PART 2: Diligence and Coverage

Introduction

One of the foundational assumptions underlying representations and warranties insurance (“RWI”) is that the buyer has conducted a reasonable diligence process prior to closing.  Although RWI is designed to transfer certain post-closing risks to an insurer, it is not intended to replace diligence or insure against risks that were insufficiently investigated.

As a result, the quality and scope of diligence frequently play a central role in both underwriting and claims handling.  In practice, insurers often evaluate not only whether diligence occurred, but also how it was conducted, what issues were identified, and whether any gaps existed in the review process.

Understanding that dynamic is increasingly important as RWI is a standard feature of most middle-market transactions.  Buyers and deal teams that approach diligence with coverage considerations in mind are often better positioned to avoid disputes later in the claims process.

Diligence as a Cornerstone of Underwriting

During underwriting of RWI policies, insurers typically review the buyer’s diligence materials across key risk areas, including financial, legal, tax, cybersecurity, compliance, labor and employment, environmental, and operational diligence.  Although insurers will not necessarily look to confirm that diligence was exhaustive in every respect, they will commonly inquire into the buyer’s investigation of the target business and may focus on any known concerns unearthed during the buyer’s diligence.

Importantly, insurers generally underwrite to the diligence performed.  Where diligence is robust and well-documented, underwriters may be more comfortable providing broader coverage.  Conversely, where diligence is limited, incomplete, or heavily qualified, insurers may seek to narrow their otherwise broad coverage through exclusions, sublimits, restricted coverage of particular representations, or targeted purchase agreement revisions.

This interplay between the scope of diligence and the breadth of representations is particularly important in competitive or accelerated deal processes, where diligence timelines may be compressed.  In those situations, insurers may look closely at whether key risk areas were reasonably addressed and whether unresolved issues were appropriately identified and analyzed.  Areas of diligence that remain open at closing may be excluded.  In some instances, however, the buyer can seek a conditional exclusion that will be removed post-close once that diligence is completed.  Examples of conditional exclusions that can be addressed and removed upon post-close clean diligence include conducting inventory counts, obtaining title surveys or title insurance, and completing new I-9s.

How Diligence Gaps Can Impact Coverage

One of the most common sources of post-closing coverage disputes involves alleged gaps in diligence.  In the claims context, insurers may argue that certain issues were either known prior to closing or could have been identified through a reasonable diligence process.

Similarly, diligence reports that contain significant assumptions, caveats, or unresolved questions may become focal points in a coverage dispute following closing.

This issue can arise in a variety of contexts, including:

  • financial statement and accounting matters;
  • cybersecurity and privacy compliance issues;
  • tax exposures;
  • regulatory or licensing concerns; and
  • customer concentration or contractual risks.

In some cases, an insurer may argue that a particular risk was sufficiently “known” at closing to fall outside coverage.  In others, the insurer may attempt to rely on policy exclusions tied to diligence findings or argue that the underlying issue was effectively disclosed during underwriting.

As discussed in Part 1 of this series, these disputes often reflect the difference between how diligence issues are evaluated during underwriting and how they may later be analyzed in an adversarial claims environment.

The Importance of Coordination During the Deal Process

Because diligence can factor prominently into the positions that an insurer may take in the face of a claim, coordination between deal counsel, diligence teams, brokers, and insurance recovery counsel can be particularly valuable during the underwriting process.

For example, where diligence identifies a potential issue, the manner in which that issue is framed and addressed during underwriting may materially affect whether the insurer seeks a broad exclusion, a narrower targeted exclusion, or no exclusion at all.  Similarly, documenting the scope of diligence performed—and any remediation or follow-up efforts undertaken—can become important if questions later arise regarding the parties’ knowledge at signing.

This coordination can also help avoid situations where diligence findings, purchase agreement disclosures, and policy language evolve on separate tracks without full alignment.  Even where those issues do not create immediate concerns during placement, they can become significant in the event of a post-closing claim.

Practical Considerations for Buyers and Deal Teams

As RWI usage continues to grow, buyers and deal professionals are increasingly viewing diligence not only as a transactional exercise, but also as an exercise that bears directly on RWI coverage.

Some practical considerations include:

  • ensuring that key risk areas are meaningfully addressed during diligence;
  • documenting follow-up efforts relating to identified issues;
  • carefully evaluating assumptions or limitations contained in diligence reports;
  • considering how diligence findings may interact with proposed exclusions; and
  • coordinating early across transaction, broker, and insurance teams where significant issues arise.

Importantly, none of these considerations necessarily require “perfect” diligence.  Rather, the goal is to create a clear and well-supported underwriting record that appropriately addresses material risks and reduces uncertainty in the event of a later claim.

Conclusion

As RWI has matured, diligence has become increasingly central to both pre-closing underwriting and post-closing claims outcomes.  Although insurers routinely provide coverage in fast-moving and highly competitive deal environments, the scope and quality of diligence often become critical reference points once a claim arises.

For buyers and deal professionals, the key takeaway is that diligence serves not only a transactional function, but also an important insurance coverage function.  Approaching the underwriting process with that perspective can help minimize disputes, improve alignment across workstreams, and better position parties in the event of a post-closing claim.

This Series

This post is part of a series examining practical issues that arise in representations and warranties insurance, including:

  • key policy terms and common coverage pitfalls;
  • the interaction between RWI policies and purchase agreement remedies;
  • common post-closing claim scenarios;
  • the realities of pursuing recovery under RWI policies; and
  • allocation and “no double recovery” issues in the claims process.

Check out Part I in this series.