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An Industry-Wide Look at Activity and Performance in North America and EMEA
Transaction Insurance
Claim Study
Foreword
Highlights
As the world began to recover in 2021 from the COVID-19 pandemic, global M&A activity surged. Buoyed by the reopening of the world economy, supportive fiscal and monetary policy, and the eagerness of both strategic buyers and private equity investors to deploy capital, deal activity hit record highs. Mergermarket data reveals annual deal value surpassed $5 trillion for the first time last year, reaching $5.7 trillion in all, with nearly 26,000 transactions announced worldwide.
Some of the trends powering dealmaking look poised to endure, which was reflected in survey respondents’ optimism around deal activity. Digital transformation remains a key motivator behind transactions, and consolidation drives are emerging in several sectors. Cybersecurity investments are particularly sought after in light of global geopolitical conditions. Moreover, many organizations are well positioned to capitalize on record piles of dry powder.
Against that, risk is on the rise. Russia’s invasion of Ukraine has raised political tensions to levels not seen for decades. The economic impacts are already being felt, most notably through a sharp spike in inflation in many economies, prompting monetary tightening; global growth is likely to be slower than expected this year.
In this report, we explore these dynamics in detail. We report on investors’ expectations for global M&A over the next 12 months, standout sectors, the key risks they see – and how best to mitigate them.
Introduction
Update on 2021 Claim Frequency and Size Trends
Claim Frequency
Figure 15: Where regulation bites
Which form of regulation do you find most challenging? (Please select the two most important)
Many areas of risk are multifaceted. Regulation is a good example – cited by 28% as a concern for their organization, the nature of this risk varies by jurisdiction, by sector and by individual business.
In an M&A context, antitrust is the area of regulation that dealmakers find most challenging, with 50% citing competition as one of their top two areas of concern. The growing number of mega deals –often reviewed by antitrust regulators as a matter of course – is part of the story here. But so too is the high-profile intervention of antitrust regulators in the TMT sector, where there are growing calls for scrutiny of ‘Big Tech’ organizations.
In a related area, the past year has also seen increased scrutiny of M&A activity by regulators concerned about national security or the broader “national interest”. Countries including the UK have moved to toughen foreign direct investment regimes, making it more difficult to pursue cross-border deal activity in certain sectors.
Correspondingly, almost a quarter of dealmakers (24%) cite export controls and foreign direct investment rules as one of their top two regulatory challenges.
Data protection regulation, meanwhile, is achallenge for 36% of respondents. With many jurisdictions now following the lead set by the European Union, with its introduction of the General Data Protection Regulation (GDPR), this latter issue is becoming a worldwide concern.
The other significant area of anxiety around regulation is environmental issues, cited by 42% of dealmakers. As increasing numbers of countries introduce demanding targets for cutting carbon emissions, the pressure is on every organization to account for their carbon footprint, and to reduce it. Inevitably, many are finding it tough to comply with new reporting requirements, as well as to make changes within their organizations and supply chains to lower emissions.
An Evolving Rulebook
An Evolving
Rulebook
Held to a Higher
Standard
Taxing Requirements
Courtroom Drama
The Tech Toolbox
An Evolving Rulebook
Held to a Higher
Standard
Taxing Requirements
Courtroom Drama
The Tech Toolbox
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Figure 14: Risk rising – from pandemic to geopolitics
What are the most significant risks that your organization will face over the next 12 months (select top 3)?
The good news is that, for many dealmakers, the COVID-19 crisis is now moving into the rear-view mirror – just 26% cite the pandemic as one of the three most significant risks their organization will face over the next 12 months. On the downside, more than half of dealmakers (54%) fear the impact of geopolitical uncertainty, and 50% cite market dislocation or disruption.
Inevitably, Russia’s invasion of Ukraine will weigh heavily on dealmakers and markets in the months ahead; European M&A is more likely to be significantly impacted than dealmaking in other markets, but sentiment worldwide will take a knock. It is very difficult to predict how long the conflict may last, or what the broader implications may be in the long term – but that uncertainty is part of the fear factor for dealmakers.
Other risks are also coming to the fore. More than a third of dealmakers (34%) cite the macroeconomic picture as of concern, as rampant inflation forces central banks to tighten monetary policy. Legislative/Regulatory change is an issue for 28%, while 26% point to technology/cyber risk.
Aside from these big-picture themes, there is also nervousness about issues such as the environmental, social & governance (ESG) agenda, supply chain risk and securing data and information during investment processes.
