San Diego Business Journal

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ALAN WEISS Sr. Vice President, Lockton Private Equity & Corporate Acquisitions Practice (213) 689-2347 aweiss@lockton.com

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KRISTINA HESS Risk Advisor & Producer Lockton (858) 587-3169 khess@lockton.com

Every company that has partici­ pated in a merger or an acquisi­ tion (M&A) under­ stands the importance of traditional financial due diligence to ensure it knows what obliga­ tions it is assuming, the nature and extent of the target company’s contingent liabilities, real and intellectual property issues, litiga­ tion risks and much more. However, many businesses are unaware of other potential risks that could alter the terms of-or even derail-a deal.

Insurance due diligence helps compa­ nies assess historic, current and future risk exposures and insurance costs prior to a transaction, ensuring financial implications are understood and included in the negotia­ tion, or modeled where appropriate. It can

also optimize structuring of insur­ ance and identify potential savings, which can unlock value going forward. Here’s a look at just a few ways expert insurance diligence can have immeasurable value.

Uncovering Blind Spots

In a stock purchase, the buyers assume all historical liabilities, including the seller’s prior acquisi­ tions. Can the buyer benefit from any surviving indemnities and insur­ ance policies mined? Many compa­ nies also have hidden liabilities that surface during diligence.

When reviewing a products liability policy for one client, Lockton noticed an exclusion for any claim arising from the manufacturing or distri- bution of a specific surgi- cally implantable product.

The sellers said they discon- tinued making that product

many years ago, but the risk offuture medical problems arising could present an uninsured current liability. Or consider another scenario. As the buyer, wouldn’t you want to know before closing a deal that millions of dollars of improvements were recommended to a warehouse fire suppression sprinkler system to prevent a total loss of a critical supply chain facility? Without due diligence, these potential liabilities would have been overlooked.

Quality of Earnings

Insurance due diligence contrib­ utes to the quality of earnings assessment for potential adjust­ ments in purchase price. Purchase price adjustments are often made in corporate carve-outs to compensate for the difference between the often-subsidized allocated P&L expenses and the amount required for a stand-alone platform. Large parent companies often retain large amounts of risk, which significantly reduces their fixed cost of insurance.

This, coupled with the loss of the parent’s purchasing leverage, contributes to the increased expense differential. Other quality of earnings adjustments come from the seller’s understated retained liabilities. For example, a company with a $250,000 workers’ compensa­tion deductible must reserve for the future development of claim values in addition to the insurer’s current case reserves. If the projected losses used for the earnings budget are based on understated histori­ cal claims reserves, there will likely be a purchase price adjustment. Buyers who overlook this type of review may be missing an opportu­ nity to save millions in the purchase price.

Management Liabilities

Because buyers are assuming liabilities for sellers’ pre-closing wrongful acts, parties in a stock purchase routinely require a six-year “tail” policy for D&O, employment practices and fiduciary liability insurance. Asset purchase agreements typically do not stipu­ late the terms of this extended claims coverage because there is usually no assumption of liability. However, there are business reasons, for buyers to suggest that sellers purchase a “tail.” For example, in situations where the seller becomes part owner of the new company through an equity rollover, buyers want to avoid the distraction and encum- berment of uninsured litigation against the selling principal for

pre-closing wrongful acts.

Mitigating M&A Risks

M&A risks can be mitigated through insurance designed to cover loss or liability arising from unknown or undisclosed matters (breaches of representations and warranties) and provides indemnity for financial loss. Representation and Warranty Indemnity Insurance has become readily available with more stream­ lined underwriting and broader terms and conditions. Other benefits include the potential reduction of buyer holdbacks, supplementing seller’s indemnity package, extend­ ing survival periods, providing coverage beyond seller’s indemnity cap, and improving auction bids.

While insurance-related issues will inevitably arise in any M&A transaction, drawing on the exper­ tise of a trusted advisor can provide thoughtful consideration to insur­ ance during the diligence process, uncover hidden liabilities and identify opportunities to save millions of dollars .