Representations and warranties insurance in mergers and acquisitions

Subject

Accounting

Publishing details

Social Sciences Research Network

Authors / Editors

Even-Tov O; Ryans J

Biographies

Publication Year

2019

Abstract

In merger and acquisition agreements, sellers signal the target’s value through the contractual representations and warranties (reps) they make. The additional provision of seller indemnities allows the buyer to impose costs due to breaches in the reps discovered after the deal’s close. But indemnities involve significant contracting costs, thus motivating the purchase of representations and warranties insurance (RWI) to mitigate these costs. Using a large sample of RWI policies, we find that the cost of reps and indemnities are economically significant, and that RWI demand reflects an attempt to reduce indemnity contracting costs and target valuation uncertainty. Shifting the indemnity risk to a third party decreases contracting costs, but disincentivizes target information production and may encourage riskier acquisitions. We show that insurers address this moral hazard by compelling due diligence during the underwriting process and by establishing retentions that correlate with target valuation uncertainty. Moreover, we find evidence that insurers mitigate adverse selection by charging premiums that vary according to the likelihood and value of future claims. Overall, our results support the view that RWI is used to reduce acquisition contracting costs and that its premiums reflect the target’s riskiness

Keywords

Mergers and acquisitions; Adverse selection; Moral hazard; Representations and warranties; Indemnification; Insurance; Valuation uncertainty; Material misstatements

Series

Social Sciences Research Network