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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.
Purchase 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.
Credit Agreement
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.
T H E P A R T N E R S ’ P E R S P E C T I V E
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