This version of INDECS Insight explains the purpose, value and importance of risk and insurance due diligence (DD) in corporate transactions. In order to do so it will:

describe the generic process of DD and some of the key insurance implications which typically arise;
explain the importance and methodology of appropriate and thorough research into corporate level insurance, and local insurance, especially when dealing with multi-jurisdictional transactions; and
provide guidance on the optimal drafting of related Sale and Purchase Agreements (SPAs).

DD is essentially a fact-finding and analysis exercise designed to reduce transaction uncertainty, and identify, mitigate and manage transaction risk.

The overall objective of performing risk and insurance due diligence is to ensure that the transaction price fairly reflects any liabilities assumed, and includes the expected future costs of those liabilities.

A typical DD scope would usually include inter alia many of the following topics

1.Capital structure and ownership
2.Industry/competitive information
3.Financial results and accounting controls
4.Assets, real property and intellectual property
5.Material contracts
6.Liabilities – actual and contingent
7.Customer/supplier information
8.Credit facilities/solvency
9.Employee benefit plans
10.Litigation history
11.Taxes
12.Organisation, Authorities
13.Health, Safety and Environmental information

And specifically, DD should be adequate to confirm composition of target/divestment; valuation including testing of assumptions; feasibility of transaction; risks inherent in transaction; and post deal implementation/divestment plan.

DD should be integrated into all deal preparations (e.g. data room visits and valuation) and linked to front-end negotiations and back-end integration planning.

DD in transactional scenarios will look at certain key areas, including: what insurance the counterparty company buys; whether policies continue for the benefit of the parties at completion or whether expiry is automatic; what are the key risk and claim exposures; and to what extent does current/historic insurance address them?

DD can also identify additional one-off risk and insurance related costs, which can be used to negotiate reductions to the purchase price.
Insurance Due Diligence for Divestments

The key objectives when divesting an asset or company will generally be to:

obtain the best price; and
exit the business in as clean a manner as possible.

A selling company’s general aim is to make all known and quantifiable historical liabilities, as well as future liabilities arising from operations, the responsibility of the purchaser. The purchaser should indemnify the seller against any loss it may suffer from these liabilities. Historical liabilities that are unknown may be retained by the seller, however the Sale and Purchase Agreement (SPA) should aim to cap this liability both financially and by duration. Different factors, including the identity of the counter party, legal environment, and the nature of the sale will affect the risk allocation of the transaction and thus the sale and purchase terms and conditions.

The asset/company should be supported by sufficient financial backing to facilitate its sale as a viable entity going forward e.g. all existing insurance policies must continue during sale negotiations and should only cease upon the date of sale completion.
Local Insurances

Local insurances must be cancelled in accordance with policy terms and conditions. Where local policies are in the name of the independent entities being disposed of they can subsist and should be transferred to the acquiring entity with adjustments for premiums forming part of the overall deal financial adjustments.
Sale & Purchase Agreement Considerations

Insurance clauses should confirm that the vendor’s insurances will cease upon sale completion and that at no stage will any proceeds of those insurances be for the benefit of the purchaser.

There should be no need to stipulate that the purchaser carries insurances unless there is a risk that a vendor subsidiary may still be associated with the asset/company post sale, or where the purchase of an insurance product is necessary to support the contractual risk allocation e.g. environmental liability insurance.

It is wise for an insurance adviser to review the liability and indemnity provisions and highlight to the deal team any areas, which will be uninsured upon sale completion. Any uncapped retention of liabilities should be challenged.

The provision of warranties in respect of any insurance related information should be resisted.
Insurance Due Diligence for Acquisitions

The key point with acquisition due diligence is to be clear how the target company will be integrated into the purchaser’s insurance programme whilst ensuring continuity of cover. Each class of insurance will need to be considered separately. Consideration will need to be given to receipt of the information that will be required by the purchaser’s insurers in order to underwrite the target company, local insurance requirements and the likely timescales of the transaction. Depending upon the nature of the acquisition there may be a need for the purchaser’s insurers to provide Difference in Conditions (DIC)/Difference in Limits (DIL) insurance.

Local Insurances

Where an acquired entity has operations in a number of overseas territories there are a number of steps or options that should be followed depending on individual circumstances. These are:

if the target has stand-alone local insurances in place to meet local statutory requirements they can be left to continue provided insurers are notified of the change of ownership;
if there is a purchaser operation in the same territory the local insurances can be extended to include the acquired entity post closing;
new stand-alone policies should be arranged where the entity is being carved out of the vendor operations and the purchaser has no other operations in that territory; and
an independent review of insurance legal compliance laws and regulations is also recommended.

Sale & Purchase Agreement Considerations

Where possible, historical liabilities should be left with any remaining vending entity. Provided the security of that entity is acceptable a full indemnity for all unknown issues relating to pre-completion activities should be sought irrespective of whether insurance policies were in place pre-completion. Any retained liabilities which are uninsured, e.g. gradual pollution, should be highlighted as part of the due diligence reporting process. Warranties in respect of disclosure or the accuracy of loss data may be necessary. This should be discussed with the legal advisors forming part of the deal team.

The sale and purchase agreement should clearly allocate responsibility for liabilities that may arise.
Transaction Specific Insurance Policies

The insurance market has designed a number of innovative solutions specifically for the risks associated with acquisitions or disposals. As a reminder, they can be utilised:

to transfer risks, which are unacceptable to vendor or purchaser and which would otherwise be “deal breakers”;
as an alternative source of capacity for exposures that cannot be catered for within either the vendors or the purchasers programme;
to ‘ring fence’ historic and contractual liabilities; and
to provide insurance or funding for those risks which are traditionally uninsurable.

Where the circumstances warrant financial assurance and/or guarantees, it may be worth exploring one of the options available.
Conclusion

This Insight hopes to have shown that Insurance Due Diligence is an essential part of the majority of corporate transactions. Should any of our readers require support in structuring effective risk allocation strategies or advice on particular negotiations, INDECS would be happy to provide assistance.