Mergers, acquisitions and other deal-making moves present corporate risk managers with a unique set of challenges. Gary N. Dubois examines M&A issues and the role insurance and risk management strategies can play in corporate restructurings.

Worldwide, the number of mergers and acquisitions announced in the first six months of 1998 grew to 12,107. The value of these deals totaled a record $1.4 trillion, fast approaching the record $1.6 trillion for all of 1997.1 Headlines heralding the next merger, acquisition, divestiture, spin-off, IPO or other transaction appear each day.

With deals worth millions or billions of dollars, the stakes are incredibly high. As a result, corporations spend an enormous amount of time and money evaluating the pros and cons of each transaction before deciding on a particular course of action. In doing so, many companies are including the risk manager as part of their due diligence teams. The risk manager can make an important contribution by accurately assessing the risks involved and by identifying issues that could potentially impact the viability of a deal. As part of the decision-making process, the risk manager can also play an integral role in developing solutions to address various concerns, mitigate risk and add value to the transaction.

Troubleshooting

Due diligence, from an insurance standpoint, entails careful assessment of the target company's risk profile. The risk manager begins by collecting detailed information about the target, its operations and its property/casualty insurance coverages. The risk manager will need to gather data on the number of employees, locations, automobiles and other exposures. Valuations for real estate, equipment and inventories should be checked against their insured values. Significant claim trends should be analyzed, and loss histories should be examined for the past five to 10 years. Site inspections may also shed light on workplace safety and other loss control issues that will need to be addressed.

All policies, premiums and self-insured retentions need to be reviewed. Are coverages claims-made or occurrence? Retro-rated or guaranteed-cost? Are there gaps or overlaps in coverage? If a captive insurer is involved, are loss reserves and security adequate? Is there any outstanding litigation? What about losses incurred but not reported (IBNR)? What is the future claims expectancy? In many cases, actuarial assessments will be necessary to determine appropriate funding levels.

Commercial general liability and workers' compensation are two areas where potential dangers exist in any merger or acquisition. Other areas include: environmental liability, commercial auto liability, property risks, fidelity and crime, directors' and officers' liability, fiduciary liability and employment practices liability.

Manufacturers can be affected by product liability issues, and service companies will need to consider the additional professional liability exposures that may result from taking over or merging with another enterprise. Increased credit risk, including exposure to new suppliers, is another hazard that exists in many M&A situations.

Unless potential problem areas are identified and dealt with prior to a sale, the buyer could be stuck with millions of dollars in unforeseen liabilities, which, in turn, could substantially reduce the value of the transaction. Clearly, the risk manager is instrumental in uncovering hidden liabilities and recommending strategies that can reduce the company's exposure to loss.

Balance sheet solutions

The majority of Fortune 1,000 companies and many other corporations today self-insure a large portion of the risks they face. Self-insured retentions and captive insurance arrangements are widely recognized as effective risk management techniques, offering companies greater flexibility and more control over the scope and cost of their insurance programs. Companies opting for these approaches set aside multimillion-dollar reserves to cover the cost of the claims they expect to experience. These reserves are used to pay losses that fall within the retention layer or the parameters of the captive.

The potential downside, though, is that over the years, self-insured losses may "stack up" on a company's balance sheet. The accumulation of five or more years of loss reserves, including IBNR, could start to impact a company's bottom line. Adverse loss developments or the timing or amount of claims payments may necessitate substantial increases in annual accruals, sometimes requiring additional collateral (such as letters of credit or bonds), while placing a strain on cash flow and contributing to balance sheet volatility.

In addition, accrued liabilities on a company's balance sheet could potentially interfere with a merger, acquisition, divestiture, spin-off or IPO. For example, a potential buyer may be dissuaded by the pending product liability litigation against an acquisition target, a pharmaceutical company. Meanwhile, an employee-leasing company with sizable accruals may wish to disband its captive for casualty coverages (workers' comp, CGL, auto liability) in order to clear potential liabilities off its balance sheet so it can command a higher sale price. Similarly, a foreign chemical company in merger negotiations with a US-based solvents business may find that the operation owns several brownfield sites requiring remediation and therefore has pollution liability issues that must be resolved before the contract can be finalized.

In each of these cases, the solution may be to transfer accrued or potential liabilities to an insurance company. Loss portfolio transfers and buyouts can be utilized to remove certain liabilities from a company's balance sheet. Loss portfolio transfers typically are structured for an existing body of losses, or claims, generally from workers' comp, CGL, auto liability, product liability or environmental liability programs. Buyouts are usually designed to address a specific claim or liability, such as pending litigation, and are more often applied to D&O, E&O, warranty risks and other losses.

In a loss portfolio transfer, the insurer evaluates a company's known liabilities and anticipated losses to determine total ultimate expected losses. Premiums are based on actuarial projections, taking into account the net present value of established reserves and an appropriate charge for transferring the risk to the insurer. In exchange for the agreed upon premium, the insurer assumes the risk and the responsibility to pay losses, eliminating the liabilities from the company's balance sheet.

With a claim/litigation buyout, the insurer reviews the case and examines litigation and settlement issues and claim trends. The insurer uses this information and its underwriting and claims expertise to determine the ultimate expected loss and the appropriate premium.

Loss portfolio transfers and buyouts are frequently arranged on either a finite risk or guaranteed-cost basis. Finite risk programs generally span a period of years, typically five to 10 although other options are available. The insured pays fixed annual premiums over the stated time period, and the contract covers specified losses up to an aggregate limit. As long as the program includes a proper amount of risk transfer (consistent with FASB 113), premiums from the buyout or loss portfolio transfer can be treated as an insurance expense - an off balance sheet item. As a result, these arrangements may offer companies considerable advantages due to tax-deductibility of insurance premiums and favorable GAAP accounting treatment.

