Insurance sector M&A transaction insights

Many insurance companies know that maintaining the status quo is not a recipe for sustainable growth. The many threats and opportunities to the sector include market disruption from new competitors as new technology is delivering unprecedented insights at scale thus creating new markets, customer value propositions and sources of capital. The continued low interest environment, volatility in underwriting losses and premium competition also contribute significant pressure on profitability. Many owner managed insurance companies are also facing succession challenges.

Insurance sector consolidators know they have a window of opportunity to innovate and transform their organisations to achieve sustainable future competitive advantage and that organic growth alone is not sufficient. This realisation is at the root of the high level of M&A activity in the sector.

The Corporate team at FSP has extensive experience of acting for both insurance company buyers and sellers. This article sets out some of the nuances and considerations that are particular to share and asset sale transactions in the insurance sector.

Regulatory considerations

The insurance sector is heavily regulated including by the Financial Conduct Authority and the Prudential Regulatory Authority.

A buyer will typically seek to mitigate any regulatory risk by insisting on the seller giving it a full suite of warranties relating to the company / business’ regulatory compliance up to completion of the sale. Warranties can include having all necessary regulatory consents, complying with all applicable laws and regulations, the proper holding of client and risk transfer cash, a clean inspection history and not having mis-sold any policies. Buyers may want the seller to provide these warranties on “an indemnity basis” as it can provide them with better £ for £ recovery than being compensated on a “common law basis” in damages for breach of warranty. Buyers may also want to include specific indemnities to cover any regulatory compliance issues identified during due diligence.  The allocation of pre-completion regulatory risk is often the focus of negotiation and can impact on the final transaction. For that reason, regulatory warranties and indemnities need to be carefully considered by both parties when progressing the purchase agreement.

Those that wish to acquire or increase control of an FCA firm must first obtain the approval of the FCA. Failure to comply risks criminal sanctions. The timeline for preparing the application and obtaining FCA approval will need to be factored into the acquisition process as the FCA can take up to 60 working days to assess any change of control application and if they query anything in the application that stops the clock on the 60 working day period.

Price considerations

Whilst not specific to the insurance sector, the purchase price structure will usually include an “earn-out” element where a proportion of the price depends on how the acquired policyholder book of business performs for a period of time, typically one or two years, from the acquisition date, against an agreed performance metric. For example, retained commission income (RCI) if the company / business being acquired is an insurance broker. Buyers favour this approach as it helps to partly de-risk the transaction should some of the policyholders not renew their policies with the buyer after completion and, by doing so, ensures it is not overpaying on the future performance of that policy book.

How much of the purchase price is paid on completion of the acquisition and thus the amount of the earn out element, largely depends on how many potential bidders are competing for the company/business. The upfront completion amount is typically between 50 – 80% of the purchase price. That price is often capped to a specific amount which, for the seller’s benefit, may include a “growth element” to reflect additional RCI secured during the earn out period from existing and new clients.

In drafting the earn-out arrangements, great care will need to be given to defining the performance metric and how it will be calculated – so there are no surprises for either party. Relevant considerations for RCI include:

• Is it just the RCI from the existing clients of the business at completion or does it also include new clients acquired during the earn out period?
• If new clients are to be included, should they be limited to those secured by existing employees of the acquired business at completion and their direct replacements or is the new client “net” to be spread wider than that?
• What commission rates are to be used? Are they the historical commission rates that applied to the business and, if so, are they calculated by reference to an average of all the commission rates received by the seller over a period prior to completion or by reference to specific rates on specific products sold?
• Are payaways, discounts, over-riders, premium finance income or similar “non-core” income streams to be factored in or ignored?

Transfer of renewal rights

For regulatory and due diligence reasons, the purchase of an insurance broker’s policy book may be structured as a transfer of “renewal rights” where the buyer acquires the exclusive right from acquisition to broker the renewal of those policies that are in place at and were brokered by the seller before completion.

Buyers may want a split exchange and completion. For example, so they can control the renewal communications with policyholders whose policies are due for renewal shortly after completion, allow time to carry out the necessary consultations with any transferring employees or have certainty that key insurer binder agreements will transfer to them on completion. A split exchange and completion will inevitably give rise to what termination rights the buyer should have before completion if anything materially adverse were to happen to the business during the interim period.

The terms of the ongoing relationship between the seller and buyer post exchange / completion as regards the policy renewal process will need to be carefully considered and documented.  This may take the form of a transitional services and data sharing agreement outlining what services, policyholder data and IT access the seller and buyer will provide the other during the policy renewal period to best manage the policy renewal process.

Run Off PI insurance

Professional indemnity (PI) insurance is designed to protect business owners if clients claim a service is inadequate by covering any damages awarded plus legal costs and expenses. Whether a buyer’s existing PI insurance will cover the historical services provided by the seller on a “claims made” basis or it requires the seller to pay for run off PI cover for a number of years post completion (usually between 2 – 6) may depend on whether the transaction is an asset or share sale and the small print of the buyer’s existing insurance arrangements. As with much of the PI market, the premium cost for PI run off cover in the insurance sector has been increasing significantly in recent years so this and the availability of suitable cover should be factored into the transaction at an early stage.

If you have any questions about the contents of this article, or corporate transactions more generally, please contact Philip Stephenson and if you are interested in seeing the full extent of our insurance sector transactional expertise, please refer to the deal announcements section of our website.