Private Equity Insurance and Employee Benefits: M&A Due Diligence in Today's New Normal
Mergers and acquisitions (M&A) in the middle-market continue amid an impacted economy. It’s vital that during the M&A due diligence process, private equity firms examine not only the seller’s operational, legal, financial and accounting records but also its insurance program and employee benefits plan – and do so early on in the process. It’s also critical to look at insurance and benefits trends that may affect the deal. This enables buyers to properly determine the value of a potential new asset, uncover possible risks that can negatively impact a company’s EBITDA and protect against post-transaction liabilities.
The Property & Casualty Insurance Due Diligence Process in M&A
The Property & Casualty (P&C) due diligence process begins by working with an experienced M&A insurance broker, such as BKS Partners, to determine whether the company’s risks are appropriately insured, underinsured or not insured at all. In most instances, all the seller’s P&C insurance policies should be reviewed, which include Commercial General Liability, Commercial Property, Environmental Liability, Directors & Officers (D&O), Errors & Omissions (E&O), Cyber Liability, Crime, Excess Liability and any other policies the entity may have. It may also be helpful to request 3 – 5 years of loss runs for all policies, especially if the business could be subject to long-tail liabilities – claims for incidents that occurred decades ago, such as asbestos contamination.
Once all policies are received, there are several important issues to vet, including but not limited to, the following:
- whether the policies are in sync with the operation’s risk profile;
- the named insureds on the policies (for example, should any subsidiaries be covered?);
- additional insured status of the seller on third-party agreements;
- policy deductibles and retentions;
- the inclusion of policy “anti-assignment” or “change of control” clauses;
- relevant policy exclusions;
- claims history as well as any pending and potential claims that may erode policy limits in the future;
- retroactive premiums associated with a policy; and
- the availability of runoff or tail coverage to provide some coverage for pre-existing wrongful acts, for example, during the expired or canceled policy’s coverage period.
The program review will determine if any new additions and changes to the insurance program need to be implemented, depending on the merger or acquisition transaction structure and agreement language.
Take Today's Hard Insurance Market Into Account in Your Due Diligence
Knowledge of the state of today’s insurance market and the impact it may have moving forward is critical to understanding potential coverage gaps and how to bridge them. Today, the insurance market is characterized by higher insurance premiums, tighter underwriting guidelines, reduced appetite for risk and diminished capacity. This means that the current insurance costs of a business are likely not indicative of what they will be at the closing of an M&A deal. Any additional Management Liability policies that may need to be added at closing will likely also be hit by higher rates as well as narrowing of coverage, reduced sub-limits and increased retention. For example, D&O rates in Q3 2020 increased by an average of 11.5%, followed by Umbrella and Excess Liability, which are up by 8.5%. The hard insurance market has also been further strained by the coronavirus pandemic, which has resulted in insurers clarifying policies that have been “silent” on certain exposures and adding new exclusions. Some insurers for D&O coverage, for instance, have introduced insolvency exclusions and– in some circumstances – require buyers to sign warranty letters because of potential COVID-related lawsuits.
Employee Benefits Critical in Due Diligence
Regarding Employee Benefits programs, compliance or accounting issues are often overlooked in companies that are being acquired. The seller should be able to provide all the necessary documentation about its Employee Benefits, including its retirement plan, health and insurance documents, Form 5500s, procedures and policies, remittance schedules, contracts with service providers and more. The seller should also provide information about the Internal Revenue Service (IRS) and U.S. Department of Labor (DOL) audits or other examinations that may have occurred in the past three years. Reviewing these documents, can identify whether anything may negatively impact the company and determine a quick path to compliance before any transaction takes place.
Before the deal is finalized, the seller, for example, may need to follow the IRS’s correction program (the Employee Plans Compliance Resolution System) or the DOL’s correction program (the Voluntary Fiduciary Compliance Program). If a 401(k) is administered in-house, during the due diligence process, it’s suggested to take a close look at the timeliness of plan contributions. It is also important to research available investment options and whether any match or profit-sharing contribution was improperly calculated and allocated. An analysis of the scope of any plan failures in terms of cost and time to resolve.
The Rising Costs of Benefits
Indications are that Employee Benefits costs are likely to rise in 2021 due to continued care for COVID-19 patients and a return to delivering previously deferred non-COVID-19 care. In looking at a potential M&A deal, attention should be paid to the impact of COVID-19 on a seller’s health care spend and the benefits currently provided, and how these may shift moving forward. Another driving force behind rising employer-sponsored health plan costs is the dramatic increase in specialty prescriptions. Forecasts for Rx drug plan costs in 2021 are expected to exceed 7% annually, primarily driven by price increases for specialty drugs, which are projected to increase by 11.5% on an annual basis. During the due diligence process, a seller’s total Rx spend should be reviewed, including the costs of specialty drugs, to determine how to manage formularies and claims predeal closing.
What Can You Do?
Ensure that P&C insurance and Employee Benefits due diligence are part of the M&A process to protect against potential liabilities and to bolster the value of the asset under consideration. Involve a trusted insurance advisor early in the deal process, before any letter of intent is drawn, so that potential issues can be addressed during the Representations and Warranties Insurance (RWI) process. In obtaining an RWI policy, the insurer will want to review the seller’s insurance and Employee Benefits.