As Premier Parks Inc. was preparing for its $1.85 billion acquisition of the Six Flags chain in 1998, a potential deal killer confronted it. Six Flags was insured against the cost of injuries suffered at its 13 U.S.-based theme parks, but retained the first $2 million of loss per injury — self- insurance that would create unknown latent costs for the conservative Premier. The challenge for the potential acquirer: assess the exposure and, if warranted, transfer it to a third party. “We wouldn’t have touched the deal without full knowledge of the hidden liabilities we were taking on,” says James Dannhauser, Premier’s CFO since 1995.
Premier, a New Yorkbased theme- park operator with 1998 revenues of $813 million, turned to its insurance broker, Aon Corp. After analyzing how much self-insurance might be drawn down in existing claims against Six Flags, Premier completed the purchase from Time Warner Co. and Boston Ventures on April 1, 1998, creating the world’s second-largest theme-park company. Premier and Aon then decided to transfer the risk to American International Group Inc. (AIG). “The hidden liabilities were exposed and removed,” Dannhauser says.
Relatively few acquiring companies face the possibility of a ferris- wheel or roller-coaster accident. Nonetheless, the popularity of insurance to mitigate the risks of unknown liabilities in a merger target seems to be growing sharply.
Many buyers are shy about discussing such coverage, of course, knowing that even having insurance may send signals that there are doubts about their targets. But AIG, the leading carrier in the field, acknowledges that it has racked up hundreds of millions of dollars in premium income so far this year from these lines, approaching 5 percent of its total premium income, and up from nothing two years ago. “We’re finding vibrant acceptance by clients for these products,” says Gregory Flood, president of AIG’s mergers-and- acquisitions division. And Aon estimates a third of its 159 private equity company clients employ the coverage in their acquisition strategies.
Five years ago, the merger-risk market was in its infancy, with few companies willing to tack on the additional cost of an insurance premium to the millions in shareholder dollars they were spending on acquisitions. Today, though, “people are paying ridiculous multiples for companies, at a time when their internal rate of return is dropping,” notes Neil Krauter, chairman and global practice leader of the M&A group at Aon, a Chicago-based insurance broker and risk-management consultant. So acquirers are having “to look with a microscopic eye at potential hidden liabilities,” he says. “We don’t get calls saying, ‘I’m concerned about paying the target’s $8 million insurance premiums. Can you lower that?’ We hear, instead, they’re freaking out about financing issues. Financing sources will charge more for the debt–or pass–when they feel they’re on the hook for hidden liabilities. Insurance resolves the financing issues that disable the deal.”
Besides AIG, major insurance markets for M&A risks are ACE Insurance, Chubb, Kemper Insurance, and Travelers Property Casualty. Deals typically are brokered by such firms as Aon, New Yorkbased Marsh & McLennan Cos., and London- based Willis, each of which has a separate consulting unit focused on the business. While not every company covers every risk, M&A insurance is available somewhere for a multitude of exposures, including environmental liabilities, securities class-action suits, seller representations and warranties, accrued balance-sheet liabilities, product recalls, and even a deal’s failure to qualify for an expected tax treatment.
“This is insurance as a business tool,” says Bryan Carey, CFO of Aearo Corp., an Indianapolis-based manufacturer of personal-protection equipment, such as respirators, goggles, and hard hats. Carey bought M&A risk insurance for Aearo’s 1995 management buyout from its former owner, Cabot Corp. “We make the type of equipment that is long- lived and, therefore, relatively uncertain as far as future liabilities,” he says. “Anyone who has used our respirators over the years and who later develops a respiratory illness might seek legal redress against us. This was a huge unknown.”
Most of the concerns were in the funding arena. “The management buyout was structured as an LBO [leveraged buyout], so we needed certainty in terms of cash flows” to obtain private equity funding, Carey notes. “We had to figure out what our future liability risks were and, once assessed, determine whether or not to transfer pieces of [the risks] to a third party. For us, this was the deal breaker.”
Aon, Aearo’s broker, “quantified our product risks using intense data collection and modeling to measure the economics of the various product liabilities,” says Carey. “What they discovered figured into the contractual negotiations between the buyer and the seller. Some product risks were deemed best for transfer, while others were handled contractually,” to be absorbed by the seller or the buyer, or shared.
“Bryan was deathly afraid that when 10 private equity firms descended upon him for due diligence, he wouldn’t be able to quantify the purchase price, because of the liabilities,” according to Aon’s Krauter. The LBO candidate hadn’t kept accurate records to allow a full review to take place, he says, so Aon performed a 20-year forensic study of Aearo’s claims. “We reconstructed how these would have run through a P&L if done properly, and then projected forward for the next five years how these would play out.”
Panic Over Pollution
Other companies seek insulation against the threat of environmental liabilities that may have originated decades ago. The United Co. routinely relies on insurance to help it transfer the environmental liabilities of companies it is either buying or shedding. The private, Bristol, Virginia-based company, with $351 million in 1998 revenues, is involved in a wide range of enterprises, including golf- course management, oil and gas, financial services, construction supply, and merchant banking. It recently sold a mining-supply division and bought a roofing-supply company, in both cases using insurance to transfer potential pollution exposures emanating from the businesses. “Our two owners, in their past lives, were insurance defense lawyers who know full well how future litigation can ruin an otherwise sound acquisition or divestiture,” says Thomas Griffin, The United’s vice president of risk management.
ECS Inc., an Exton, Pennsylvania, managing general underwriter, underwrote The United’s insurance, which was brokered by Atlanta-based insurer Charter Insurance & Consulting. “Before United could sell off its coal-mining operations, it needed a way to transfer any unknown, future claims that could arise from past pollution at these sites,” says Scott Britt, ECS vice president. “The buyer wanted to be assured it would not be liable for pollution caused by something The United did in the past.”
