insurance section requires coverage for them.
- It is economically efficient for the borrower to carry a $250,000 per claim GL deductible and it has the financial strength to withstand high variability in claims. However, the lender's standard agreement limits borrowers to a $50,000 deductible.
- The target has WC coverage through a carrier with an "A-" A.M. Best rating. However, the lender requires an "A" rating.
Other insurance related requirements contained in credit agreements which may be unachievable, undesirable and/or unnecessary include:
- Payment of claim proceeds to lender. Lenders often have provisions requiring the borrower to apply the proceeds of any insurance claims against the outstanding balance of the loan. This clause should always be accompanied by language which first provides the borrower a reasonable period of time (12-18 months) in which to apply those proceeds to the repair/replacement of damaged property (which was the basis for the claim payment). Only if the borrower elects not to repair/replace should the lender be able to make such a requirement.
- Certificates of insurance with different designations for lender. Lenders can reasonably expect to be named as additional insureds, loss payees, and even assignees (in the event of a default) on borrower insurance policies. However, we have seen certain lenders ask to be an additional named insured, and others that require the right to have policies assigned to the lender at its discretion in situations other than borrower default. Neither of these is usually appropriate.
- Notice of cancellation. Typical insurance policies provide an insured with 30 days written notice prior to cancellation, other than for non-payment of premium, which requires 10 days notice. However, lenders often ask for 60 days notice or more.
- Evidence of renewal. We continue to be amazed by the number of lenders requiring insurance certificates as "evidence of renewal" 30 or more days prior to the expiration of a policy. Policies are not renewed prior to their expiration and thus, evidence of such renewal is not available until renewal.
The deal documents discussed above are included in our list of information requests submitted at the outset of a diligence process. Given that the drafting of these documents typically does not begin until later in the process, we often find that in spite of periodic requests, we don't end up seeing these until immediately before (or even after) closing. Please remember to send us these items early enough for us to review, comment, and have a favorable impact on terms and conditions.