Part 2: Risks and Regulation
Claims Impact on Underwriting
As the utilization of R&W insurance grows, insurance carriers have continued to refine their underwriting focus with an aim to streamline the overall process and focus on matters most material to a given transaction. For example, insurers are becoming
more attuned to the specific risks and liabilities attributable to specific businesses and sectors and are focusing their underwriting efforts on areas that have resulted in claims in the past. Examples include cyber exposures for tech-focused businesses, wage and hour matters for businesses with a significant number of independent contractors and/or businesses located in specific states such as California, condition of assets for transactions where a substantial amount of the consideration being paid is tied to the underlying value of physical assets being acquired, and the diligence around material customer reps, where the industry has seen a significant percentage of the total claims payouts.
Figure 16: Dealing with ESG
How do you expect ESG scrutiny to change in deals over the next three years?
But the environment is just one element of ESG more broadly, where 90% of dealmakers expectto see increased scrutiny of transactions over thenext three years – and more than half of those respondents expect to see a significant increase.
In part, this reflects the growing perception that strong ESG performance and commercial strength often go together. Aside from the external pressures driving increased ESG scrutiny, research has continued to draw firm correlations between material ESG factors – including social issues such as diversity, inclusion and employee engagement –and corporate financial performance.
It is also the case that ESG regimes such as the Sustainability Accounting Standards Board, and going forward the International Sustainability Standards Board, have shown corporate issuers and investors how to quantify social issues more effectively. As a result, we are better equipped today to dig past feel-good narratives to get to metrics that are meaningful for current and future financial performance. And demographic shifts among the workforce and consumers mean pressure to address material social issues is coming from the bottom up and not just top down from investors and regulatory bodies. The time to act is now.
Held to a Higher Standard
Figure 17: Tax risk on the rise
How much more acute is tax risk to deal success now as compared to the recent past? (Select one)
Tax risk is also on the increase, with 50% of dealmakers warning it is now significantly more acute to deal success than in the past – a further 40% say it is somewhat more acute.
“The value of the target company cannot be determined accurately without knowing about the tax risks,” warns the managing director of an investment bank in Canada, while the managing director of a private equity firm in Australia adds: “We have to hire local advisers who know more about these risks, and we then prepare a strategy for deals accordingly.”
Certainly, 2021 saw an increase in cross-border tax concerns. These included increased scrutiny of large multinational deals taking place across multiple jurisdictions and with exposure to multiple currencies, as well as inbound foreign investment into the US, withholding tax concerns and transfer pricing.
Indeed, dealmakers warn of growing tax risks on multiple fronts. More than a quarter (28%) pickout the proliferation of anti-abuse rules as their most pressing concern, but others include entity classification rules and increases in tax rates.
Mitigating these risks is increasingly important. For example, Aon’s clients continue to secure tax insurance to remove the worry of inheriting liability for particular known tax issues in M&A deals throughout the world. And with the rapid speed at which deals were being completed in 2021, there was an increase in tax risk management outside of the traditional deal timeline, including post-closing mitigation strategies and target-level risk management before commencement of the bid process.
Many dealmakers report increased dependence on both talent and technology as they confront tax risk. “We find it useful to hire expertise on a temporary basis to assess tax risks,” says the senior vice president for corporate development at a US corporate. “It is important to get an unbiased view about the tax environment and the challenges specific to the target.” The partner of a British private equity firm adds: “We use technology to assess tax risks –artificial intelligence and automated functions can help us ascertain the actual risk level without forgetting about any important indicators.”
Taxing Requirements
Figure 19: Litigation risk in focus
What type of litigation creates the most concern in a deal? (Select top two and rank 1-2)
Litigation risk also worries many dealmakers. The biggest area of concern, cited by 26%, is litigation related to antitrust issues, mirroring respondent’s most pressing anxiety about regulation. That is closely followed by labor and employment, which 22% of dealmakers identify as the area of litigation that worries them the most.
Other potential flashpoints include data protection/IP, cited as the most concerning litigation risk by16%, and financial disputes, singled out by 18% of respondents.
Courtroom Drama
Figure 20: Putting technology to work in credit insurance
A) Do you currently have a credit risk technology in place?
With other types of risk, different mitigation strategies make sense. In particular, 44% of dealmakers say they are currently employing some form of credit risk technology. Of that group, 50% say they now have access to a credit risk management system powered by artificial intelligence, while 41% point to their customer relationship management software.
Such tools can help reduce uncertainty, explains the partner of a private equity firm in the UK. “The pandemic has had a broad impact on credit markets; credit risk has become something of an enduring threat over the past few years,” the executive adds. “We cannot predict the underlying risks.”