In the purchase of the roofing- supply company, The United wanted to guarantee that the target’s pollution liabilities would not cause financial stress down the line. So ECS put together a single insurance policy with Reliance National Insurance, transferring the pollution risks of both the divested coal operations and the acquired roofing company. The insurance provides $4 million in aggregate protection above a $50,000 deductible. “Courts are getting broader by the day on pollution liability,” Griffin says. “This kind of insurance takes away any uncertainty, making business transactions run smoothly.”
Insurance companies also may need to cover their own M&A risks. When ACE Ltd., in Bermuda, considered buying the property/casualty insurance division of Cigna Corp. last year, it had concerns over the Philadelphia-based company’s environmental, asbestos, tobacco, and lead-paint liabilities. Cigna had restructured in 1996, putting all its liabilities prior to that year in the control of Brandywine Holdings Corp., a company Cigna formed just for that purpose. The new company was given $4 billion in capital assets to administer and to pay off the uncertain liability claims, giving Cigna some breathing room to continue normal operations.
But when Cigna sought to sell its property/casualty business to ACE, the conservative 14-year-old insurer had trouble with Brandywine claims going “back into the dark ages,” says John Burville, ACE’s chief actuary, who reports to CFO Christopher Marshall. “We don’t like claims that have a long tail. Consequently, we wanted to buy some ‘sleep’ insurance that effectively got rid of this liability before we would undertake the acquisition.”
Enter Berkshire Hathaway Inc., Warren Buffett’s diversified insurance and financial services concern. ACE cut a complicated deal with Buffett calling for Berkshire Hathaway to assume $1.25 billion of Brandywine’s assets and liabilities in return for $2.5 billion in insurance coverage. “We gave them some asset-earning investment income to receive the sleep-easy coverage, while retaining a big block of reserves that earn interest for us,” Burville says.
Why Just Cross Fingers?
The breadth of items covered in the M&A-risk marketplace seems limited only by the imagination. Partners in mergers that eventually fall apart can even obtain insurance to pay the costs they incurred putting the deal together. “We represent Lloyd’s of London on what we call aborted-bid cost insurance, which provides coverage for a merger that fails because of things outside the parties’ control, like pressure from regulators or labor unions killing the deal,” says Patrick Tatro, president of TOI North America Inc., a Carson City, Nevada, managing general agency.
Not every company likes M&A-risk insurance. “It’s a product designed to accommodate bad business decisions,” argues Gary Nelson, vice president of risk management and legal administration at Medtronic Inc., a Minneapolis medical technology firm with $5 billion in anticipated fiscal-year 2000 revenues. Although a broker tried selling him on M&A insurance strategies for the five major acquisitions Medtronic completed in 1998 and 1999, Nelson passed on the offer. “Insurance should not be an excuse for not doing the risk manager’s job,” he says.
“I’ve been consulting on mergers, valuations, and acquisitions for 17 years, and I just don’t see the need for M&A insurance,” adds Steven Grove, owner and principal of S. Grove & Associates LLC, a Hamden, Connecticut, accounting and consulting firm. “It’s like getting married. You have to do the dating and courting before you walk down the aisle. Sure you can get a prenuptial, but what does that say about the partners’ confidence in the arrangement? Instead of buying insurance for bad decisions, why not just make the right decision?”
Aon’s Krauter, though, says M&A risk coverage provides the security to create partner confidence. “Given high merger failure rates and the horror stories of companies that have become unglued, it is imprudent to think due diligence alone provides all the answers,” Krauter says. “Why keep your fingers crossed over a potential partner’s unpredictable liabilities, when you can transfer them to a third party?”
That’s certainly the view at Premier Parks. Aon’s unearthing of the hidden liabilities and subsequent transfer of these exposures “gave us the comfort of knowing what we were taking on when we acquired Six Flags,” says CFO Dannhauser. “The element of surprise–the enemy of shareholders and Wall Street–was taken away.”
Insuring a Good Deal
Some merger-related policies that are gaining popularity
|Type of Coverage||Extent of Coverage||Policy Term||Premium||Policy Limits Available|
|Covering Direct M&A Risks:|
|Representations and Warranties Insurance||Designed to replace or reduce indemnification requirement under purchase-and-sale agreement||Up to seven years or statute||4% to 10% of the policy limit||$1 mill. to $200 mill.|
|Tax Opinion Liability Insurance||Designed to address potential liability resulting from an adverse tax ruling||Statue of limitations||5% to 10% of the policy limit||$1 mill. to $200 mill.|
|Aborted- Bid Cost Insurance||Designed to reimburse the company for external costs resulting from an aborted transaction||Must incept no later than 5 days after signing letter of intent; coverage typically runs 12 months||Average is 5% to 10% of the limit||$1 mill. to the $50 mill.; typically 1% of the transaction size|
|Envirocap||Designed to cover cost overruns from environmental remediation projects||One year or term of project, whichever is less||7% to 10% of estimated cleanup costs||$1 mill. to $100 mill.|
|Portfolio Transfers||Designed to assume a company’s entire portfolio of multiple liabilities (often casualty or product liabilities)||Immediate transfer of liability; aggregated||Varies||Varies|
|Covering M&A Financial Risks:|
|Litigation Liability Cap Coverage||Designed to cap liability associated with existing litigation||Determined through resolution of litigation||Varies||Varies|
|Litigation Risk Arbitrage||Designed to transfer the entire liability for the litigation to an insurance company for a one-time premium||Immediate transfer of liability||Agreed- upon valuation of claim and buffer||Varies|
|Litigation Retro Funding||Designed to provide the insured company an alternate method to finance a settlement||Multiyear policy||Settlement amount plus risk- transfer premium||Varies|