Representations and warranties insurance in mergers and acquisitions

Abstract

To mitigate information asymmetry in acquisitions, the seller makes contractual representations and warranties (referred to as “R&W” or “reps”) about the state of the target, such as attesting to the accuracy of the target’s financial statements. While seller indemnities allow buyers to impose costs due to breaches in the reps discovered after the deal’s close, these indemnities involve significant contracting costs. To mitigate these costs, the acquisition parties have increasingly turned to purchasing representations and warranties insurance. Using a proprietary and novel sample of R&W insurance policies issued worldwide for acquisitions of non-public targets, we find that the demand for R&W insurance, the premium charged for it, and the likelihood of a claim being filed are correlated with industry metrics for valuation uncertainty, the type of acquirer and seller, and the target’s legal regime. In particular, we find higher demand for R&W insurance and a higher R&W insurance premium charged when the target belongs to an industry with weaker internal controls. We also find that a higher premium is charged when the target is in an industry with relatively high levels of R&D to sales, indicating that the insurance company expects unrecognized intangible assets to have a greater risk of future claims. Our study adds to our understanding of how parties reduce target valuation uncertainty and the role of disclosures and R&W insurance policies in private mergers and acquisitions transactions.