Challenges with Insurances in Carve- out Transactions

1. Introduction

Carve-out transactions, i.e. the disposal of certain parts of a company (e.g. individual business units) by way of an asset or share deal, are a common phenomenon in today’s market environment. One of the reasons for the comparatively high frequency of carve-out transactions (or “carve-outs”) is the current market environment which is driven by a strong demand for solid-quality targets with only a limited offer of such targets. This is an attractive outset for corporates in need for liquidity to sell parts of their business. The same is true for business divisions or locations that do not match the cor-porate’s strategy.

For a number of reasons, carve-outs are challenging for both buyers and sellers. This is also true with respect to insurance matters. In our experience, the complexity of insurance matters in carve-outs is oftentimes underes-timated by sell- and buy-side. The parties often forget that insurance matters in a carve-out scenario are linked to significant risks when handled incorrectly. Below, we offer an overview of the problems arising for the parties when dealing with insurance aspects in a carve-out sce-nario. Among other things, we examine in detail aspects such as the discontinuation and new placement of an insurance program at closing, the risk of post-closing claims and the recent hardening of the insurance market.

2. Insurance carve-out

Usually, companies install their insurance programs at the highest operating level of the parent company (sometimes even at holding level). The subsidiaries are typically covered as co-insureds under the insurance program. An insurance carve-out means that in the course of a carve-out the policyholder remains with the selling parent company whereas the co-insured part of the company is transferred to the buyer. Insurance policies placed on parent level often stipulate an automatic cease of insurance coverage for co-insured companies once the parent’s controlling in-fluence ends. As a consequence, a new insurance pro-gram has to be put in place for the carved-out company (“target”) as of closing.

3. Implications for the Target

3.1 Asset Deal vs. Share Deal

The structure of the transaction (i.e. the differentiation between an asset deal and a share deal) may have implications for the continuation of insurance coverage. If individual assets are sold by way of an asset deal, sec. 95 para. 1 of the German Insurance Contract Act (“VVG”) foresees a statutory transfer of the property insurance relating to the tangible assets transferred to the purchaser. This applies to business interruption in-surance by way of analogy as well as property-related liability insurance (e.g. landlord’s liability insurance) and car insurance. However, such statutory transfer of insur-ance always requires a specific link between the insurance coverage and the transferred asset.1

By way of exception, a statutory transfer of business li-ability insurance applies if the insured business is sold as a whole as part of the asset deal (sec 102 para. 2 in connection with sec. 95 VVG); the same is true for busi-ness interruption insurance. However, this scenario is rather rare in practice. The most common case of legal transfer of an insurance policy in the course of an as-set deal is property insurance for assets that are carved out from a parent company.

If the carve-out is done by way of a share deal, secs. 95 VVG and 102 VVG do not apply. Despite the share transfer, all insurance policies remain in force unless a policy contains a change-of-control (CoC) clause which, depending on its wording, may result in the respective policy being terminated by closing. However, one has to keep in mind that in most cases of a carve-out done by way of a share deal, the sold target is co-insured via the parent company with the consequence that the tar-get is no longer covered by the relevant policies per closing.

3.2 New insurance coverage as of closing

The new insurance cover for the carve-out business needs to be in place from the time of closing. In case of a financial sponsor acquiring the carved out target, a stand-alone insurance coverage for the target from the time of closing is market best practice. Such place-ment of the new stand-alone insurance program regularly poses great challenges for the buyer and the target management, in particular because of the typical time pressure and moreover the existing confidentiality agreements of the transaction.

In case of a strategic investor acquiring the carved out target the challenge is usually to integrate the target into the existing insurance program of the buyer, which results in different challenges.

3.2.1 Tailored insurance program

In general, the insurance program existing prior to the transaction is tailored around the risk of the parent company, in particular in relation to the risk profile. This includes, inter alia, the company’s operations, global footprint and risk philosophy. Depending on the size of the parent company in relation to the target, the indi-vidual risk profile of the carved out target often differs significantly from the risk profile of the parent company (e.g. if a global chemical group with production sites in Europe and Asia sells its paint and coatings manufactur-ing division with only one production site in Germany).

Optimal insurance protection in terms of coverage quality and cost efficiency can only be achieved by means of an insurance program tailored around the carved out target. This requires a detailed analysis of the target’s risk, among other things also in order to address matching insurers as potential risk carriers in the context of a tender process. The operating activity, industry segment and global presence play an impor-tant role in the selection of the insurers as their risk preference and internal (risk) underwriting authority varies widely. The risk philosophy of the target as well as of the new owner must also be considered when designing the adequate insurance coverage, because it is not uncommon for the risk mitigation approach of the selling company to differ substantially from that of the target and the new owner (e.g. a financial sponsor).

