The role of insurance in M&A transactions
The importance of insurance issues, the value to be gained from controlling them and the risks to which companies are exposed if they do not consider such issues are increasingly taken into account in mergers and acquisitions. Insurance issues must be considered from both a financial and legal perspective. The legal aspects of insurance policies are seemingly the most important, as the value of the policies largely depends on qualitative criteria: exclusions contained in agreements, reconstitution of cover, scope of insurance, definition of claim, etc. They overlap with quantitative aspects when the available amount of cover is defined by a clause in the insurance policy.
The aim here is to shed light on the principal insurance matters of interest to the various participants in an M&A transaction (the purchaser’s internal team, lawyers, auditors, etc.), by focusing on topics relating to financing lines and third-party liability insurance. Legal work in this area must not only take account of civil law, but also broadly integrate the specific provisions of insurance law, which contains a large number of specific standards and practices. These two branches of law each have their own vocabulary and logic, which must necessarily be combined if effective and relevant due diligence is to be carried out.
The last part of this series of articles will focus on the compliance issues faced by insurance intermediaries. In fact, where an acquisition of this type of activity is contemplated, these issues must be looked at very carefully given the large number of new regulations that apply (IMD, IDD, Hamon law, etc.) and the high level of supervision carried out in this area by the Autorité de Contrôle Prudentiel et Réglementaire (French Prudential and Regulatory Supervisory Authority (“ACPR”)). Investors must therefore consider the target company’s ability to comply with regulations, with a view to avoiding the imposition of sanctions in the future (all the more so since they are tending to increase in size) and assessing the amount of investment that needs to be made post-acquisition to bring the target into line with the regulations. This analysis will therefore enable the target company’s fair value to be established, as it will determine the potential risks involved and the amount that needs to be spent after the acquisition.
The purpose of this article is therefore to describe the main insurance issues in M&A transactions. This article is primarily illustrative and is not intended to be exhaustive. The topic is, in fact, huge and the analysis differs depending on the business area. In addition, each transaction may have its own specific features.
An insurance audit is not always carried out at the time that due diligence is carried out as part of an acquisition. It can, however, be very valuable to the purchaser because it allows it to identify and address the risks posed by the company. This sometimes leads to the renegotiation of contracts to better meet the needs of the new entity, where necessary. An evaluation of insurance risks requires a good knowledge of the target company’s business sector and of the policies.
In terms of pre-acquisition due diligence, the main points to be addressed are the following:
I. Identifying the target company’s policies
Analysis of the target company’s policies involves first identifying what policies it has and then ensuring that they are still in force, in particular that relevant premiums have been paid. This comprises an extremely formal check on the validity of the policies, ensuring that the company has the necessary certificates and has actually the premiums. The certificates on the validity of the policies must be issued by persons authorised to do so. It is always preferable to request such certificates from the insurer rather than from intermediaries, since they are only able to guarantee the validity of a policy under authority delegated by the insurer.
Secondly, the objective characteristics of the policies must be described, principally covering their type, term, excesses, limits no cover and the amount of premiums.
2. Analysing the content of policies
2.1 Variety of policies
Generally, any audited company will have taken out policies to cover its assets, third-party liability, the various types of mandatory insurance, most often linked to a specific business activity (there are more than 100 mandatory insurance policies under French law) and, possibly, in one form or another, policies to cover the third-party liability of its officers.
In addition, insurance may be taken out to cover more specific events, which should attract the auditor’s attention. For example, there may be policies insuring against the following risks:
- Kidnapping and political risk
Especially for transnational firms that operate in sensitive areas of the world.
- Specific policies against fraud and cyber risks.
Such policies have proliferated over the past ten years. This is most often damage insurance, but the amount of cover provided is often quite limited, and therefore a risk for the buyer.
- Credit insurance and factoring.
This type of insurance, which is widespread, has until now been taken out solely by large companies. The growth in distance selling and different payment methods make it more accessible to smaller companies.
2.2 Principal clauses
Of all clauses, the definition of the scope of insured business activities is the clause in the policy that must be looked at the most carefully. This is the clause that focuses parties’ attention when negotiating policies. Even more than the exhaustion of cover clause, their scope will, in most circumstances, determine whether or not a claim is covered under the policy. As it is not an exclusion, but a condition of the cover, it is sometimes passed over during a rapid review. The purchaser therefore needs to have a clear idea of the target’s business activities that fall within the scope of the cover that has been taken out and, conversely, those activities for which the company is in reality not insured. The due diligence stage must enable the purchaser to verify that the business activities covered by the insurance policies are consistent with the actual business activities of the target company.
There are many grey areas here due to the difficulty of precisely defining all the business activities carried out by a company, especially if it is a medium-sized company. Many SMEs may provide certain services on a one-off basis that in reality fall outside the scope of the commercial services they generally offer.
