Key M&A Due Diligence in Today’s Insurance Market

By Paul Zederbaum, Senior VP, Practice Leader, Private Equity Risk Advisors (PERA)

In the ever-evolving landscape of the property and casualty insurance market, mergers and acquisitions (M&A) bring both opportunities and challenges that demand a meticulous approach to due diligence. As insurance professionals in this dynamic space, understanding the nuanced focus areas for due diligence is paramount to navigating the complexities of valuation, risk exposure, and policy alignment.

Whether evaluating property or casualty aspects of an acquisition target, this article provides valuable insights into safeguarding interests and ensuring a robust risk management strategy that helps to maximize enterprise value.

Valuation

Inflation has driven up construction costs to replace buildings, as well as the cost of new machinery and equipment. Underwriters, whose policies provide for “replacement cost” coverage, expect reported values to be current and accurate. These values are the basis for calculating premium, however, and can therefore drive a proportionate increase in insurance costs. Certain policies can also contain “coinsurance” penalties if reported values by the insured are inadequate.

Property Engineering/Safety

In a hard market, underwriters seek the comfort of “highly protected” occupancies. Older buildings that lack adequate fire protection (i.e., sprinklers) will face tougher scrutiny, restrictive terms and conditions, and higher premiums.

Named Insured Language

Often accompanied by the creation of new entities/holding companies and other organizational structure changes, M&A can create unintended gaps in coverage if the Named Insured language in the policy does not align with the go-forward structure. Lenders will also likely have specific requirements for “Additional Insured” and “Loss Payee” status.

Concentration of CAT-exposed Locations

While geographic diversification is typically more attractive to underwriters, sometimes a company’s locations are concentrated in areas that are disproportionately exposed to natural catastrophes (i.e., Atlantic/Gulf Coast and Named Wind or California and Earthquake/Wildfire). CAT Modeling can help set expectations on probable maximum loss (PML) amounts if a large-scale event were to take place.

Collateral

When an insured retains a portion of the risk through a large deductible, the insurer will often require collateral (typically in the form of a Letter of Credit). Depending on the life cycle of the casualty program, this could continue to increase over several years until full maturity. Rollups or other fast-growing assets could have a material impact to the amount of collateral held.

Umbrella Limits

As the potential for claim severity increases, procuring umbrella limits that adequately protect against catastrophic losses will be tremendously important for the company’s financials. A partially uninsured loss of significant magnitude can trigger non-compliance of debt covenants, negatively impact EBITDA, or worse. Benchmarking, claim scenarios, and a review of limit availability in the market are all key components of the due diligence process.

Risk Control/Safety and Claims Management

Loss prevention is often the best way to directly and indirectly minimize insurance expense. A strong safety culture, along with the necessary processes and procedures to ensure that employees and customers avoid or minimize injuries as much as possible, is often missing in target companies. This is especially important as sellers often prioritize short-term initiatives that help maximize their enterprise value in advance of a transaction at the expense of sound long-term risk management strategies.

In a time where multiple obstacles to deal-making persist, the importance of astute due diligence cannot be overstated when an acquisition opportunity arises. The key focus areas outlined in this article, ranging from property valuation intricacies to casualty risk control measures, serve as a compass for navigating the multifaceted challenges inherent in M&A transactions. By proactively addressing these concerns, insurance professionals can not only mitigate potential risks, but also optimize their strategic positions in a rapidly evolving market.

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