Other respondents are keen to see further development of technology solutions to help them in this area. “There are insufficient risk-assessing tools in the market,” says the managing director of a US investment bank. “From a lenders’ perspective, the current environment is increasing credit risks –although lending trends are improving, the risks of the pandemic still remain.”
Many dealmakers worry there is still significant work to do to get the best out of technologies that address credit risk. More than three-quarters (76%) worry about their limited infrastructure, while 64% say deployment has been slow and 62% cite skills shortages.
With credit risk still elevated, these problems must be addressed. The corporate development director of a corporate in the Netherlands says: “Operating challenges have continued in 2022; there are companies in capital intensive sectors that have not been able to revive operations completely, which has led to higher credit risks.”
While long established, awareness of how the insurance markets can address credit risk to transactions is limited. With a risk capacity exceeding $4 billion, live credit insights into over 100 million discreet commercial entities and a regulatory framework that can deliver cost of capital benefits, the insurance market offers dealmakers concrete opportunities to add value to transactions and portfolio companies. Aon has seen the successful structured non-payment, political risk and surety solutions on single and portfolio risks resulting in improved cash positions by enabling short-term financing, creating off balance-sheet solutions for transaction-related demands for collateral, shortened cash conversion cycles and lower cost of capital.
The Tech Toolbox
Figure 18: Tax issues on many fronts
Which of the following tax-related issues is of greatest concern to you? (Select one)
B) If yes, what tools are you currently using to address credit risk?
Figure 21: Bars to credit risk technology
What are your greatest challenges in addressing credit risk using technology? (Select all that apply )
In 2021, Aon’s M&A and Transaction Solutions team in North America placed more than 1,000 representations and warranties (R&W), tax and contingent liability insurance policies. We helped clients navigate nearly 100 new claims, as well as an even higher number of existing claims that moved their way toward resolution during the year. The volume of new claims was slightly lower than in 2020, for reasons discussed in this 2021 study. However, the early data from 2022 suggests that claims are again returning to historic frequency levels.
The size and scale of the Aon TS business makes us uniquely positioned to offer insight into current mergers and acquisitions (M&A) and tax claims activity. In our 2021 study, we continue to focus on R&W claims, examining trends that are emerging with respect to claim size and frequency on policies placed between 2015 - 2021 in North America. In addition, we have gathered data from our Europe, Middle East, and Africa (EMEA) region to provide insights into that growing practice. In 2021, the EMEA region placed more than 400 warranty & indemnity (W&I) , tax and contingent liability insurance policies and continues to see significant claims activity, as we discuss further in the report.
In a continuation of a practice begun in last year’s study, we again surveyed insurers in the R&W space about their claims experiences and incorporated their insights into our findings. This year, 17 insurers participated in our 2021 Insurer Survey, six more than in 2020. Additionally, we examined Aon’s tax and international claims data to provide a fuller picture of the global transaction solutions industry.
Last year we highlighted that while the global pandemic impacted the R&W business, most notably leading to many transactions being put on hold in Q2 and Q3 2020, claims volume remained unaffected. However, with a further year of reflection we note that the slowdown in deal placement in mid-2020 may have resulted in a delayed impact to claims volume in 2021. With a heavy skew toward Q4 placements in 2020, the overall distribution of policies was not as mature as in a typical year and could account for the slight reduction in new claims filed in 2021. However, the early data from 2022 suggests this may have been just a temporary lull as claims volume appears to be returning to historic levels.
That said, with both new and complex claims from the prior year driving toward resolution, we continue to see the claim process evolving. Insurers and their consultants consistently refine their own internal process, focusing on claim details around breach and digging into the basis around loss calculation. Despite some additional diligence, we note that insurers continue to act in a commercial and reasonable manner as good partners to Aon clients, with claims resulting in fair and successful resolutions.
Since 2013, Aon clients have filed over 600 total claims on R&W policies. Of those claims 21% settled within the policy’s retention, 14% resulted in payment by the insurer, 49% remain active, 12% are inactive and 4% have been denied.
Insurers reported that 31% of claim payments in 2021 were based on a multiple, up from 24% in 2020.
Through 2021, R&W insurers paid more than $560 million to Aon clients in North America.
Insurers have now paid more than $60 million to Aon clients on warranty and indemnity (W&I) policy claims in EMEA.
19% of policies issued between 2015 and 2019 have had at least one claim made.
In 2021, as the world pushed through a second year of the pandemic, we continued to analyze Covid’s impact on R&W claims activity. Conclusions regarding the impact of the pandemic on the industry as a whole are still difficult to draw. However, certain facts seem to imply that any impact on claims activity is temporary and that a return to prior historical norms is likely.
