M&A and insurance

The recent publication of the Liberty Global Transaction Solutions 2021 Claims Briefing identified a number of trends that are likely to characterise the M&A insurance market going into 2022. The briefing looks at M&A insurance claims by industry, by region and by cause, providing data on the types of deals that are most likely to lead to a claim, as well as highlighting current claims.

One of the key findings of the report is that the COVID-19 pandemic has not led to the anticipated surge in ‘buyer’s remorse’ claims, however, the rapidly changing environment has disrupted underwriting norms and fundamentally changed the M&A risk landscape due to the altered nature of some previously well-understood risks – notably travel, hotels and real estate.

The Claims Briefing also found that overall, claims are being made earlier, with some 57 per cent of notifications being made in the first twelve months of the policy period in 2020, compared with 48 per cent of claims in 2019. This partly reflects the fact that many lawyers are beginning to carry out post-deal reviews of target businesses as a matter of course, with the specific objective of identifying potential breaches for a possible claim.

In addition, large claims (US$10 million plus) are being discovered and notified more quickly than in the past. Around 52 per cent were notified in the first twelve months of policies written in the period 2018-2020, compared with 41 per cent in 2015-2017.

The briefing identified some of the most common causes for M&A claims and found that tax-related matters were the cause of a third of pre-claim notifications in Europe and Asia-Pacific, albeit actual large tax losses remain rare. In addition, accounting and financial issues made up 41 per cent of high severity claims, many of which involved stock control or revenue recognition issues. Liberty GTS also found that cyber claims, claims relating to failed IT projects and claims around class-action wage disputes are all increasing in frequency. A number of the high severity claims notified involved sales by company founders, some of which involved suspected fraud. Overall, the most common type of fraud involved management fabricating revenue to boost the bottom line of the company up for sale.

Industrials and healthcare dominate

Two sectors dominate when it comes to high severity claims. Industrials has accounted for a high proportion of such claims, with most of these falling within the area of manufacturers of capital goods. This year there has been a cluster of claims in aerospace and defence, mostly relating to customer contracts. These types of businesses are often dependent on a small number of contracts for a large part of their revenue. If a contract issue slips through the net during a deal, there is the potential for a large claim.

In second place, healthcare businesses have been generating an increasing number of claims in the last few years, largely in the Americas, with this sector seeing more severe claims as a proportion of notifications received than any other. We believe healthcare transactions must be examined under a heightened risk standard.

Many claims relate to billing or coding issues that have been triggered by audits or a whistleblower report. These can result in large claims and can also trigger government investigation where Medicare and Medicaid are involved. Other more recent healthcare claims have involved cyber-related issues. The sharp increase in the number of such attacks reported means that deal teams will in future need to ensure that the underlying business has adequate cyber cover in place as part of their due diligence.

By contrast, businesses operating in the pharmaceutical, biotechnology and medical devices space are generating production-related claims, and these notifications have accounted for some of our largest claims in this sector. Interestingly, we have seen very few claims involving IP issues, usually one of the most significant areas of focus during the due diligence process.

IT deal pricing pushes up claims

In 2020 there has been a noticeable uptick in claims involving companies in the IT sector, reflecting the larger number of deals in this space. This has thrown a spotlight on high valuation multiples on deals involving young, fast-growing tech businesses. A high valuation multiple can obviously result in a large claim where the loss is calculated on a ‘multiple-of-EBITDA’ basis, even when the underlying issue is not particularly significant.

We predict that the market may increasingly look to cap the size of the multiple or even exclude the use of a transaction multiple altogether.

Education risk up in consumer discretionary

Consumer discretionary businesses tend to be the most sensitive to economic cycles. One unexpected area of increased risk in the last year has been in the education services sub-sector of private universities and schools. There have been a number of claims relating to deals in this space, which have involved a range of issues, including the lack of appropriate permits, unpaid tax, non-compliance with health and safety, and irregular enrolment practices. This suggests that this sub-sector may involve more risk than traditionally thought.

Tax leads real estate claims

In the real estate sector, a high proportion of claims are tax related, though we see many notifications for lease and tenancy-related issues, meaning that deals involving retail sites generate more claims than those involving office buildings. Other common issues include unpaid utility bills and disputes between landlord and tenants around fit-out costs. We are also seeing an increasing number of claims relating to health and safety issues, including non-compliance with fire regulations, which are receiving greater scrutiny from local authorities.

Food and beverage claims on the rise

In the consumer staples sector, the food and beverage industry has garnered a significant proportion of claims in 2020-21, particularly in the Asia-Pacific region. This is partly down to the fact that this industry has complicated supply and distribution agreements, which are susceptible to problems with obsolescence and spoilage. We have also seen wage-related disputes, reflecting the reality of a low cost, shift-based workforce. There has been an increase in consumer actions against food and beverage companies based on allegations of deceptive advertising.

M&A insurance shift

The recent boom in M&A has fuelled unprecedented short-term demand for insurance coverage. Longer-term, this is likely to result in a significant increase in claims activity which has the potential to shape the M&A insurance market in several ways in the next few years. Firstly, it will throw insurers’ M&A claims handling processes into sharp relief, with an expectation from insureds that claims will be dealt with by experienced, specialist in-house teams, and implying that M&A carriers will have to compete on the quality of their claims function as well as price, coverage, and deal execution. This increase in claims activity could also curb the appetite of some insurers in this space, triggering significant structural changes in the M&A insurance market. In particular, some of the mono-line MGAs that operate in this space will see a contraction in capacity as underwriting partners reassess their deployment of capital. This is notable because it is the capacity providers, rather than the MGA, which typically control significant claims decisions. If they choose to retrench from the M&A market as a whole, of from backing specific MGAs, it could result in a lengthier and more unpredictable claims process.

This shift is also likely to lead to a more data-driven approach to underwriting as new claims trends emerge, driving changes in appetite for some deals and some jurisdictions, and movement on both pricing and coverage. However, this environment will also lead to opportunities for those M&A insurers which have sufficient data and an effective claims feedback loop to provide more tailored coverage to insureds.

This article was published in the January-February 2022 issue of CIR Magazine.

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