Clean Slate.

Buyers and sellers engaged in mergers and acquisitions look for insurance to protect them from unpleasant surprises.

When Big Wheel Rossi Auto Parts Stores sold its assets but retained its stock in 1999, the owners didn't want any leftover liabilities coming back to haunt them. With stores throughout the upper Midwest, Big Wheel resold automobile products and provided service at some locations. "We were afraid we could still be held liable for defective product or service claims," said Steven Shaller, Big Wheel vice president.

The shareholders solved their problem by buying an insurance policy from the Chubb Group of Insurance Cos. to cover any claims for the next seven years, up to a maximum of S1O million. "We paid one premium, and then we could sleep at night," Shaller said.

Shaller and his colleagues at Big Wheel are not alone in their quest to protect themselves from liabilities after buying or selling a company. As more companies have become involved in mergers and acquisitions, both buyers and sellers are looking for insurance to guard against potential trouble after the close. When insurance brokers were brought into due-diligence processes to review existing insurance policies before mergers, they realized that some risks could be transferred to insurers.

The risks fell into different categories, depending on the nature of the companies and the structure of the transactions. Brokers and insurers saw that insurance could smooth the bumps in a deal by transferring claims and future risks associated with general liabilities; professional, environmental and product liabilities; workers' compensation liabilities; representations-and-warranties liabilities; and some directors-and-officers liabilities. Since 1997, innovators in the insurance industry have scrambled to adapt old products and introduce new ones to meet these needs.

In many cases, taking those risks off the balance sheet could save a deal that otherwise might have fallen apart. The products won't make a bad deal good, but they can bridge the gaps between buyer and seller and help reduce uncertainties that can impede the transaction, said Michael Karmilowicz, vice president of representations-and-warranties insurance at Reliance National Insurance Co., New York. The policies also can clean up a possible acquisition target and make it a lot more attractive.

Customers for M&A insurance products range from parent companies trying to sell themselves or a subsidiary to the parties buying those businesses, which may include corporations, private equity funds, venture capitalists and strategic partners.

Long-Tail Products

Big Wheel's case is typical. A buyer doesn't want to assume liability for products it didn't manufacture or distribute, and a seller doesn't want to have to continue worrying about them. Chubb, based in Warren, N.J., was able to adapt an existing product, Continuum, to meet these needs.

Originally, Continuum was created to help companies that purchased claims-made policies in London or Bermuda during the hard market of the 1980s to convert to occurrence coverage when they wanted to bring their insurance back to the United States in the early 1990s. In making the switch, the companies left prior occurrences uncovered, so Chubb built a policy form that would respond to future claims resulting from prior occurrences.

"We called it Continuum because it has the effect of reaching back and picking up old contingencies," said Chubb Vice President John Cavanaugh. When someone asked about successor liability in mergers and acquisitions, Chubb realized it could apply the same "tail coverage" product to that problem. Even in assets-only sales, the courts have held buyers responsible for liabilities because the structure of the deal didn't leave the seller adequate resources to pay claims, Cavanaugh said. Customers have included buyers and sellers of businesses or parts of businesses, as well as companies that are discontinuing a product line.

Private Equity Interest

Private equity funds make up a little more than 60% of the M&A-related business that American International Group writes. Participants in the funds are short-term investors, so they don't want to have any retrospective liabilities, said Greg Flood, who was president of AIG's Mergers and Acquisitions Services Division until he left the company in January. Investors in private equity funds also are interested in guaranteed multiyear contracts for prospective future risks.

The merger-and-acquisition risks covered by New York-based MG include product liability, directors-and-officers liability, employment-practices liability, workers' comp claims and environmental issues.

In one case, an investment group that had combined a number of healthcare businesses couldn't manage them all and had to sell some The companies had 180 open medical-malpractice claims and 85 that were closed. To make the companies attractive to buyers, the sellers bought a policy from AIG that covered the open claims and another policy that covered the closed claims in case they were ever reopened.

Recently, AIG completed its first pension-fund buyout. The acquirers of a company didn't want to manage the company's pension fund, so AIG fashioned a life policy that for a fixed premium would pay employees the retirement benefits to which they were entitled.

The point is to get liabilities off the seller's balance sheet, Flood said. The insurance premium fixes the cost of the liability and reduces volatility. Sellers will buy a policy if they can't get the price they want because of outstanding liabilities. Buyers may buy a policy if they're uncertain about the investment.

AIG combined its M&A-related products and services into a single division in February 1997. The division does underwriting primarily in New York, but it has offices in six other U.S. cities and Toronto, London and Paris.

A Clean Sheet

Reliance National offers loss-portfolio transfers to help companies clean up their balance sheets by eliminating insurance liabilities that are expected or accrued for. This arrangement allows the company to package losses and transfer them to the insurer. Workers' comp claims are the most common type of liability covered by loss-portfolio transfers, said Marla Donovan, senior vice president, Reliance National Casualty Risk Services. Other frequent candidates are auto liability and general liability.

Companies can purchase one contract to cover known and unknown claims, Donovan said. Most contracts will set a time frame, usually five to 10 years, for claims covered and a dollar cap for total liability.