According to both the Aon and the corresponding insurer data, new claims are slightly down year over year. That said, the impact of Covid-19 and the resulting
shutdown in Q2 and Q3 2020 lead to an outsized proportion of all policies being issued in Q4 of that year. In 2019, 29% of all R&W policies were placed in Q4, while in 2020 just over 46% of all policies were placed during that same period. As such, the average 2020 policy is less mature than in a typical year and may have impacted claims timing in 2021.
Given this less than standard time on risk for 2020 policies, and that 2021 was a more typical year based on distribution of when policies were placed throughout the year, we anticipate that new claims should increase (in raw numbers) in 2022 year over year. In fact, early data from 2022 supports this anticipated outcome. As businesses and the insurance industry have learned how to continue working through pandemic conditions more consistently, we expect that the future timing impact on claims as a result of Covid-19 to be minimal.
Impact on R&W Claims as the Covid-19 Pandemic Stretched into Its Second Year
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Claim Frequency
Claim Size
Claim Trends
Claim Frequency
Claim Size
Claim Trends
We examine two breaches related to inventory to demonstrate the nuanced approach to calculating damages.
When there is a breach due to a discrepancy in inventory, the goal is to determine the exact amount of loss incurred that would return the buyer to the state they would have been in if the inventory was provided as initially represented. Thus, the simple question arises: if the insured is reimbursed for the costs of the missing or defective inventory, would this dollar-for-dollar payout return the buyer to this initial state?
From climate change risk to social issues, ESG considerations will play a role in every M&A transaction. In due diligence processes, buyers will increasingly scrutinize targets’ ESG credentials, homing in on reputational risks as well as regulatory concerns.
The Rise and Rise of the ESG Agenda
With risk heightened and the outlook uncertain, dealmakers will look for more imaginative and creative methods of mitigating risk.
Enhanced Use of Risk Mitigation Tools
Sellers continue to demand higher prices, but withan increasingly uncertain big picture outlook, and buyers becoming more dependent on third-party deal finance, a determined focus on the fundamentals of financial due diligence will be crucial.
Increased Financial Due Diligence
Digital solutions played a crucial role in facilitating M&A even at the height of the pandemic; having seen the advantages of working this way, dealmakers will continue to invest. Technological innovation has the potential to support M&A in multiple areas, from understanding tax and credit risk to driving valuation models.
Increased Investment in Technology
This report suggests that last year’s resurgence of M&A can be sustained, with dealmakers looking forward to further transactions as they exploit recovering global growth and pursue digital transformation. The outlook looks especially promising for M&A in sectors such as TMT and in the APAC region.
Nevertheless, there are some dark clouds on the horizon. First, it is by no means clear that the COVID-19 pandemic is behind us. While many countries are finding ways to cope with the crisis, some lockdowns and restrictions as the virus breaks out on a localized basis seem likely – this is bound to impact dealmaking. In addition, Russia’s invasion of Ukraine has hugely increased anxiety about geopolitical risk and threatens to hold back global growth. The longer the conflict lasts, the greater the impact on M&A is likely to be.
Then there are more specific risks. Regulation is on the increase across several fronts. Credit markets look more uncertain. Tax risk is rising too. Against this backdrop, the next 12 months is likely to be defined by four key trends.
Conclusions: Key Trends for the Year to Come
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Multiple Damages
In last year’s claim study, we did a deep dive on the issue of multiple damages and its potential influence on the growth of average claim size. A year later, the trends we identified seem to be persisting. Both Aon and the insurers that participated in the survey are seeing more deals allege loss on the basis of a multiple.
Insurers now state that 31.3% of all paid claims have alleged damages on the basis of a multiple, up from 24% last year.
Material contract breaches can be extremely burdensome for buyers, especially when the company relies on just a few customers for its revenue. Additionally, calculating the damages on a material contracts breach can be influenced by many factors, including length of contract, the type of contract and how the customer was being charged, the previous renewal rates of the customers, how actions pre-close led to a material change to the contract represented, and a variety of other factors.
We examine two material contracts scenarios to demonstrate how contract length, type of contract and preclosing actions can greatly impact the way material contracts damages should be calculated.
When looking at when claims are typically made in relation to the closing of the insured transaction, we see that most continue to be made within the first 12 months (see Figure 6). 27.1% of claims are made within six months, and another 28.1% are made between six months and 12 months of closing. However, this 55.2% of claims made within the first 12 months is down from the data set analyzed last year which showed that 61% of claims were made within the first 12 months. In addition, we have seen a slight increase in the number of claims that result from third-party litigation, which are nearly as likely to come in after 12 months as before 12 months.
