Representations and Warranties Insurance in Mergers and Acquisitions

Abstract

To mitigate information asymmetry in acquisitions, the seller makes contractual representations
and warranties (referred to as “R&W” or “reps”) about the state of the target, such as attesting to
the accuracy of the target’s financial statements. While seller indemnities allow buyers to impose
costs due to breaches in the reps discovered after the deal’s close, these indemnities involve
significant contracting costs. To mitigate these costs, the acquisition parties have increasingly
turned to purchasing representations and warranties insurance. Using a proprietary and novel
sample of R&W insurance policies issued worldwide for acquisitions of non-public targets, we
find that the demand for R&W insurance, the premium charged for it, and the likelihood of a claim
being filed are correlated with industry metrics for valuation uncertainty, the type of acquirer and
seller, and the target’s legal regime. In particular, we find higher demand for R&W insurance and
a higher R&W insurance premium charged when the target belongs to an industry with weaker
internal controls. We also find that a higher premium is charged when the target is in an industry
with relatively high levels of R&D to sales, indicating that the insurance company expects
unrecognized intangible assets to have a greater risk of future claims. Our study adds to our
understanding of how parties reduce target valuation uncertainty and the role of disclosures and
R&W insurance policies in private mergers and acquisitions transactions.

Keywords: information asymmetry, representations and warranties, insurance, valuation uncertainty, mergers and acquisitions, seller indemnities

JEL Classification: D82, G22, G34, K12, K22, K41, L14, M41