Insurance policies are a lot like lifeboats on a ship: no one pays them much attention until something goes wrong. But in the context of an M&A transaction, they should not be overlooked. When evaluating an acquisition target, it is important for a buyer to understand what types of coverages are in place, what risks are covered and the amount of coverage. Not all insurance policies are created equal. Two policies that appear similar on their face may operate in very different ways, either because of nuances in policy language, deductibles and self-insured retentions, or exclusions and endorsements that alter and modify the base policy. It is always advisable to carefully review the target company’s insurance policies to get a complete understanding of the coverages, particularly when the business to be acquired operates in an industry where claims can be frequent and/or sizeable. A complete understanding of the insurance policies is essential for the buyer to ensure that the business is fully protected post-acquisition.
Occurrence vs. Claims-Made
When evaluating an acquisition target, it is important to understand what type of coverage the target’s insurance policies provide. Most liability policies will be written on either an “occurrence” or a “claims-made” basis.
Occurrence policies provide coverage for covered incidents that occur during the policy period. An occurrence-based policy provides coverage regardless of when the claim is made against the policy.
Claims-made policies provide coverage for covered incidents if both: (1) a claim is made during the policy period and (2) the incident giving rise to the claim occurred within the period from the “loss inclusion date” or “retroactive date” to the end of the policy period. The loss inclusion or retroactive date is typically either the inception of the policy or the inception of the first policy in a continuous line of claims-made policies.
Why It Matters
Consider the following example and assume that all other conditions to coverage are met:
Target’s insurance policy period is January 1, 2016 to January 1, 2017. Customer injures herself at Target’s place of business on April 1, 2016. Buyer acquires Target via merger on August 30, 2016, and Target becomes a wholly-owned subsidiary of Buyer. A claim is made on the policy on June 15, 2017, shortly after Customer files a lawsuit or sends a demand letter claiming Target is liable for her injuries.
If Target’s liability policy is occurrence-based, the policy will cover Customer’s claim and any resulting damages and defense costs, because the incident giving rise to the claim occurred during the policy period, and thus Buyer will not have liability for the claim. If Target’s liability policy is claims-made, the policy will not cover Customer’s claim and the resulting damages and defense costs, because the claim was made outside of the policy period, and Buyer may therefore incur liability for the claim.
What To Do
Many lawsuits are not filed until months or years after the incident giving rise to the claim occurs. Claims-made policies provide a buyer less protection because of the measuring point of coverage: when the claim is made rather than when the incident occurred. As a result, buyers should identify a target’s claims-made insurance policies (including those that ended prior to the acquisition) when evaluating the risk of post-closing claims for pre-acquisition actions or transactions.
Although claims-made policies would appear to expose a buyer to an uninsured risk, claims-made policies can be extended beyond the initial term of the policy. What is commonly referred to as a “tail” policy can be purchased to extend the time under which a claim can be made and still be covered. In many cases, a buyer may require the seller to purchase a tail policy for a specified period.
A common example of this is directors and officers liability policies (“D&O policies”), which are typically implicated in M&A transactions. D&O policies are almost always written on a claims-made basis, and a buyer will want to avoid the risk that a former shareholder, member or limited partner of the target makes a claim against the target’s officers and directors after the acquisition and after expiration of the target’s D&O policy period. Therefore, many acquisition agreements provide that a D&O tail policy will be acquired in connection with the closing of the acquisition.
Tail policies do not extend the time period in which an incident can occur and still be covered, only the time period in which a claim for a covered incident can be made. For example, a two-year tail policy will provide coverage for claims that occurred during the policy period and were made within two years after the expiration of the policy period. It will not, however, provide coverage for an incident that occurs during the two-year tail period. Most claims-made policies contain the duration and prices of tail periods that can be purchased within the policies themselves.
Understanding the types and amounts of insurance coverage that a target maintains allows a buyer to take the appropriate steps to protect itself from pre-acquisition and post-acquisition claims relating to pre-acquisition actions. Recognizing that a target has certain policies that are written on a claims-made basis and requiring that tail policies be purchased on those polices ensures that some measure of protection remains even after the policy period expires. In addition, identifying inadequate coverages or gaps in coverage permits a buyer to establish adequate reserves or alter the purchase price to prepare for future liabilities. Thoroughly evaluating a target’s insurance coverages in the due diligence process can alleviate financial liability after the transaction is completed.
Matthew H. Stabler and David P. Creekman are attorneys in the M&A Practice Group of Wyrick Robbins Yates & Ponton LLP, which represents clients across a broad range of industries in connection with their significant corporate transactions. The group publishes Practice Briefs periodically as a service to clients and friends. The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.