In fact, as Figure 7 illustrates, of the most common breach types for claims that come in after 12 months, 57% are third-party claims, whereas 15% are undisclosed liabilities and 14% are financial statement breaches. Since seller indemnities typically expire one year
from the date of closing, a buyer would have no recourse for these claims. However, a buyer who purchases a R&W policy has significantly more protection as the policy would provide coverage for three years post-close.
Timing for Discovery of a Breach
In Europe, the Middle East and Africa (EMEA), Aon warranty & indemnity (W&I) policies have resulted in 185 claims since 2015. Between 2017-2020, Aon saw claims notified on an average of 16.2% of the W&I policies placed in EMEA.
As shown in Figure 8, the largest frequency of W&I claims across EMEA for the period are tax-related claims (23%), followed by financial statement claims (18%).
Given that in certain EMEA jurisdictions tax audits are often undertaken as a matter of course following a transaction, we find it unsurprising that tax-related claims are the most frequent type of breach in the region.
Timing
Differing from the corresponding North America data, most EMEA claims are filed more than 12 months after the closing, as only 44.68% of claims are filed in the first year (see Figure 9). Moreover, the EMEA claims data shows a longer tail of risk as 21.28% of claims are filed after 24 months. This is both an increase from last year’s data set, which showed a 17.6% of claims filed after 24 months, and notably above the North America
number of 14%.
As the product matures across EMEA, we have seen claims recoveries increasing. As of last year, claims recoveries stood at $13 million. However, last year we noted a trend of more complex and potentially severe claims emerging. Now one year later, total claims
recoveries for Aon clients exceed $60 million in the region.
This section discusses Aon’s experience with bespoke tax insurance policies as opposed to claims for breaches of the tax representations under R&W and W&I policies,
which are discussed above. Due to the extended nature of tax contests as well as the large volume of programs placed in the last five years, Aon is beginning to see
increased claims activity on tax insurance placements.
To date, most of Aon’s claims experience on tax insurance policies has involved situations where a formal contest has been initiated by a tax authority and a successful claim for defense costs has been made by our clients, but where it was ultimately determined in the contest that no tax was due. However, we have now seen claims where the tax authority successfully asserted that a tax was due. In these situations, we
were pleased with the insurers response, as they covered the tax loss and contest costs and made our clients whole via the gross-up mechanism in the policies. As such, Aon clients have now collected more than $32 million in payments for losses under tax
insurance policies.
Tax Insurance Claims
When handling Aon client tax claims, insurers continue to be responsive and cooperative when claims are brought or when approvals are needed during the audit process. Their approach has been collaborative, as the insurers typically view the tax claim as a partnership in the defense of the covered tax position with their insureds and counsel. It would be highly unusual for a tax insurance claim to require mediation, arbitration or litigation, and to date, every resolved claim under an Aon tax policy has either been paid, settled within the retention, or ultimately no tax was owed to the tax
authority.
Insurers reported that 28% of tax policies placed between 2013 and 2020 received a pre-claim notice of a general audit and 7% were notified of a claim, indicating a targeted review of a covered tax position arising from the audit or the beginning of a formal
contest with the tax authority. In our experience, Aon clients have seen multiple general audits become more targeted and result in a claim. Currently, most of these placements are still working their way through the audit or appeals process. It is our expectation that over time, as the tax contests progress, the percentage of claims resulting in a payment will climb.
Claims Process
Aon clients have filed more than 600 claims on R&W policies placed in North America. Of those, 21.1% settled within the retention, 12.3% became inactive over time, 13.7% resulted in a payment by the insurer, 3.9% were denied coverage, and 49% remain active. Outright claim denials continue to be rare within the industry. When there are outright denials, they tend to center on deal-specific exclusions. One trend identified last year that continues to be true is that insurers are increasing their review around breach conditions and causes. Many times, the insurer will not acknowledge breach until it has had a complete opportunity to investigate the issue. That said, given the low number of denials, we continue to see insurers generally get comfortable with the alleged breach.
The process over quantum continues to be the main driver in the length of the claims process. As stated earlier, we are seeing more claims alleging a multiple of damages based on a diminution in value of the purchased company. These calculations are open
to levels of interpretation. The insurers continue to retain high-quality experts who conduct a detailed investigation to understand the rationale behind the claimed loss. Despite this enhanced review, we continue to see most claims work their way
toward resolution. In fact, when insured’s experts communicate directly with insurer’s experts we tend to see a smoother claims process. These communications lead to better understanding, both in what exactly the insurer needs to adjust the claim and exactly what the insured is able and has access to provide.