Another advantage of a loss-portfolio-transfer product is that the seller can get the tax advantage of paying the premium before selling the company, said Mark Rusas, director of the mergers-and-acquisitions practice of Lockton Cos. If the seller doesn't buy the policy, a buyer trying to raise capital for the purchase might use the policy to improve the value of the target company, he said.

Lockton is an insurance brokerage firm based in Kansas City, Mo., with an M&A practice in New York. Marsh & McLennan Cos., New York, and Aon Corp., Chicago, also have brokers who place M&A-related insurance. The process of selling M&A-related insurance, particularly to a private equity group, differs from selling other types of insurance in that there are more and different players, such as investment bankers and law firms, involved, Rusas said. "A lot of brokers profess to be able to do this, but in reality I think only three are doing it," he said.

Contaminated Property

If environmental concerns cloud a merger or acquisition, buyers or sellers

may want to transfer that risk to an insurance company. AIG offers policies that can insure any excess above the projected cost of remediating a property or any property or bodily injury damage caused by pollution on the property being sold. In addition, there are policies that insure against pollution damage after the transaction closes.

Chubb's Property Transfer Policy covers contamination that was unknown at the time the property was sold. If contamination is known, Chubb offers insurance to cover excess cleanup costs.

Hedging Against the Truth

One of the most popular forms of merger-and-acquisition insurance involves representations and warranties. In any purchase agreement, the seller makes declarations about the company or assets being sold. The declarations range from the fact that the seller legally owns the company to statements about taxes, inventories, accounts receivable, known litigation and a host of other concerns. Usually, the seller is required to put aside an escrow account to cover losses the buyer may incur if any of the representations proves untrue. If the seller doesn't want to do that and the buyer is uneasy, problems arise.

For example, Jacobs Engineering Group Inc., Pasadena, Calif., was acquiring Sverdrup Corp., an engineering firm based in St. Louis. Sverdrup was a private company owned by its employees. With about 500 employee-owners, Sverdrup wanted the transaction treated as a merger of two public companies, in which case the representations and warranties would end after the closing, said lawyer Gary Blitz of Piper Marbury Rudnick & Wolfe, Washington, D.C.

Jacobs was unwilling to proceed on those terms. The company wanted indemnities from Sverdrup against the representations and warranties. "Part of the motivation was that you had employee-owners that after the transaction would be working for the new owners," Blitz said. "It gets sort of awkward if you have to go chasing after your executives [if you have problems]."

To solve the problem, Jacobs purchased a three-year, $25 million reps-and-warranties policy from Lloyd's Tax and Financial Risk Indemnity Line Slip. The policy sat in excess of a $2 million retention.

Reps-and-warranties coverage works well for private equity funds. For example, instead of a group of investors posting $1 million in cash, Lockton can place a $1.5 million insurance policy for $90,000, Rusas said.

Chubb underwrites reps-and-warranties coverage through Chubb Executive Risk, a subsidiary based in Simsbury, Conn. Chubb has been writing the policy since April 1998, offering it only to sellers.

Fear vs. Strategy

Even if there is no concern about a specific risk, a reps-and-warranties policy can be an important strategic tool in negotiating a purchase agreement, said David DeBerry, vice president and underwriting counsel for Reliance National's Financial Products Division. Sellers may simply want to decrease the amount they have to indemnify or the amount of the purchase price that gets held in escrow.

One of the worst things that could happen to a private equity fund would be to liquidate an investment and then have to go back to its investors and say the fund needs the money back because it had a breach of a representation from a prior deal, said Karmilowicz from Reliance National.

Reliance National underwrites reps-and-warranties policies for sellers and buyers. The advantage of the policy to the buyer is that if there is a breach, the company doesn't have to sue the seller for the indemnification; it can collect directly from the insurer, DeBerry said. Also, a buyer who purchases the policy may be able to negotiate a reduction in the purchase price in exchange for a reduced escrow-and-indemnification ceiling. The reduction in price may exceed the cost of the policy premium, which means the buyer transfers the risk and makes money.

As Inevitable as Taxes

Reliance National also offers a taxindemnity insurance policy to buyers and sellers. Tax indemnity can be a stand-alone policy or a complement to a reps-and-warranties policy, DeBerry said. While the reps-and-warranties policy covers old tax obligations, the tax-indemnity policy covers tax consequences arising from the transaction itself.

For example, if a parent company sells a subsidiary, the transaction could potentially result in a contingent tax liability if the parent is later acquired. In this situation, the buyer of the parent may consider purchasing a tax indemnity policy to avoid inheriting this contingent tax liability.

When a Deal Falls Through

Despite the best intentions, attempted mergers and acquisitions often fail to close. Yet buyers and sellers will have invested a good deal of money in due diligence to evaluate the transaction. Aborted-bid-cost insurance covers expenses if the deal aborts. The policy that Lockton Cos. places begins coverage when the letter of intent is signed, Rusas said. To underwrite the policy, the insurer must have exposure information, including the nature of the transaction, debt covenants and transaction history. Coverage triggers could be regulatory intervention, shareholder disapproval or findings within due diligence, Rusas said.