Definition of insured entities (legal entities and sometimes individuals) is the second way of limiting cover after exclusions. It usually takes the form of a global definition, accompanied by a non-exhaustive list of entities. As, by definition, the scope often changes for a group of companies, this clause will be looked at closely by the auditor.
The term of policies is also an important area to look at closely during due diligence. Although policies are generally tacitly renewed in France, it is not uncommon to come across fixed-term policies. Such policies will need to be expressly renewed or, more often than not, the entire policy in question will need to be renegotiated.
Policies governed by non-French laws, in particular English law, are usually fixed-term policies. Policies governed by English law are virtually never subject to tacit renewal. It is becoming routine to evaluate policies that will apply to future financial years based on current or past claims that have resulted in compensation being paid in the same year as the company is acquired.
Particular attention is paid to insurance programmes structured in successive levels or with different “co-insurers”, the norm for large policies. Different insurers may interpret the same clauses in a different manner, which may have an impact on the availability of the cover in the event of a claim.
Finally, the frequent practice of optionally extending cover is contractually complex, and is often difficult to interpret for insured companies.
3. Analysing the transfer of policies
The transfer of policies is a subtle exercise, which combines civil law and insurance law.
3.1 Transfer of policies in the event of an acquisition of assets:
In the event that a target company’s business rather than its shares is acquired, the transfer of insurance policies is governed by Article L.121-10-1 of the French Insurance Code: “In the event that …. the insured item is sold, the insurance shall automatically continue to benefit… the purchaser, and the purchaser shall be responsible for complying with all the obligations by which the insured party was bound vis-à-vis the insurer under the policy.
The insurer or the… purchaser may, however, terminate the policy. The insurer may terminate the policy within three months of the date on which the ultimate recipient of the insured items requests that the policy be transferred into its name.”
The policy is therefore transferred automatically and by operation of law.
The insurer or the new insured party is, however, free to subsequently terminate the policy subject to complying with the requisite notice period.
The transfer is not, however, automatic:
In the event that the risk become more severe or is altered
In relation to personal insurance policies (key person, etc.)
In relation to insurance policies for motorised land vehicles
3.2 Transfer of policies in the event of an acquisition of shares:
When the acquisition takes the form of a purchase of shares, which is by far the most frequent scenario, the legal personality of the target company remains unchanged. In these circumstances, insurance policies should remain in place. Nevertheless, analysis must be carried on scenarios in which the policy may be terminated by the insurer on completion of the transaction on contractual grounds or as a result of the cover being taken out on an intuitu personae (personal) basis.
The clause known as the increased risk clause may be used by the insurer if the transaction leads to a change in the nature of the target’s business activity, especially in the event of a merger. Such changes to the insured risk must be notified in advance to the insurer.
“Key person” policies and directors’ and officers’ liability insurance policies can also be a thorny issue that needs to be looked at closely. These policies will need to be altered after the majority of transactions have been completed. Once scarce, these policies have become very common. Almost all officers of listed companies are now covered by D&O insurance. These policies, which provide cover against the personal liability of officers are always a very important aspect of company mergers. Under D&O policies, the change of control of the company needs to be declared to the insurer. Furthermore, this type of insurance is always provided by insurers on a global basis to a group of companies, usually under a single policy.
Another scenario that needs to be looked at closely is where the purchaser already has a group policy in place. In such circumstances, the benefits of extending the policy to the target company need to be determined, which would require the group policy to be extended and the target company’s current insurance policies to be terminated. Analysis must then be carried out on the conditions applicable to the termination of such policies by the target post-acquisition.
4. Analysis of claims made under the policies
Where insurance due diligence is properly carried out, it may also include more business-focused and more operational aspects of the policies, which can often be very valuable in understanding the target company’s business activities.
Legal due diligence can therefore involve much more than simply certifying agreements from a legal point of view.
Matters that may usefully be reviewed include:
- the company’s past claims history, which can be used to assess its level of expertise and risk.
- previous claims under policies and issues encountered in obtaining compensation. This involves evaluating, in concrete terms, the effectiveness and limits of the policies.
- claims that are in progress and not yet settled, in order to assess the amount to which the target remains exposed.
For the M&A practitioner, the opportunity to carry out an extended assurance audit during the due diligence stage is therefore particularly instructive and a source of tangible information on the quality of the target company. This analysis will be all the more useful as it will have been carried out by insurance auditing specialists who are familiar with the specific features of such policies.
As set out above, an insurance audit carried out as part of an M&A transaction is very legal in nature, ranging from the identification of policies to the detailed review of the target company’s historic and current claims.
The information to be gleaned from such analyses is significant, both in terms of understanding the target company and its value. The lawyers who negotiate the terms of the sale and purchase agreements may, together with the lawyers carrying out the insurance due diligence work, propose price adjustments and solutions to take account of the information revealed by this highly technical due diligence work.
We will supplement this initial article with an article on the compliance issues faced by insurance intermediaries, as well as an article on warranty and indemnity insurance.
END: 1st Part