The insurers that participated in our survey also confirm that most claims are resolved via the claims process, as only 2.3% of claims end up in arbitration and 0.4% of claims end up in litigation. This 2.7% of claims ending up in a dispute resolution process is a
slight uptick from last year’s 2%, but still a relatively minor number of claims. Aon has only seen 1% of claims head into arbitration, with only six claims in arbitration out of 600 filed. We will continue to monitor whether more claims wind up in arbitration/litigation as the claims process continues to be refined.
In addition, as Figure 10 shows from the insurer’s perspective the top three issues that can prevent a smooth claims process are (1) inadequate information provided to analyze the claim, (2) the length of time taken to provide information, and (3) the complexity that comes from a demand for damages on the basis of a multiple.
4. Beware of insurer rights under the R&W policy when negotiating a settlement
The policy likely includes recourse for the insurer against the seller in the case of fraud. When negotiating any settlement with the seller it is important to make sure that the rights of the insurer are not prejudiced should it choose to subrogate. We recommend seeking insurer consent for any such settlement (or at a minimum carving out the insurer’s right to go after the seller in the case of fraud) to avoid any issues under the policy.
Claims Resolution
As of end 2021, R&W insurers had paid more than $560 million to Aon clients in North America and recognized more than $850 million in total loss (when factoring in erosion of policy retentions). This includes payments by 20 different R&W insurers to Aon clients in North America since 2013, with $425 million of that amount being paid in the last three years.
As Figure 11 illustrates, most claim payments on Aon policies are for less than $5 million, with 31% of payments being for less than $1m, and 38% of payments ranging between $1 million and $5 million. However, 15% of payments are for more than $15 million.
The breakdown of claim payments between 2015 and 2021 from the 2021 Insurer Survey is shown in Figure 12. Similar to the Aon data, Insurers reported that the bulk of these claim payments were between $1 million and $5 million (37.3%). Notably, the insurer data shows a higher percentage of payments between $5 million and $10 million as compared to the Aon data (22.4% and 14%, respectively), while the Aon data shows that Aon clients have received a notably higher percentage of payments above $10 million (16% for Aon clients compared to an insurer rate of 9.2%).
We continue to see several large, complex claims that are still working through the claim process. Once these claims resolve we may see even more payments for Aon clients in the upper end of the range.
We have consistently seen that the claims experience varies greatly based on our clients’ level of engagement in the process. We recommend that our clients: engage a broker and advisors as soon as they learn of a potential breach; spend time pressuretesting the case; retain the appropriate financial
experts; provide a comprehensive response to the insurer; and answer insurer inquiries in a timely manner. By doing so, our clients can aim to ensure that they have maximized their chance to have a smooth claim process and a satisfactory resolution to the claim.
Figure 6. Time from Closing to Notice on Aon Policies:
Figure 7. Type of Breach Most Often Notified More Than 12 Months Post-Close
Figure 8. Frequency by Type of Breach EMEA (2015-2021)
Figure 9. Months Between Closing and Notice of a Claim EMEA (2015-2021)
Figure 10. 2021 Insurer Survey Results: Top Issues That Prevent Efficient Claims Process (Top Three Areas Identified)
Rank the top three out of the following issues that prevent the claims process from running as efficiently as it could in order of importance (where 1 = the most important issue and 3 = the third most important)
Figure 11. Claim Payouts Above the Policy Retention Aon Client Policies (2015-2021)
Figure 12. 2021 Insurer Survey Results: Claim Payouts Above the Policy Retention (2015-2021)
What percentage of all claim payments above the retention made on policies placed between 2015 and Q3 2021 falls within each of the following categories?
– Average percentages shown
Our claims frequency chart this year tracks the number of policies that result in at least one claim. This provides a more accurate representation of the percentage of deals that have a claim. Moreover, it also normalizes the data where one client submits all its claims at once compared to another client who may submit multiple claim notices as it discovers different breaches at different times. In both situations our data is consistently tracking the percentage of policies that see at least one claim and not double counting when a client makes multiple notices.
While we reported last year that the claim rate appeared to be settling at around 20%, recent data has shown a slight downward trend in overall claim frequency with respect to claim rates on 2021 policies. The current claims frequency from 2015-2019 is 19%. While Covid-19 impacted claim rates for 2021, there are other factors that could be contributing to the downswing. As the product matures, our clients are gaining a
better understanding of how the policy works and what types of claims may be worth pursuing. As a result, fewer precautionary notices may be being submitted for breaches first discovered before the dropdown retention if the claimed loss would be less than the amount reduced on the dropdown date.
