Insurance-related risk management in private equity

There are many unanswered questions relating to September 11, and a large number of them relate to the economic and financial consequences of the catastrophe.

One of the industries that is going through a particularly intense period right now is insurance. Less than two months after the terrorist attacks on Washington and New York City, underwriters continue to be locked into debates on just how large their losses are going to be, and how they and their reinsurance providers are likely to react to them.

There is immense uncertainty, but a number of basic conclusions are relatively safely drawn. Practitioners have no doubt that going forward insurance coverage is going to be more expensive, that it will come with restrictions, and that less of it will be available in the marketplace. Real estate will find it particularly tough to secure cover, but it is across all sectors of industry that the repercussions will be felt.

The market had been hardening even prior to the attacks, as capacity dropped and underwriters struggled with balance sheet issues that made it difficult to take on new business. Now that situation has deteriorated still further.

Protecting earnings will be costly

The implications of recent developments for activity levels in the
M&A and buyout markets are likely to be far reaching. Insurance-related risk makes up a significant portion of the overall exposure that investors in corporate assets take on. It should come as no surprise that the use of specialist due diligence advisors has become widespread among financial buyers who are looking for ways to cut through the complexitites of issues that the insurance programmes of target companies often represent. Now these specialists are called upon to reassess these issues in light of radically different market conditions, a task that is particularly relevant for private equity.

Protecting the balance sheet is key for private equity investors and, as Nick Maher, Managing Director of Aon's Global Risks division, explains, 'the cost of purchasing limits private equity require is likely to be more expensive going forward”.

Due diligence specialists can help soften the impact of rising prices. Says Mark Roberts, Chairman of Aon Mergers and Acquisitions Group: “Private equity is under substantial pressure to create value under a very difficult set of circumstances. We feel that we can help make sure that perhaps not the entrepreneurial risks, but at least some of the more finite and calculable risks they are running are covered.”

Roberts says it is misleading to think of the relevant issues as mainly evolving around fixed assets. Investors will need to be certain that the management of a portfolio company can still be insured, and that its pension and benefits liabilities are covered. They will want to know how much protection is actually available, whether business interruption coverage can be purchased, and whether different rules will apply to different geographies.

They will also want to know about insurance-related expenditure. “Insurance pricing can well affect the decision of whether or not to go ahead with an investment”, Roberts knows, and at the moment this is more true than ever before. It is therefore a key task of his team to look for the parts of a company that are not sufficiently covered, as well as spot those that have excessive coverage.

Thereby the single most crucial factor is time. Historically, and owing to the highly confidential nature of the transaction process, due diligence advisors have had to do their jobs with scant information available to them, and to extremely tight deadlines. In the context of insurance-related risk management, practitioners believe, this is a practice that will almost certainly prove unsustainable from now on.

Buyers and sellers – who's responsible for insurance?

Nick Maher points out that after the terrorist attacks in September, the insurance market is no longer a competitive one, and underwriters will no longer take on new business simply for the sake of market share. Instead, they will take a highly selective approach, both to individual transactions and entire investment portfolios, ask tougher questions, require more information and take more time to assess the risks on the table.

“This means we will have to change the way we do business”, Maher insists, adding that private equity firms will find it tough to comply with the market’s demand for better quality information and more time for analysing risks. But comply they will have to, otherwise underwriters won’t hesitate to turn their backs on new business that would probably have been perfectly welcome as recently as August.

Despite the difficulties, Maher expects private equity firms to find a way to respond to the changed realities. He also believes that there may well be pressure on sellers of businesses as well to steer underwriters into a comfort zone: “Perhaps we need to look at who actually accepts responsibility for arranging insurance in the first place. The people with the information are the vendors.” If a sale is first initiated by the vendor, it is usually not difficult for them to make this information available on time. But if it is the buyer who makes the initial approach, things will always be more difficult.

So in finding a way of giving the insurance market enough time to become comfortable with a transaction lies a key challenge for the deal-making community and their advisers. Both Roberts and Maher expect the current climate to prevail for several months, possibly years. Says Roberts: “We don’t want to cry wolf and make the situation seem more disastrous than it is, but it is very hard at the moment.”

The key to adjusting to the situation is for insurance-related risk to be given the attention it requires, both pre-acquisition and then afterwards during the process of value creation that private equity firms typically go through.

AMAG is set up to work with clients throughout the entire process, across countries and regions, and this is where Roberts sees the firm adding value. “There is no point in making a red flag report highlighting areas that really do need addressing and then, after a deal is done, forgetting about the measures that have to be put in place. That is clearly a role that we have to fulfil, and that is why we like to partner our clients.”

The effort required to do the job is large but, if done properly, helps avoid major hits further down the line in the life of private equity backed companies.

This is a message that won’t be lost on the market. Given the current climate, the likelihood is that few buyout players will choose to go through an acquisition without consulting an insurance adviser early on in the process.