Volume 10

Partners' Perspective

Property & Casualty Insurance Integration Issues for Add-on Acquisitions:

Add-on acquisitions are a common way for our portfolio company clients to meet their growth objectives. Natural synergies must exist between the Parent (or "buyer") and the Target (or "subsidiary") in order for the acquisition to be successful. However, careful consideration must be taken in the due diligence process in order to ensure that the same synergies exist between the respective insurance programs.

The list of objectives to accomplish in the due diligence process is always long. As a result, it is common for decision makers to supplant insurance due diligence with potentially unsafe assumptions as to how the Target's insurance program should be handled. Here are some of the most common assumptions that are made and the subsequent issues that result:

"It will be easier to keep the Target's insurance program in place and integrate it once it expires". Virtually all policies contain a "change in control" provision which states that in the event of a consolidation, merger, or other change in control, the policy will automatically become invalid without written consent from the insurer. Many policies are written on a "claims-made" form which means that the policy will only respond to claims that are made and reported during the policy period. When a change in control takes place, these policies automatically convert to "run-off" status. Once a policy is in run-off, it no longer responds to any claims that relate to events that occur after the date of the change in control. In short, if a policy is in run-off status that entity would be uninsured for any claims that relate to events which occur post-closing.

There are other issues that may arise even if the insurer(s) assigns the policies to new ownership. There are additional, and unnecessary, administrative burdens for the Parent's staff when reporting claims and processing premium audits. The Parent's staff will be forced to keep track of which claims should be reported to which policies, and they will be forced to go through the premium audit process for the Parent and the new subsidiary. These are especially burdensome when several add-on acquisitions take place in a given policy period. In addition, when a claim occurs a savvy plaintiff's attorney might submit claims to both the Parent and subsidiary's policies.

It is also important to know that if the policies are cancelled in conjunction with the close of the transaction, the subsequent audits can be expedited. Additional premiums due to the insurer(s) can be paid with funds held in escrow. If the policies are allowed to run through their natural expiration date the escrow fund may expire by the time the audits are completed.

The deal structure might further determine whether or not maintaining separate programs is a prudent approach. For instance, if the Target is acquired as an asset purchase, it is common for the seller to keep their policies in force post-close, which actually provides little or no benefit to the seller. Therefore, the policies are not the Parent's to maintain unless they are specifically included assets in the purchase agreement.

"The Target's premiums are low so they are getting a great deal". There could be some enhanced coverages, terms, and conditions that the Target's current broker did not negotiate. With certain types of policies, one or two missing endorsements could have a significant impact on premium. The Parent and Target could be exposed by these coverage inconsistencies.

It is common for Workers' Compensation to be a company's largest property and casualty insurance expense, and virtually all Workers' Compensation policies include an Experience Modification (x-mod) factor. An x-mod is a credit or debit applied to Workers' Compensation insurance premium to reflect the individual loss experience of a company. The benchmarking average for any given industry is 1.00. The information used to calculate the x-mod includes a company's industry classification, workers compensation class codes, audited payroll by class code, number of claims, incurred losses, and the value of each claim. Typically, x-mod's are reset to 1.00 shortly after the transaction closes, or the Target could be subject to the Parent's x-mod. If the Target has a credit x-mod their premium could be substantially higher post-close (or lower if the Parent's x-mod is lower). Therefore, the cost savings associated with the Target's pre-close Workers' Compensation policy might not remain post-close.

"The Target is much smaller than the Parent so integrating the two should be easy." As the saying goes, "dynamite comes in small packages." Oftentimes smaller Target companies do not have access to the same resources, quality control, and loss control standards as the Parent. These challenges make it common for the Target to have at least one significant historical loss. The Target's historical loss history could have a significant negative financial impact on the Parent's insurance program once the two are integrated. The difference in cost should be included in the combined entity's financial modeling and the valuation of the acquisition.

"We will concentrate on insurance issues after the deal is closed." Some important information must be obtained in order to efficiently integrate the Target's exposures into the Parent's program. Most of this information should either be at the seller's fingertips or just a phone call away. If the seller insists that this information is too difficult to obtain, it should generate some red flags. Also, it is not uncommon for the Equity Risk Partners due diligence team to communicate directly with the seller's current broker(s) in order to obtain this information while maintaining confidentiality.

In addition, if policies are cancelled due to a change in control the policy holder will receive pro-rata refunds for unearned premium. If the policies are not cancelled until after the close of the transaction the insurer could return unearned premiums to the Target with a short-rate penalty, thus allowing the insurers to keep some of the Target's earned insurance premiums.

"We aren't going to perform insurance due diligence for this add-on because we do not need another deal related expense." This assumption is never valid since Equity Risk Partners performs their due diligence services for add-on acquisition free of charge.

Josh Warren is Director, Client Service at Equity Risk Partners. Mr. Warren can be reached at 312-980-7853 or atjwarren@equityrisk.com. Equity Risk Partners is 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.equityrisk.com.