Contingent legal risks come in a broad and diverse variety of forms, but share the common theme that they must be risks that are capable of legal analysis and evaluation. They are often low probability but high severity risks which makes them well suited for an insurance solution as the prospective insured may be unwilling to bear that risk on its own balance sheet.
Contingent legal risks may, and often do, arise in the context of an M&A transaction but they may also be stand-alone risks with no connection to a deal. When used on a deal, Contingent Legal Risk Insurance (CLRI) may be used in conjunction with Representations and Warranties/Warranty and Indemnity Insurance (R&W/W&I) policies and are often used to cover a known risk that is excluded from cover under the R&W/W&I policy, which may otherwise block a deal if neither the buyer nor the seller is willing to bear that risk. The fundamental distinction between CLRI policies and R&W/W&I policies is that, like Tax Liability Insurance policies, CLRI policies cover known legal risks whereas R&W/W&I policies are designed to cover unknown risks.
2. What types of legal issues can be covered by CLRI policies?
Policies can be structured to cover loss incurred as a result of the crystallization of a legal, judicial, administrative, regulatory or legislative risk or an unexpected interpretation of a contractual provision or because a judgement or an arbitral award in favor of the insured has been overturned on appeal.
Some examples of the types of risks suitable for cover by CLRI policies are as follows:
- The risk of a regulatory body finding that a business has been operating without the necessary permits or licences (e.g. environmental, planning, building or health & safety) or that it has been operating in breach of their terms.
- The risk of a court judgement or an arbitral award being overturned on appeal requiring the claimant to return damages that it has been awarded at first instance.
- Legacy deal liabilities that could prevent the liquidation of a private equity fund and the return of capital to investors.
- Potential unsecured creditor claims that might make a security trustee unwilling to distribute insolvency proceeds to secured creditors following its asset realization process.
- The risk of a change in law or regulation adversely affecting a business’ future revenues.
- The risk and uncertainty flowing from counterparties’ differing interpretation of contract terms.
- Unforeseen creditor claims that might be made following the winding-up of an offshore fund structure and the return of residual proceeds to investors.
- The risk that a payment into a defined benefit pension scheme is triggered by the sale of one of the participating employing companies.
- The risk that a court or arbitral tribunal makes a much larger damages award than anticipated against the defendant, with the insurance being used as a stop-loss mechanism providing “catastrophe cover”.
Note that a common thread running through many of these examples is the use of CLRI policies to release cash from trapped or stagnant situations that then can be used by the insured in other parts of its business. In the current climate this is a key issue for many clients and has driven a significant growth in demand for CLRI policies over the past year.
3. What makes a contingent legal risk insurable?
A legal opinion from a law firm with expertise in the subject matter of the risk in question which: (i) sets out the factual background, (ii) analyses the applicable law and/or regulation, (iii) details the loss that may be suffered should the risk crystallize and (iv) reaches a clear and quantified conclusion as to the likelihood of the risk crystallizing. A risk is also much more likely to be suitable for a CLRI policy if the insured can demonstrate a clear commercial rationale for seeking to insure the risk (such as unlocking an impasse in deal negotiations). Finally, risks that are based on factual or commercial, as opposed to legal, issues are less likely to be suitable for cover under a CLRI policy.
4. How could Contingent Legal Risk Insurance help?
CLRI policies can be used in a number of ways, including: (i) to transfer legal risks that might otherwise prevent or adversely affect a range of transactions, including M&A deals, or which might result in one party bearing a greater exposure to that risk than they are commercially comfortable and (ii) to release cash that is otherwise trapped or held against a contingency by using insurance capital to replace that cash collateral.
Each CLRI policy is unique and tailored to the specific facts related to the legal risk to be insured. The Liberty GTS CLRI underwriting team will focus on the facts and commercial context that shape and inform the risk in question in order to provide bespoke policy coverage that meets our clients’ requirements.