Considerations for Claims Made Errors and Omissions Insurance as Part of Mergers and Acquisitions

The growth in acquisitions and divestitures raises unique considerations for the transfer of liabilities and the need to adequately structure appropriate insurance programs to transfer these risks, particularly in today’s economy.



Organic growth may not be feasible; many companies see acquisitions as the only way to provide growth, and divestitures as the sole solution to exit unwanted assets. Additionally, an acquisition may provide the fastest and least expensive method to fill a gap in a company’s technology or product line. 

Under claims made insurance programs, the policy in force on the day of the lawsuit or claim responds rather than the insurance policy that was in force the day of the incident or occurrence. Issues may arise, however, if a policy is cancelled upon an acquisition or divestiture and a lawsuit is brought in the future (e.g., one year later). Similarly, asset only transactions where liabilities are not passed to an acquiring company may raise concerns as well.

Unfortunately, these issues are often an afterthought, particularly for professional service firms with respect to professional liability/errors and omissions (E&O) insurance coverage. Typically, the acquiring company provides E&O coverage for claims arising out of acts that occur after the transaction date. However, the acquirer’s insurance policy will likely exclude coverage for the target/acquired company’s acts that took place prior to the merger or acquisition.

The traditional method of dealing with these liabilities was to purchase an extended reporting period endorsement or policy. In recent years, however, the trend has been to incorporate the prior acts into the acquiring company’s policy(ies). In these situations, the acquiring company should weigh the advantages and disadvantages of adding the liability for past acts of the target company to its insurance program or purchasing an extended reporting period.



A third option is to leave the liabilities uninsured. However, most professional services companies have contracts in place that require that coverage be maintained for a certain time period after the contract period. The following analysis examines E&O insurance options for insureds that accommodate for mergers and acquisitions activity.

Option #1: Extended Reporting Period

Extended reporting periods are also known as tail coverage, run-off, or discovery periods. Most claims made policies automatically convert to run-off as of the date of a change in control and run to the end of the natural policy period.



As is the case with the automatic run-off  period, purchase of an extended reporting period endorsement or policy provides insurance coverage for claims made during such period that arise out of wrongful acts that occurred prior to the effective date of a change in control. In other words, this is a form of prior acts coverage.



To reiterate, this tail coverage/extended reporting period does not extend the policy term for new acts; it simply provides more time to report claims arising from past acts. If an endorsement to the existing policy is purchased then the limit of liability is not increased; it merely extends the existing policy limit of liability through the run-off period. An extended reporting period endorsement should be purchased from the existing insurer while an extended reporting period policy can be negotiated with either the existing insurer or a new insurer.

Advantages

  • This approach provides dedicated limits of liability for each entity. Claims against the acquired company for acts occurring prior to the acquisition do not erode coverage for the acquiring entity from its own E&O policy.
  • The coverage provided under an extended reporting period endorsement for acts occurring prior to the acquisition will not change from the original policy terms. (If an extended reporting period policy is purchased from a new insurer the terms of that policy must be negotiated.)
  • The timing of the policy period and the terms and conditions can be matched to existing customer contract requirements.
  • The acquiring company can separate its claims history from that of the target company. A poor claims history for the acquired entity does not tarnish that of the acquiring company for actions that were not under its control.


Disadvantages

  • This option is likely more expensive.
  • Extended reporting periods are pre paid and non cancelable.
  • The program will provide a limited time to report claims—generally three to six years. Thought needs to be given at the end of this period to review the need to purchase an additional period of time in which to report claims.
  • The acquiring company has less control over insurance policy terms and conditions.
  • Depending on the jurisdiction, this policy may not be assignable to the acquiring entity. This limits the company’s ability to manage claims and to receive insurance proceeds.
  • There is potential for insurance coverage disputes between the run-off insurer and the acquirer’s insurer for pre-existing service contracts that go beyond the acquisition date.
  • If the seller’s policy limit is already impaired by reports or paid claims this reduces the limit available for the run-off coverage if the extended reporting period endorsement is purchased.

 

Option #2: Add coverage for the prior acts of the acquired company to the acquiring company’s E&O insurance program

Advantages

  • Pricing for this option is generally less expensive than purchasing an extended reporting period endorsement or policy as the two companies (the acquirer and the acquired) now share one limit of liability.
  • The acquiring company has confidence in the terms and conditions of the program as it is their program.
  • The same insurer and policy(ies) will be utilized for claims against either company, which eliminates the potential for disputes between two insurers at the time of a claim. This is especially important if there are pre-existing projects or service contracts that span the two ownership periods.
  • The coverage is not limited to a three to six year period to report claims. Coverage for the prior acts of the target company is maintained for as long as the acquiring company’s E&O program remains in place and includes prior acts coverage.


Disadvantages

  • When adding prior acts coverage for a target entity on a midterm basis, the insured does not have a strong negotiating position as they cannot move their policy to a new insurer until renewal. However, it may be possible at renewal time to negotiate out or reduce the additional premium.
  • The prior acts/retroactive date for the newly acquired entity will be separately endorsed from that of the master program. This will need to be carried forward indefinitely on subsequent policies or negotiated out of the policy.
  • The companies will share a limit of liability, potentially eroding the limit of liability for the acquiring company due to claims made against the target entity. The adequacy of limit of liability for the combined programs should be reviewed.
  • If the retention for the larger, acquiring entity is higher than that of the smaller, acquired entity, the acquired entity may have to retain additional risk.
  • If there is significant time left until the natural expiration of the target company’s insurance policy, it may go into automatic run-off. Duplicative or double coverage and the “other insurance” clause may apply during that time period so as to avoid a windfall to the insured.
  • Insurers may not offer this option for some industries or transactions.


Option #3: When acquiring a subsidiary or division of another company, past acts will be covered by the seller’s E&O policy

If the entity being acquired is only a part of the selling company—such as a subsidiary or division—the seller’s E&O policy will likely continue to cover any acts that occurred while the divested operations were owned by the seller. Therefore, the acquiring company can add the newly acquired operations to their policy for acts occurring after the acquisition date and rely upon the seller’s insurance program to cover the acts occurring prior to the acquisition.

Advantages

  • Claims against the acquired entity for acts occurring prior to acquisition do not erode the limits of liability available for the acquiring entity.
  • The terms of coverage for acts occurring prior to the acquisition will remain unchanged unless the seller changes the terms of their policy.
  • The acquiring company can separate their claims history from that of the target entity. A poor claims history for the target entity may not tarnish that of the acquiring company for actions that were not under its control.
  • The additional premium for adding the acquired operations will be less than if prior acts coverage is included since past acts coverage is not required.
  • Coverage for the prior acts of the acquired entity remains as long as the seller’s E&O policy is maintained rather than being limited to the duration of an extended reporting period endorsement or policy.


Disadvantages

  • The acquiring company has no control over policy terms and conditions of the seller’s insurance program.
  • The prior acts/retroactive date for the newly acquired entity will be separately endorsed from that of the master program. This will need to be carried forward indefinitely on subsequent policies or negotiated out of the policy.
  • If the purchaser acquired the liabilities of the target operations along with the assets, then the insurance will not be aligned since the liability will be the responsibility of the acquirer while the past acts insurance is in the seller’s policy.
  • There is a potential for insurance coverage disputes between the seller’s insurer and the acquirer’s insurer for pre-existing service contracts that go beyond the acquisition date.
 

Marsh recommends that clients explore all available options to find a solution that best fits their risk transfer needs early in the acquisition negotiation process in order to achieve the most appropriate program terms and conditions. Please contact your local Marsh representative or the following E&O experts to discuss this topic in more detail.