What's Ahead?

Many insurance policies associated with mergers and acquisitions have been available for only two or three years, yet the demand for the products is steadily increasing. Rusas said that since June 1998, Lockton's M&A practice has been working on an average of seven transactions a month. In a 30-day period at the end of 1999, however, the brokers submitted seven policies and bound three others. "So the pace is obviously picking up," he said.

Reliance National's Karmilowicz estimated that reps-and-warranties policies were written for less than one half of 1% of the total M&A transactions among private and public companies in the United States last year.

The key to continued growth is awareness. "We're seeing an increase in the sale of these types of policies almost specifically because the private equity community is becoming more educated about their availability," Rusas said. Also, as more carriers make them available, they become less expensive, he said.

Insurers hope that as buyers and sellers become more aware of the value of the policies, they'll involve brokers and carriers earlier in the transaction process. "Many times, these liabilities are the last things negotiated because they're the toughest piece," Flood said. "Or, they'll address it up front, find out we're available for a remedy and then go back to negotiating everything else and come to us with a week or days left." This late entrance puts tremendous pressure on insurers to underwrite the policies with great speed.

Rusas said that typically a company will have around 30 days to underwrite an insurance package. In an M&A situation, however, that time could be cut to five business days, he said. "And if it's a case of getting something less complicated, like flood insurance, we may have only 24 hours," he said.

Spread the News

Because of the intense nature of the underwriting, Lockton M&A has eight professionals dedicated solely to the transactional side of the business. "They don't have to get involved in any servicing or other responsibilities," he said.

Chubb has tackled the awareness problem by sponsoring continuing education classes for lawyers and accountants to tell them about M&A risks and the remedies that the insurance industry can provide. The classes work best when they are cosponsored by an agent "who is pretty sharp on merger- and acquisition-type situations," Cavanaugh said.

AIG and Reliance National market their merger-and-acquisition products primarily through insurance brokers. Rusas said much of the success in marketing M&A products depends on the broker's track record and relationships. Lockton M&A also advertises through trade magazines and a monthly newsletter sent to private equity funds. "We market ourselves as a due diligence partner to find things your attorneys and accountants won't recognize but that can impact your purchase price," he said. "And if they do recognize them, they don't have the ability to quantify them for you so you can put an accurate purchase price on the table.

The Growing Market

As the insurance industry tries to penetrate the M&A market, the market itself is likely to grow. "There's a huge bubble of private equity capital that's been formulated," Flood said. "There's $90 billion that has to be deployed in funds that were floated [last] year."

Many baby boomers are in their 50s now and are selling their businesses, so a lot of property and business is changing hands, said Chubb's Cavanaugh. "General liability for M&As is one of the key sources of new business to our field operations," he said.

M&As Hit All-Time High in 1999

Insurers looking to assume risks associated with mergers and acquisitions had the most fertile field ever last year. Dealmakers completed 9,192 transactions as of Dec. 31, 1999, up 17.7% from 1998, according to Houlihan Lokey Howard & Zukin's Mergerstat, which tracks mergers and acquisitions involving U.S. companies. The total value of the transactions was $1,418 trillion, up 19% from 1998 and nearly triple the $495 billion in deals in 1996.

The average size of transactions with a reported value was $425.5 million in 1999, up 8.1% from a year earlier. Continued strong action in mergers valued at $1 billion and above drove the increase in the average value. Dealmakers hammered out 194 megadeals with a combined value of $1.08 trillion, for a 23% increase in transactions and 18% increase in combined value over the prior year.

Four of the top 10 mergers and acquisitions in history were announced in 1999, said Scott Adelson, managing director of Houlihan Lokey Howard & Zukin.

"Dynamically, 1999 was a repeat performance of 1998," Adelson said in a statement. "Overall activity was up, but megamergers accounted for $1.08 trillion, or 76%, of the total measurable deal value."

The top five industries accounted for 56.5% of dollar value of the M&A market. The communications industry led the way with $304.8 billion in transactions accounting for 21.5% of the value of all transactions, moving up from its second-place ranking in 1998. The other industries in the top five are broadcasting; drugs, medical supplies and equipment; computer software, supplies and services; and utilities.

                    20 Years of Mergers and Acquistions
        Number     Total Value [2]
Years of Deals [1] ($billions)
1980     1,889           $44.3
1981     2,395            82.6
1982     2,346            53.8
1983     2,533            73.1
1984     2,543           122.2
1985     3,001           179.8
1986     3,336           173.1
1987     2,032           163.7
1988     2,258           246.9
1989     2,336           221.1
1990     2,074           108.2
1991     1,877            71.2
1992     2,574            96.7
1993     2,663           176.4
1994     2,997           226.7
1995     3,150           356.0
1996     5,848           495.0
1997     7,800           657.1
1998     7,809         1,192.9
1999     9,218         1,418.1
(1.)The number of deals includes only those
transactions disclosing a price.
(2.)Total value is based on the price paid to
shareholders of a target.
(3.)Based on information available through Jan.4, 2000
Source: Mergerstat, Los Angeles; FirstLine, Precott
Valley, Ariz.