In addition, large corporations usually operate with captive insurance companies (i.e. a licensed insurance company being part of the group and providing coverage for the group) and are able to accept high deductibles under existing (re-) insurance programs. In contrast, such concepts are usually not an appropriate option for the carved out target. For this reason, a specific determi-nation of the target’s risk profile and a market inquiry based on this is essential. The right timing is a crucial element in this process

3.2.2 Preparation of the insurance placement and timing aspects

A particular difficulty is the right timing of the place-ment process of the new insurance program. In most cases, the buyer does not start to deal with the place-ment of the new program shortly before signing. Whereas there are usually several weeks to several months between signing and closing, which at first glance seems to be a relatively long period of time, this should not obscure the fact that the placement process takes about two to three months depending on the in-dividual risk of the target.

While the target’s risk management was led by a risk manager or in-house broker of the parent company before closing, after closing the target is responsible for its own risk management if, as is so often the case, a financial sponsor acquires the target. Frequently, it is not only the insurance experience at target level that is missing, but rather the risk-relevant information elementary for the new insurance placement. Such risk information (e.g. property values and loss statistics) is usually available to the parent company which, how-ever, is usually not fully disclosed in course of the trans-action, because it often includes confidential data relating to the business of the selling parent company.

Once such risk-relevant information is available, the broker can approach the insurers as a first step of the placement. As to the further timing, it may take sever-al weeks before insurers are in a position to provide a binding offer. The duration of this process depends

heavily on the available data and ultimately the seller’s assistance in obtaining the data. The placement process and related requirements should therefore be proactively addressed by the buyer prior to signing to allow suffi-cient lead time to closing to ensure seamless insurance coverage from closing.

3.3 Late claims risk due to legacy issues

Especially for carve-outs, there is a significant risk of late (post-closing) claims due to legacy burdens. In the technical sense of the term, this means losses that orig-inated before closing of the transaction (i.e., production of a certain good or the breach of a certain duty) but only occur or become known after closing. There are numerous circumstances that represent a potential late claims risk for the target. We have summarized the most important cases below:

3.3.1 Violations of duties by management

Financial consequences of violations of duties by man-agement (e.g. board of directors, managing directors and further advisory board members, senior executives) can be insured under a Directors’ & Officers’ Liability (D&O) insurance policy. D&O insurance policies work with a so-called claims-made trigger. This means that insurance coverage is triggered when a claim covered by the scope of the D&O is actually raised against the insured manager (in contrast to so-called occurrence coverage where the insurance coverage is triggered when the loss event actually occurred). As a consequence, wrongful acts committed by management of the sold business that occurred prior to closing (e.g. incorrect accounting or non-payment of corporate tax) are not covered under the seller’s D&O insurance policy, if the relevant claim is raised against the management after closing.

For such situations there are two options to obtain insur-ance coverage. The first option is to purchase retroactive coverage under the new D&O insurance policy of the carved out target placed with closing. In order to limit the insurer’s risk exposure, the policy will, however, limit the retroactive coverage to a certain pre-agreed ret-ro-active date. The second option is to place a so-called run-off cover under a separate policy. Such run-off cover technically is a subsequent notification agreement under the seller’s D&O insurance policy, but structured via a separate policy with a separate limit of liability. To place such coverage, the seller must provide its approval.

In principle, the run-off cover is the more appropriate coverage option for carve-outs compared to retroactive coverage under a new D&O insurance policy. The run-off cover offers the advantage that the buyer or new owner can clearly demarcate “old” liabilities from the - now legally independent - target. Also, the run-off cover can generally be installed with less effort, because it is an annex to the existing D&O policy of the parent company. The insured therefore does not have to conduct a new risk analysis.

3.3.2 Defective Products

Defective products pose a significant commercial risk, because the defectiveness of a product is usually dis-covered long after the product has been manufactured and introduced into the market, mostly when an actual damage occurs. Damages caused by defective products are covered by the product liability insurance. Such insur-ance based on a so-called occurrence trigger, which means that the insurance policy that was in place at the time when the damage actually occurred is triggered. In case of personal injury, the damage is deemed to have occurred when the injury is caused. For property damage, this is the time when the property of a third party is damaged.

The risks of late damages are coverable through so-called IBNR (Incurred But Not Reported) coverage. Such coverage provides protection for damages that origi-nated before closing but occur only after closing. Alternatively, retroactive coverage can also be included as part of the new product liability policy that is placed at closing. In order to separate old claims from the target and to prevent that late damage actually erodes the coverage of the product liability policy newly placed at closing, IBNR coverage is in many cases the preferred option.

3.3.3 Environmental damage

Late losses due to environmental damage or environ-mental contamination play an important role in many in-dustrial sectors (e.g. chemicals, manufacturing, and real estate). In practice, environmental damage often involves unknown soil and water contamination. In particular environmental damage that becomes known after clos-ing represents a major risk for the buyer, especially if the competent authority orders remediation which often has significant financial consequences for the buyer. To cover this risk, a special environmental insurance policy, a so-called Pollution Legal Liability (PLL) insurance, can be placed at closing. Such insurance covers both unknown damages and already identified pollution where the relevant thresholds that would require reme-diation have not yet been exceeded.

Although traditional environmental impairment liability and environmental damage insurance generally provide some - but limited - coverage for contamination, PLL insurance provides enhanced insurance coverage. Opposed to environmental impairment liability and environmental damage insurance PLL insurance covers pollution that was gradually caused in the course of ordinary business and further insures environmental risks with retroactive effect.

