Deal Insurance: Representation & Warranty Insurance in Mergers and Acquisitions

Abstract

Efficient contracting depends upon imposing risk on the party with superior access to
information. Yet the parties in mergers and acquisitions transactions now commonly use
Representation and Warranty Insurance (“RWI”) to shift this risk to a third-party insurer.
Because liability and trust go together, RWI would seem to give rise to a credible commitment
problem between the transacting parties, and it raises adverse selection and moral hazard
problems for the insurer.

This paper examines the emergence of RWI, focusing on three interrelated questions. First, how
does RWI affect transactions? Second, why do transacting parties use RWI? And third, why do
insurers sell RWI?

The paper follows a two-fold empirical methodology. It develops data both by surveying RWI
market participants—insurers, brokers, lawyers, and private equity managers—and also by
analyzing a sample of over 500 acquisition agreements, approximately half of which involved
RWI.

Analysis of this data reveals a broad transfer of mispricing risk from transacting parties to
insurers. RWI allows sellers to minimize risk at exit and allows buyers to control risk aversion in
selecting investments. At the same time, RWI threatens to disrupt the contracting process by
introducing problems of credible commitment, moral hazard, and adverse selection. Insurers’
ability to respond to these problems through shifts in the deal market and the underwriting cycle
may determine whether RWI ultimately facilitates or impedes mergers and acquisitions.

Keywords: mergers, acquisitions, contract, insurance, representations, warranties, private equity, indemnification, escrow, adverse selection, moral hazard, credible commitment, M&A, deal, rep & warranty, transaction insurance

JEL Classification: K22, K12