Mergers and acquisitions are continuing at a steady level in spite of uncertain corporate and political landscapes in some regions. Indeed, the global M&A market reached US$3.9 trillion in 2016, down on 2015’s all-time high of US$4.7 trillion, but still representing the third best year on record, according to figures reported by JP Morgan. The outlook is for more of the same this year; with on-going modest GDP growth expected globally many companies will look to M&A to accelerate their expansion.
Unsurprisingly, demand for M&A insurance has also been rising. This is partly because of the buoyant transactions market but the other factor is an increase in awareness – demand has picked up as deal parties and their advisors have become more familiar with the product, its strategic uses and claims history. Deal-makers are now more aware than ever that while the strategic rationale for a merger or acquisition may be obvious, there is always the risk of an unknown or undiscoverable issue turning what was thought to be the perfect deal into something rather less attractive.
AIG research shows a marked increase in companies making claims on warranty & indemnity (W&I) policies. Overall, 18% of all global W&I policies written by AIG between 2011 and 2015 resulted in a claim, up from 14% a year earlier. The figure rises for larger transactions: one in four policies written on deals of over $1 billion resulted in a claim.
Claims are still being made on these policies as long as seven years after they are issued, and while a good portion of claims (27%) are reported in the first six months following a deal, the majority (48%) are reported between six and 18 months after a transaction. A substantial 17% of claims were reported in the 18-24 month period following a deal and 8% were reported after 24 months or later.
The size of loss is reflected in AIG’s severity statistics. More than half of all material claims (those in excess of US$100,000) incurred a seven-digit claims cost and the average for nearly half of these is US$3.5m. A small but meaningful proportion (7%) of material claims were in excess of US$10m with the average of such claims being averaging US$22m. The final claims figures are likely to be even higher, given the fact that the numbers do not take into consideration possible pay-outs from the excess carriers above AIG’s retention.
So M&A claims are increasing, but what exactly is driving them? Financial statements breaches remain the most common trigger, accounting for 20% of all claims. Within this group the top reasons given for this type of claim are accounting rules statement breaches (26%) and misstatements of accounts receivable/payable (25%), followed by undisclosed liabilities (19%), misstatement of inventory (17%) and overstatement of cash holdings or profit (13%).
The standout exception was “compliance with laws” which jumped to 15% of alleged deal breaches, up from just 5% last year, making it the second-leading claims trigger ahead of discrepancies in a company’s contracts (14%), tax-related claims (14%) and intellectual property matters (8%).
Regionally, there are some differences. In EMEA, tax was the most common alleged cause of breach, responsible for 31% of notifications. Compliance with laws was the primary reason given for a breach in the Americas, a factor responsible for 19% of alleged claims breaches. Many of these are third-party claims, which may include allegations of violations of employment, consumer protection or competition laws, to name a few.
In Asia Pacific, financial statements and material contracts were the cited cause of nearly two thirds of breaches while the third main portion of claims – responsible for 11% of notifications – were employee-related.
Overall, buyers of M&A insurance are becoming more familiar with the product. Where breaches do occur they are submitting notifications that are well-structured. AIG is seeing more repeat customers who understand what they can and can’t claim for, and they are becoming much more sophisticated in their use of the products. While fewer policies are sold on the sell-side, these do result in a much higher frequency of claims at 29%, as opposed to 18% on the buy-side.
Whichever side you are on, a deal can come back to haunt – transactions pose risks to a significant number of companies, despite their best efforts during due diligence. Even the most sophisticated companies can and do miss critical issues during the deal process, owing to fraud, concealment, unexpected third party demands, managerial oversight or human error in due diligence.
More and more, M&A insurance is becoming a key part of deal negotiations and strategy. Companies rightly see it as a better alternative to leaving money in escrow with the significant benefit of insuring unknown deal risks.
This article first appeared in Insurance Day on 3 July 2017