The use of reps and warranty insurance is on the rise because it allows sellers to take almost all of their money, and in many cases, all of their money, off the table when the deal closes.

This insurance product is a different way of structuring post-close protection for things that may go wrong, instead of the seller putting up an escrow or indemnity obligation, says Vipul Patel, a senior vice president at Aon.

“It’s a tool that’s used to facilitate the transaction, because it makes the negotiations go much smoother and it streamlines the process of negotiating those reps and warranties and the diligence process, generally speaking, with the buyer,” says Patel, who brokers and structures reps and warranty insurance.

Patel, who also has experience as an investment banker and M&A lawyer, talked about the nuts and bolts of reps and warranty insurance at the Smart Business Dealmakers Conference in September in Columbus.

How common is it for a claim to be brought against a company post-closing?

I’d say 20 percent of deals have some sort of claim. The bigger the deal, the higher the likelihood there is a claim, because the materiality of that diligence has a higher disclosure. These policies have materiality scrapes, meaning you don’t have to show that something is material to file a claim. You just have to have a loss in breach of a rep.

The frequency of claims has gone up. Many policies, however, don’t require a payout because there’s a deductible, and a lot of claims are within that deductible.

But I’d say 5 percent of policies require a payout, and they can be pretty large because they don’t exclude multiplied damages or valuation issues. If a private equity firm bought a company in a $100 million deal that paid a 10x multiple, and they discover a breach of a rep in the financial statements that results in a permanent loss of $1 million in EBDITA, that’s a $10 million claim, not just the $1 million.

Why is reps and warranty insurance so attractive to buyers?

That’s the beauty of this product — the buyer doesn’t have to go after the seller to get paid out on a claim. Instead, they go after an insurance company, which helps in many situations.

If you’re a private equity buyer and you bring on the whole management team, the last thing you want to do is involve them in a claim. You want to preserve that relationship and let them run the business, but you still want to be paid out on that claim. This is a way you can go after an insurance company instead of a management team.

It’s similar with a public company. When you’re going to have folks come into the business and run a division, the last thing you want to do is involve them in a claim. Of the 20 percent of these policies that have a claim, we haven’t seen a situation where the seller has to be involved in that claim, aside from providing additional information around a pre-existing liability. The only cases where an insurance company can actually involve a seller is if there was fraud.

Is the cost typically defined as a percentage of the deal value? And if so, what could you expect?

The cost of the policy is based on the amount of insurance that you’re seeking. In most cases, buyers are insuring around 10 percent of deal value. If it’s a $50 million deal, they could’ve taken out a $5 million policy. The cost is around 3.5 to 4 percent of that $5 million, $350,000 to $400,000 for a $5 million policy.

How do you typically work with buyers and sellers during a transaction?

We usually get involved when the deal is going out to market. We’ll get the insurance quoted, and ultimately, we work with the buyers once the deal flips to the buyer. But the seller’s involvement is, of course, very important, because the way insurance companies get comfortable insuring an agreement is through the buyer’s diligence, which is dependent on the seller providing what they need.

If we can get involved early, to get the deal quoted, it helps streamline the process. The buyer doesn’t have to go back out to the markets and requote the deal.

That benefits the transaction in a few ways. One, it confirms that the buyer will have an insurance option available, and they won’t have to negotiate a seller escrow or indemnity holdback. Two, it gives some guidelines on how much the insurance is going to cost. And three, it informs the buyers of any specific areas of coverage that they will not be able to get underneath an insurance policy. It allows them to understand how they’re going to cover any exposures around those risks.