Loss portfolio transfers and buyouts enable companies to stabilize their insurance costs, reduce balance sheet volatility and protect shareholder value. The collateral required as security for accrued liabilities is also freed up, improving lines of credit and increasing a company's borrowing capacity. While finite risk programs generally require a larger upfront premium commitment than traditional insurance, they often provide companies with the opportunity to earn investment income and share in underwriting profits if losses are lower than expected.

As mentioned earlier, loss portfolio transfers and buyouts can also be pure risk transfer arrangements. For instance, a private company preparing for an IPO may want to transfer its workers' comp or CGL losses, eliminate its self-insured retention, and convert to a guaranteed-cost insurance program that offers greater security and can help boost investor confidence.

An offshoot of this strategy is the buydown, where a company purchases insurance on a guaranteed-cost basis for the specific layer of its self-insured retention that contributes most to balance sheet volatility. For instance, the company could continue to self-insure the retention layer that carries smaller and more predictable losses, as well as the higher layer where losses are more severe but less frequent. The middle layer - the most unstable - would be transferred to the insurer, enabling the company to reduce prospective accruals and improve its balance sheet.

Specialized coverages

While certain environmental liabilities can be managed through loss portfolio transfers and buyouts, both buyers and sellers may need to consider other options as well. Real estate transfer policies provide coverage for past and present owners that may be held jointly liable for environmental impairment. Before or after a deal, a company owning contaminated property may also decide to purchase environmental coverage that responds if the actual cost of site remediation and clean-up greatly exceeds estimates. This type of stop-loss coverage puts a cap on environmental liabilities that could seriously impact a company's bottom line. Reliance National, through ECS Underwriting, Inc., is one of the few insurers that offers these specialized environmental insurance products.

Insurers like Reliance National are also skilled at developing new M&A risk management solutions. For instance, when a US multinational stood to lose $20 million if a $220 million deal with an overseas partner fell through, Reliance National was able to structure a program that provided indemnification if the merger was called off due to regulatory concerns. This type of break-up fee indemnity coverage is gaining favor as a way to further mitigate the risks involved in M&A transactions.

Another example is representations and warranties insurance. A standard element of the purchase agreement is the representations and warranties section, in which the seller makes certain representations - for example, property is free and clear of any liens, financial statements are accurate and audited, business machinery is in good working condition, Y2K issues are being addressed, operations are environmentally compliant - the list is virtually endless. Frequently, a portion of the sale price is held in escrow for a certain period of time after the closing to help ensure that representations and warranties are not breached.

A representations and warranties insurance policy can stand in lieu of escrow, providing security for the buyer and enhancing the liquidity of the deal for the seller. Tailored for specific risks, representations and warranties insurance provides reimbursement for covered losses sustained by the acquirer as a result of misrepresentation(s) by the seller.

For instance, a decision to buy a particular enterprise may be made on the basis that the acquirer will receive certain tax credits due to net operating losses on the seller's balance sheet. If accounting irregularities are found or if the IRS disallows the tax credits after the deal closes, the acquiring company could lose millions. Representations and warranties insurance can be arranged to cover this contingent tax liability.

Since representations and warranties insurance is a relatively new concept, its use to date has been somewhat limited. However, this coverage is an option that companies may want to consider as they review potential M&A risk management strategies.

Protecting management

D&O insurance is an essential part of any M&A strategy. The 1997 Watson Wyatt Worldwide D&O Liability Survey reports that companies engaging in merger, acquisition or divestiture activity are nearly twice as likely to have at least one claim against their directors and officers, and will probably have, on average, three to four times as many D&O claims as companies that have not undertaken such restructurings.

Due to the prevalence of lawsuits against corporate directors and officers, both buyers and sellers need to have adequate D&O coverage in force. For while a company may cease to exist following a sale, the potential liability of former directors and officers continues long after the deal is complete. To protect the previous board, the purchase agreement should contain a clause mandating the maintenance of a D&O runoff policy for a period of time, usually four to six years. The runoff policy covers directors/officers for actual and alleged wrongful acts committed prior to the change in control. Policy terms and conditions need to be negotiated so that the scope of runoff coverage is no less favorable than the protection the directors and officers had been afforded previously.

Putting it together

More and more, corporate risk managers are being challenged to examine risk on an enterprisewide basis. This means understanding the traditional insurance exposures as well as the financial risks - including balance sheet issues and interest rate, commodity and foreign exchange exposures - that could jeopardize the future of a company.

Insurers and insurance brokers are looking at these risks as well and are working closely with risk managers to develop innovative, multiline programs that cover both insurance and financial risks. Due to the multitude and magnitude of risks involved in corporate restructuring, the risk manager will want to find a broker and an insurer that are able to integrate various strategies seamlessly and are experienced in meeting the needs of clients on both sides of the buy-sell equation.

Some major brokers and insurers such as Reliance now have dedicated units specializing in M&A risk management. These units bring together a cadre of professionals with backgrounds in investment banking, accounting, law, insurance, financial analysis and other areas to develop highly customized M&A solutions. With a keen understanding of business risks and insurance/financial issues, these skilled professionals are a vital resource for risk managers seeking the very best in corporate M&A protection.

Gary N. Dubois is senior vice president of the integrated risk services department at Reliance National, a principal unit of Reliance Group Holdings, Inc. in New York City. Reliance National provides a broad range of property/casualty and accident and health insurance coverages and risk management services in the United States and internationally.

1. According to Securities Data Company.