What Is Transactional Liability Insurance? A Plain-Language Guide to RWI
Representations and Warranties Insurance (RWI) is a policy that pays a buyer's losses if the seller's statements about the business turn out to be inaccurate. It replaces most of the escrow and personal indemnity structure that used to protect buyers, letting sellers walk away with clean proceeds and buyers rely on a well-capitalized carrier instead of personal pursuit. Day 2 of our M&A insurance series.
Yesterday we introduced the idea that transactional liability insurance exists to solve specific problems in mergers and acquisitions. Today we are going deeper into what the product actually does, in language that is free of insurance jargon.
If you read a purchase agreement for the first time, you will notice that a large portion of it is the seller describing the company. Usually in section three or four of the agreement, the seller makes dozens, sometimes hundreds, of specific statements. These are the representations and warranties.
Representations and Warranties, Explained Without Jargon
A representation is a statement of fact. A warranty is a promise that a fact is true. In practice, they are used interchangeably and always appear together. Examples from a typical purchase agreement:
- "The financial statements attached as Exhibit A fairly present the financial condition of the Company."
- "The Company has filed all required tax returns and paid all taxes due."
- "There is no litigation pending or threatened against the Company."
- "The Company owns all intellectual property used in its business free and clear of liens."
- "All employees are properly classified and all wages and benefits are current."
A sophisticated purchase agreement can contain over a hundred of these statements. Each one becomes a promise. If any of them turn out to be wrong, the seller has committed what is called a breach of representation and warranty.
What a Breach Actually Looks Like
Breaches are rarely intentional. Most of them are the product of honest mistakes, incomplete records, or events the seller genuinely did not know about.
The Employee Classification Problem
A growing company uses a mix of W-2 employees and 1099 contractors. The CEO represents at closing that all workers are properly classified. Six months later, a state labor board audit determines that forty contractors should have been classified as employees. Back taxes, penalties, and interest exceed $800,000. The representation was breached even though nobody acted in bad faith.
The Forgotten Lawsuit
A small claim was filed against the company two years before the deal. The lawyer handling it left the firm. The file sat untouched. The seller genuinely forgot it existed. It surfaces ten months after closing with a $450,000 verdict. The seller represented that there was no pending litigation. That representation is now wrong.
The Software License
The company has been using a specialized engineering software for years. The seller represents that all software licenses are valid and current. Post-closing, the buyer discovers the software was licensed to a specific engineer who left the company three years ago. The license was personal, not corporate. Replacing the software and defending an audit costs $200,000.
These are the kinds of scenarios where insurance turns a dispute into a claim. Without insurance, the buyer's only remedy is to sue the seller. With insurance, the buyer files a notice with the carrier, and the carrier pays the covered loss.
Known vs. Unknown Breaches: The Single Most Important Distinction
If you only remember one thing about how transactional liability insurance works, make it this: RWI covers the unknown, not the known. A breach that the seller disclosed, or that due diligence surfaced, is not covered. A breach that neither side knew about at signing is covered.
This distinction drives much of what happens during the deal. Disclosure schedules, which are attached to every purchase agreement, serve two purposes. First, they give the seller a place to affirmatively disclose anything they know that might be inconsistent with a representation. Second, they determine the boundary between insured and uninsured risk.
The Disclosure Incentive
Sellers sometimes hesitate to disclose marginal issues, worrying that too much disclosure will spook the buyer or reduce the price. With insurance in place, the incentive flips. Disclosing something converts it from a potential personal liability into a known issue that can be handled through escrow, specific indemnity, or contingent liability insurance. Not disclosing it keeps it within the RWI policy — but at the risk of the carrier later arguing that the seller knew.
The Knowledge Qualifier
Purchase agreements often include "to the knowledge of the seller" qualifiers on some representations. RWI policies evaluate these carefully. A knowledge-qualified representation only triggers coverage if the seller actually knew (or sometimes should have known). Well-drafted policies extend coverage to unknown breaches even where the representation itself is knowledge-qualified. This is a point worth fighting for during policy negotiation.
How the Policy Is Structured
An RWI policy has a few key economic components that buyers and sellers need to understand before signing off on a deal.
Policy Limit
The maximum dollar amount the policy will pay out. Typically set at 10 percent of enterprise value, though larger deals may carry lower percentages and smaller deals may carry higher. On a $40 million deal, a $4 million policy limit is standard.
Retention (the Deductible)
The amount the insured bears before the policy pays. Typically 1 percent of enterprise value for the first year, dropping to 0.5 percent thereafter. On a $40 million deal, retention is usually $400,000 initially.
Premium
The cost of the policy, typically 2.5 to 4 percent of the policy limit, paid once at closing. On a $4 million policy limit, premium is usually $100,000 to $160,000. There is also a one-time underwriting fee of $30,000 to $50,000.
Policy Period
How long the coverage lasts. General representations are covered for 3 years. Fundamental representations such as tax, title, and capitalization are covered for 6 years, which aligns with the statutory limitations periods for those issues.