With this in mind, Figure 1 illustrates the percentage of Aon-placed policies that have seen a claim filed between 2015 and 2021. As the policies in 2019, 2020, and 2021 remain on risk, we expect those claims frequencies to continue to rise. Figure 2 provides
Insurer data for the same time period. The variations reflected in the Insurer data are consistent with the fluctuations in the Aon data.
As the claims sample size continues to grow, a notable trend has begun to emerge. While still accounting for a large number of the overall claims, deals with an enterprise value of less than $100 million are starting to comprise a slightly smaller share of the overall claims. As a result, as illustrated in Figure 3, the data now shows that all deals above $100m are showing a claim frequency higher than their respective percentage of deals.
We also analyzed claims filed between 2015 and 2021 for severity. The initial calculation of loss for these claims is increasing. Between 2015 and 2021 this initial calculation
of loss across all claims was 33% of the policy limit. However, further refining this data set to 2018-2021 shows that this same initial calculation of loss increased to 42% of the policy limit. We also saw that initial claim amounts as a percentage of enterprise value were highest for deals with an enterprise value of less than $100m. Finally, 15% of all claims across 2015-2021 had initial claim amounts in excess of the policy limit. It is again important to note that the initial claim amount is not necessarily representative of the final amount that will be recovered. However, it does provide us some insight into the direction that claims may be trending.
Deals with enterprise values in excess of $500 million continue to be significant drivers of the total amounts paid by carriers accounting for just under half of all recoveries of Aon clients between 2015 and 2021.
Claim Size
Analyzing the data from 2015-2021, we looked into the most common type of breaches on Aon-brokered policies and their impact on claim recovery. Figure 4 illustrates that the most common breach that our clients report are for breaches of a financial statements representation, followed by breaches of undisclosed liabilities,
compliance with laws, tax, and material contracts representations. When asked to list their respective top breach types, insurer data closely mirrors our data. The insurers responded by providing their three most common breach types seen in the claims they receive. As Figure 5 illustrates, these insurer responses are consistent with
what we are seeing.
Looking at the amount of loss paid by insurers, we see that claims alleging either a breach of the financial statements representation or a breach of the material contracts representation have resulted in recovery well above their respective claim
frequencies. Again as Figure 4 shows, financial statements claims resulted in 16% of all claims but 32% of all recovery, while material
contracts claims resulted in 10% of all claims but 38% of all recovery. The reason for this outsized impact of these two particular breach types is the frequency with which clients seek damages beyond a simple dollar-for-dollar calculation. This is also the first time that material contracts recoveries have surpassed financial statement recoveries in the Aon data. However, as a number of large financial statement claims are still active, we would not be surprised to see overall financial statements recoveries surpass material contracts in the near future. Either way, these breaches remain drivers of recovery.
Deals with enterprise values in excess of $500 million continue to be significant drivers of the total amounts paid by carriers accounting for just under half of all recoveries of Aon clients between 2015 and 2021.
Other Claim Trends
Outside of claims that allege a multiple, we also see the data shows that conditions-of-assets claims have losses as a percentage that are larger than frequency. Often
these are complex claims, involving multiple levels of investigation. Clients must first prove that the asset was deficient prior to close. Once it is determined that the asset was not in the state represented by the seller, there will then be a discussion around the appropriate repair costs. The crucial discussion will center on what are truly repair costs (which are covered) versus what are upgrade costs (which are typically not covered).
In our experience, alleged condition-of-assets losses can be severe even though there is likely no multiple involved. In certain transactions, the assets being received constitute a large portion of the enterprise value. Therefore, if certain assets do not conform to the conditions represented, the loss can easily surpass the types of loss we see in other dollar-for-dollar recoveries.
Figure 1. Claim Frequency 2015-2021 Policy Years on Aon Policies
Figure 2. 2021 Insurer Survey Results: Claim Frequency 2015-2021 Policy Years
Figure 3. Claim Payment Frequency and Value by Deal Size (2015 - 2021)
Figure 4. Frequency by Type of Breach versus Percentage of Total Claim Payments Attributable to Each Type of Breach
Figure 5. 2021 Insurer Survey Results: Frequency by Type of Breach (Top Three Breaches Identified)
Which of the following types of R&W are most commonly said to have been breached in claims which your firm received? (Please select the top three and rank them 1-3, where 1 = the most commonly cited breach)
2. Preserve, compile, and assess supporting information and documents
Clients can be proactive at the start of the R&W claim process by taking steps to preserve, compile and assess the information and documents that provide support for the breach and associated loss. This will allow a more comprehensive production of information to the insurer who does not have the same detailed knowledge of the deal as the client.
