Class Report: Transaction Risk Insurance

Transaction risk insurance has come into its own following the record-breaking value of global M&A transactions in 2021. And despite a slight slowdown in 2022, interest in transaction insurance is continuing to grow.

Global mergers and acquisitions (M&As) broke records in 2021, with the total value of transactions topping $5trn for the first time. According to PwC, the number of announced deals exceeded 62,000 globally in 2021, up 24% from 2020. Publicly disclosed deal values reached all-time highs of $5.1trn, including 130 megadeals with a deal value greater than $5bn, 57% higher than in 2020 and beating the previous record of $4.2trn set in 2007.

Things have quietened down somewhat since then. Nuala Read, transaction risk insurance manager – UK, Tokio Marine HCC, says that after a record breaking year in 2021, there was an expectation that the pace of M&A activity levels would slow, but she says the reduction has been steeper than envisaged. She says current estimates are that M&A activity has reduced in all major regions, with APAC deals falling by 17%, the US by 19% and Europe by 6%.

Andrew Collins, head of warranty and indemnity GB, WTW, notes that global M&A activity in 2022 recorded a strong start with the number of completed deals valued in excess of $100m in the first quarter exceeding the same period last year. “However, a number of factors – Russia’s invasion of Ukraine; increasing inflation; global interest rate rises; market volatility; intensifying regulatory scrutiny of M&A transactions; and continued supply chain disruption – are starting to point to a slowdown in M&A activity in certain regions.”

However, he says there is good deal flow with a strong pipeline of activity, looking ahead in 2022 in Asia and Australia, while in Europe, deals are still progressing. “In spite of all these challenges, there remains significant unspent investor dry powder and there will be investors as well as strategic corporates who continue to seek M&A opportunities,” he adds.

Transaction insurance
According to Read, the use of transaction insurance has been growing exponentially for the past five to ten years. “As deal parties become more familiar with the product and the advantages it can provide, a virtuous circle has developed that has increased the use of M&A insurance. While these products have limitations, it’s safe to say that the M&A market has increasingly embraced M&A insurance,” she says.

Transactional risk insurance includes warranty and indemnity (W&I) and representations and warranties insurance (RWI), which cover financial loss if a sale agreement warranty proves to be incorrect, as well as specific tax insurance and contingent risk insurance.

All types of transactional risk insurance have seen rapid growth in recent years. Collins says W&I/RWI insurance market activity grew across all regions in 2021, with volumes seen by the WTW M&A team increasing by an average of 50%. “As the W&I/RWI insurance has matured, dealmakers and advisers have become more experienced and familiar in the use – and benefits – of such insurance. W&I/RWI insurance is now being used on a greater proportion of deals than before,” he says.

The market has also seen a significant increase in the use of specific tax insurance and contingent risk policies, with insurer appetite and capability expanding.

Main drivers
So what are the main drivers for purchasing this cover? Tokio Marine HCC’s Read says the use of this insurance was initially driven by private equity houses, as it allowed sellers to reduce their post-deal financial obligations and have a “clean exit”.

“As these insurance products mature, we are seeing an expansion in the types of buyers using transaction insurance,” she says. “Nevertheless, this insurance continues to be useful in facilitating cross-border deals as it provides protection, usually beyond what sellers will normally provide, in an unfamiliar jurisdiction. It has also proved helpful in M&A auction processes – with W&I insurance offered ‘as standard’, sellers are then able to assess bidder offers on a level playing field.”

Read says she has seen the demand for transaction risk insurance expand beyond the private equity market, as companies are increasing using the product in M&A deals. WTW’s Collins agrees, saying one of trends he is seeing is a notable increase in the use of W&I insurance by corporate buyers. “Given the seller-friendly market over the past couple of years, we have seen an increase – particularly in Europe – in ‘stapled’ W&I insurance solutions whereby the seller runs a competitive sale process, thereby enabling it to significantly limit possible recourse against it,” he says.

Other drivers for buying the cover include preservation of commercial relationships where management sellers remain in the business; alleviating buyer concerns around the financial standing of a seller; and providing comfort to key stakeholders (particularly lenders on debt financed transactions).

The increased demand for specific tax insurance and contingent risk insurance has largely stemmed from an increased awareness of the products, a widening of the risks that can be covered and a gradual reduction in rates, says Collins.

“More broadly, the private equity market has increasingly become a sellers’ market in recent years, which has inadvertently resulted in buyers looking to insurance solutions to cover risks that they are required to take on for them to win a deal,” he says. “As the tax and contingent insurance market has matured, insurance teams have hired tax and litigation professionals into their teams, which has also allowed markets to offer terms on risks they would have historically declined as they have been able to better gauge how ‘risky’ issues practically are.”

Capacity and rates
Tokio Marine HCC’s Read notes that the sharp increase in M&A activity in 2021 meant that the insurance market, alongside many other areas in M&A, struggled to service the deals. “In fact, most of the reported 2021 insurance capacity issues were due to insufficient underwriting resources, rather than the availability of insurance capacity. However, we see more capacity and more underwriters coming on line for M&A insurance in 2022,” she says.

Collins says there were capacity constraints in 2021, particularly in Q4 2021, in terms of both capital capacity as well as bandwidth of underwriting staff, but these have started to diminish as deal activity has dropped off, existing insurers have increased their team sizes, and new entrants are entering the market.

As a result of the capacity constraints in Q4 2021, there was upward movement in pricing, which was more severe in some regions than others, explains Collins. North America saw larger transactions (greater than $350m) commanding rates 15%-20% higher on average than lower middle-market transactions, with carriers reducing their appetites for what they perceived as more complex risks, he says.

He says Asia saw primary rate increases of 20%-50% during H2 2021, and up to 100% on select larger transactions in certain jurisdictions, while Australasia was similar for larger deals in terms of primary layers, seeing nearly 50% increases, although emerging earlier in the year. The UK and Europe saw rate increases of 10%-20% for operational targets, with smaller transactions particularly affected by reduced appetite and increased minimum premiums.

However, Collins says all regions have seen a stabilisation in rates in Q1 2022, or even a slight dropoff as capacity constraints have eased and insurer appetite has become less selective.

Read agrees that for the first quarter of 2022, there has been a slight reduction from the rates offered in Q4 2021, but they are still ahead of the ‘average’ 2021 rates. “The consensus is that, while it has dipped due to reduced deal volume, the failure to revert to the 2021 lower average is due to the increased number of claims being paid under US policies. For Europe, after Q4 2021, the rates reduced as M&A activity dipped to more usual levels and they look to remain soft while there is less M&A activity,” she says.