Tax Liability Insurance: A Different Animal
Separate from RWI, tax liability insurance addresses known or identified tax risks. This is important: RWI excludes known issues. If due diligence identifies a specific tax exposure, RWI will not cover it. But tax insurance can.
Common uses include:
- State tax nexus: The company may owe sales tax in multiple states where it was not registered. A tax insurer can wrap the identified exposure.
- R&D credit positions: The company has claimed research credits on positions that could be challenged. Tax insurance can protect the buyer from IRS disallowance.
- Transfer pricing: International companies with intercompany transactions often have transfer pricing positions that could be challenged.
- Section 1202 qualified small business stock: Sellers relying on QSBS gain exclusion can insure against the position being challenged.
Advisor insight: Tax insurance has exploded in middle-market deals over the past three years. Positions that would have required six- or seven-figure escrows can now be insured for a fraction of the escrow cost.
Contingent Liability Insurance: Solving Specific Problems
Contingent liability insurance addresses specific, identified non-tax legal risks. If due diligence surfaces a patent infringement lawsuit, a pending regulatory investigation, or a class action in progress, that specific matter can often be insured rather than indemnified or escrowed.
The policy ringfences the risk. If the matter resolves favorably, nobody pays. If it resolves unfavorably, the insurer pays up to the policy limit. Both buyer and seller get certainty.
The Anatomy of an RWI Policy
A typical RWI policy runs 60 to 100 pages. Most of it is boilerplate that rarely matters in practice. But a handful of sections determine whether the policy actually pays when a claim arises. Before you sign off on a policy, your broker and counsel should walk through each of these.
- The Insuring Agreement: The core promise. Usually one or two paragraphs stating that the insurer will pay loss resulting from a breach of representations and warranties in the defined acquisition agreement, subject to the retention and limit.
- The Schedule: The deal-specific details. Policy limit, retention, premium, policy period, named insured, and the specific purchase agreement being insured.
- Definitions: How loss is defined, what counts as damages, how indemnity is measured. Subtle differences here can meaningfully change a claim's outcome.
- Exclusions: Both standard exclusions (known matters, covenants, consequential damages) and deal-specific exclusions (areas the underwriter is not comfortable covering).
- Conditions: The obligations of the insured — notice periods, cooperation requirements, mitigation duties, subrogation rights. Failure to comply can void coverage.
- Endorsements: Custom amendments to the policy. This is where deal-specific coverage enhancements live. Review these carefully — they often contain the most material terms.
Policy review tip: Before binding, have your counsel mark up the policy against the purchase agreement. Misalignments between the definition of loss in the PA and the definition in the policy are the most common source of post-closing coverage disputes.
How Premium Is Priced
Insurance carriers evaluate several factors when pricing an RWI policy. Understanding them helps you structure a deal that qualifies for better rates.
- Industry: Software and services tend to price lowest. Healthcare, financial services, and heavy industry price higher due to regulatory and operational risk.
- Quality of due diligence: The better the buyer's diligence, the lower the premium. Third-party Quality of Earnings reports and legal due diligence are expected on any deal above $10 million.
- Deal size: Larger deals generally have lower premium rates as a percentage of the policy limit.
- Structure: Stock deals, asset deals, and mergers are priced differently due to the underlying legal risk.
- Jurisdiction: US domestic deals price differently than cross-border transactions.
Key Takeaways
- Representations and warranties are the seller's statements of fact in the purchase agreement. A breach happens any time those statements turn out to be inaccurate.
- Most breaches are unintentional. Insurance is designed for exactly those situations.
- RWI typically covers 10 percent of enterprise value, with a 1 percent retention.
- Tax liability and contingent liability insurance address risks that RWI specifically excludes.
- Premium pricing depends on industry, due diligence quality, deal size, structure, and jurisdiction.
Frequently Asked Questions
What is the difference between a representation and a warranty?
Technically a representation is a statement of fact and a warranty is a promise that the fact is true. In modern purchase agreements they are used together and treated as a single concept.
Does RWI cover everything in the purchase agreement?
No. RWI covers breaches of representations and warranties but not breaches of covenants, purchase price adjustments, or known issues that were specifically disclosed.
What are fundamental representations?
These are core representations about the seller's authority to sell, the ownership of the company, the capitalization structure, and tax status. They are typically covered for six years rather than three.
What does retention mean in an RWI policy?
Retention is the deductible. It is the amount of loss the insured absorbs before the policy begins to pay. Retention is usually 1 percent of enterprise value for year one, dropping to 0.5 percent thereafter.
Is RWI the same as directors and officers insurance?
No. D&O insurance protects directors and officers from lawsuits alleging breach of fiduciary duty. RWI protects parties in an M&A transaction from breaches of representations and warranties in the purchase agreement.
Can a policy be purchased after closing?
No. The policy must be bound at or before closing. You cannot buy insurance for a deal that has already closed.
Yesterday (Day 1): The insurance mistake that can kill your M&A deal.
Tomorrow (Day 3): Why buyers need RWI even when the seller seems trustworthy. We will cover the five most common post-closing surprises buyers face and how insurance turns a dispute into a simple claim.