3. Determine how best to support the loss calculation both before and after a claim arises
Where a policyholder alleges that a breach has led to recurring loss or a diminution in value of the target company and seeks to apply a multiple to calculate the damages, the insurer will take a close look at the transaction valuation documents (i.e. internal presentations such as an investment committee memo, board minutes, presentations to lenders) as part of its investigation to confirm the appropriate damages methodology. As such, we recommend that the client carefully consider how the deal was valued at the onset and determine how best to explain the loss in value to the company from the breach. We also recommend considering the ways that the retention of an outside accounting/financial expert could add value to the process.
Earlier this year we published an article listing tips for a smoother claims process. We identified the following areas for our clients’ consideration:
1. Do not delay in submitting a claim notice
Aon believes initial communication with the insurer is key to a better claims process. There is typically no downside to reporting a claim and informing the insurer early on of any issues. This has generally proven to be important for ensuring that all potential avenues of mitigation can be considered and insurer input/consent can be given in a timely manner.
EMEA Claim Trends
A buyer, who upon taking a closer look at their inventory, discovers that 10% of their inventory is obsolete and that this obsolete inventory has no other impact on business operations. If the insurer pays the cost of replacing the inventory, the buyer receives what was represented as part of the transaction and the loss has been averted. The application of a multiple to this loss may cause a windfall to the buyer since they would be able to purchase significantly more units of inventory than were obsolete.
Scenario 1
Aon Example
Client purchased a manufacturing plant that produced contractor-grade items. An inventory audit was performed post-closing and noted that prior pre-closing audits were inaccurate. Most notably, the percentage of scrap material had been miscounted, with items that were now set aside as scrap being shown on the inventory records as usable inventory. Insurer initially concluded that the loss was in the improper counting and that the remedy should be a replacement of the inventory and costs to improve inventory controls. Client countered that the loss related to the balance sheet, as the scrap was the result of the machining process so that more material was needed to produce every product thereby increasing the costs of goods sold and lowering the profitability of the item being produced. After considerable negotiation between the parties and the experts, the Insurer agreed to pay damages on more than a dollar-for-dollar basis.
Scenario 2
A buyer discovers that 10% of their inventory is defective. Upon further analysis of the inventory, the buyer realizes that the current method of production consistently results in a 10% defective rate on their product, which was not disclosed. Thus, in order to produce 100 units of inventory, they actually need to use approximately 11% more material than had been assumed. Since each product costs X amount to produce, the costs to create 100 units has now increased by Y (the amount to produce an extra 11% of inventory). This increase in costs of goods sold has a direct impact on EBITDA and, if known by the buyer, may have resulted in a lesser purchase price. This diminution of the value of the business constitutes a loss to the buyer that is greater than just replacing the defective inventory, since they will have to incur additional costs on every unit of inventory produced.
Scenario 1
The purchased company is a supplier of goods and has a renewable two-year contract with a material customer. Pre-closing, the seller represents that all material customer relationships are stable, and they have no knowledge of any upcoming terminations of any material contracts. After closing, the buyer finds out that this material customer notified the seller pre-close that they would be changing to another supplier and would not be renewing the contract. The question becomes whether damages should be based on a multiple or some other metric given the renewable but finite contract terms.
Aon Example
Buyer purchased a supplier of perishable goods with a small group of material customers that accounted for a very significant amount of the company’s yearly revenue. While it was represented to the buyer that there had been no known changes in pricing, volume, and terms with any material customers, post-close the buyer was informed that two material customers were essentially halting all business with the company. One customer reviewed the company’s pricing model and decided to switch to direct sourcing and the other customer had decided to switch vendors, both of which had been communicated directly to the seller prior to closing but were not disclosed. After compiling the documents detailing the material customers plans prior to closing, the insurer paid out the full policy limit and proceeded to subrogate against the seller for fraud.
Scenario 2
A company supplies goods on a less structured contractual basis, whereby there are continuous discussions about pricing of specific goods. Post-close, the buyer learns that the largest customer who accounts for over 50% of the business had told the seller that it will no longer be purchasing the company’s goods once they switch to a competitor at the end of the year. This shift cripples the business and makes it unprofitable to operate. Should damages be calculated on a multiple basis or some other metric given that the resulting business is effectively worthless?
Claim Frequency