3.4 Costs

Identifying the total cost of the new insurance program is one of the biggest challenges for the buyer. There are several reasons for this:

3.4.1 Omission of synergies

Often, the individual risk of the target as part of the bigger seller group represents a relatively moderate risk, which is therefore not particularly significant in terms of costs. Moreover, when the target leaves the parent company, synergy effects cease to exist and the target’s risk must be considered separately. The conse-quence is an increase in the premium.

3.4.2 Non-risk-adequate premium allocation by the seller

In the course of the sale negotiations, the seller often provides the buyer with a total premium estimate for the new insurance program of the target after closing. The relevant costs can often also be taken from the financial due diligence. However, an individual risk assessment of the separated target is usually not done in connection with such cost estimate. This means that in most cases the total premium allocated by the seller is much lower than the total premium accruing under the newly placed insurance program for the target.

4. Implication for the seller

Unlike the buyer, the implication for the seller of the carved out business is less significant from an insurance perspective. Whereas, the seller’s interest in the exiting company is limited, the seller should nevertheless con-sider certain aspects.

4.1 Late loss risks also for the seller

In accordance with the above, late claims risks may arise in the course of a carve-out which can also become relevant for the selling parent company. This is particu-larly true for violation of duties by target’s management or defective products.

4.1.1 Violations of duties by target’s management

During the sales negotiations with the buyer, the seller should make it clear that late loss risks due to violation of duties by managers of the target that occurred prior to closing cannot be picked up by the selling parent’s D&O insurance policy. Even if a claim under such D&O insurance policy would not be possible under the rele-vant policy, this should be clearly stated in the purchase agreement in order to prevent misunderstandings. Such claims should be rather covered under a run-off policy, as described above. The cost allocation for the run-off policy between buyer and seller can be contrac-tually agreed on an individual basis.

4.2.2 Defective products

The seller should also make clear in the purchase agree-ment who is liable after closing for defective products. Even though this matter is comparatively clear under the product liability insurance due to its occurrence trigger (whereby loss events after closing are no longer covered by the seller’s policy) defective products repre-sent a significant loss risk, which makes it worthwhile to clarify with the buyer.

4.2 Seller process

The discontinuation of insurance coverage for the target as of closing creates challenges for the buyer, which can hardly be solved without the support of the seller. In the placement process, the insurers need detailed underwriting information about the target, which the buyer requests through the Q&A process as part of its due diligence. However, the information request often turns out to be rather complex. To simplify and accelerate this process for both the seller and the buyer, the existing insurance broker, in-house broker or risk manager can already compile this data in the course of preparing the sales process and make it available in the data room.

Especially in the case of globally positioned companies, it is necessary for the buyer to also evaluate the risk in-formation of the companies abroad. The sell-side broker or risk manager can provide support at an early stage and thus relieve seller’s management and M&A team.

5. Hardening insurance market

After more than a decade of a “soft” insurance market, characterised by steadily decreasing premiums and suf-ficient capacity to place risks, we observe a trend towards strongly increasing premiums in recent years. Rising premiums and limited capacities are character-istic of this phase, which has global repercussions and affects various insurance lines. The causes for such development of the global insurance market are complex. One of the main reasons for this market trend are nat-ural disasters in recent years (e.g. bush fires in Australia and hurricanes in the USA), which triggered signifi-cant claims payments in the insurance industry (espe-cially in the reinsurance sector). As a result, insurers and reinsurers had to revalue their portfolios and decided to charge higher premiums for insurance cover. Against the backdrop of the inadequacy of the business written and the persistently low interest rates on the capital markets, insurers are forced to generate underwriting income, which is accompanied by sometimes substantial premium increases. The recent pandemic has further exacerbated the situation.

For the buyer, this market phase poses a particular dif-ficulty, as the risk of the target, which was previously co-insured under the parent company’s insurance pro-gramme, is now re-assessed in the course of the placement process in a highly tense and restrictive insurance market. In individual cases, this can make it challenging to obtain insurance cover and requires the involvement of the global insurance markets.

6. Conclusion

Carve-out deals will continue to be a common M&A scenario, especially where the current economic situation forces companies to sell parts of their business. From an insurance perspective, the big challenge for the buyer is to ensure that a new insurance program tailored to the target is properly installed at closing.

Clarity about potential late loss risks and an understanding of how risks stemming from defective products, violations of duties by management or environmental contamination can be minimized or excluded via insurance solutions is elementary from the buyer’s perspective.

Furthermore, the buyer should have transparency with regard to the total costs incurred for the new insurance program from closing. To ensure that the new insurance program is installed at closing, it is also necessary to start the tender and placement process in a timely manner.

From the seller’s perspective, a carve-out involves fewer insurance-related issues. Nevertheless, the seller should clearly delineate potential legacy issues during negotiations with the buyer. A structured sales process, also with regard to insurance issues, saves the seller unnecessary effort and accelerates the sales process.