Key issues for buyers
Global | Publication | July 2015
W&I insurance has increased in popularity in recent years. This briefing considers W&I insurance from a buy-side perspective, including when W&I insurance coverage may be most relevant for buyers, as well as practical and legal issues relating to, and the process for arranging, a buyside W&I policy.
Warranty and indemnity (W&I) insurance provides cover for losses arising from a breach of a warranty and claims under a tax indemnity (and, in certain cases, other equivalent provisions) in connection with a corporate merger or acquisition (M&A) transaction. The warranties given in the sale and purchase agreement (SPA) play an important role in the transaction. Properly drafted, they aid the information gathering process and clarify the position of the target company by requiring disclosure of certain key characteristics and issues. Failure properly to disclose against warranties can result in large compensation claims enabling the purchaser to recover the diminished value of the company it has purchased.
W&l insurance has increased in popularity over the past 5-10 years. Initially viewed as too expensive and inflexible, it has developed an increasingly solution driven approach. Brokers and underwriters have recruited M&A specialists (including financial advisers and commercial lawyers) making product and policy negotiation more adaptable to deal requirements and more compatible with deal timelines. Initially found only in the UK, US and Australia, W&l insurance has developed an increasingly global reach, with a growing presence in Asia, Africa and the Middle East. The advent of the ‘buyside’ policy in recent years has provided greater certainty for buyers, and this has arguably resulted in an increase in the use of W&l insurance.
The warranties given in a SPA are often heavily negotiated and form one of the most contentious parts of a transaction. Under heavy negotiation and time pressure, there is always the risk that factual matters are overlooked during the disclosure process that could lead to a claim for breach of a warranty. There are a number of reasons why a buyer may seek to gain additional protection by taking out W&l insurance, these are explored further below.
Buy-side W&l insurance is particularly relevant where the buyer doubts the seller’s financial standing post-closing of the transaction, or the seller caps its exposure at a lower level or insists on a shorter claim period than the buyer is prepared to accept. Specific scenarios in which the buyer may seek coverage include where:
As with other insurance policies, careful consideration needs to be paid to the wording of the insurance contract, particularly the exclusions and conditions. W&l insurance aims to offer as close as possible to ‘back-to-back’ cover with the warranty language in the SPA. However, insurers will seek to exclude warranties and/or areas of risk that they do not deem appropriate for their policy. A list of some of the most notable exclusions is included in the FAQ section below. Not all exclusions are uniform across insurers and it is important for a buyer seeking a policy to look past the price being offered to ensure the areas they believe to be important are included in the policy that they choose. A buyer should ensure that the insurer has not carved out risks that are material to that transaction.
It is important that the prospective buyer understands that an insurance policy is not equivalent to a guarantee for a number of reasons.
First, W&l insurance will not offer complete protection against all costs that may be involved in bringing a claim under the policy. The buyer will initially need to show that the claim brought falls within the insurance coverage, and initial research costs and time issues (or, indeed, resolving any disagreement with insurers as to coverage) will not be covered by the policy. Most insurers include a de minimis (i.e. small claims) amount within the policy which corresponds to the equivalent provision in the SPA.
Second, there will be a policy attachment point before the policy takes effect. A party (typically the seller but sometimes the buyer) will be expected to bear some financial risk and therefore suffer some loss before the policy provides cover. The attachment point is not uniform across insurers and is a variable subject to negotiation and price, but the starting point is typically around one per cent of the transaction value as a rule of thumb.
The first tranche of risk (or ‘deductible’) is typically reflected in a seller escrow, designed to ensure the seller is focused on due diligence. The policy starts to pay once claims exceed the escrow. The effect is that the buyer has to ‘finance’ the deductible (unless the seller pays out) before the policy kicks in, and then recovers/refinances after that.
Finally, as with any commercial insurance policy, there is a duty on the insured (i.e. the buyer) to disclose all material facts to the insurer. Failure to do this could result in the policy being unenforceable.
There are a number of legal issues that should be addressed when considering buy-side insurance. W&l insurance is designed to cover unexpected issues that arise after a deal has completed; however, this assumes that the buyer has performed thorough due diligence (both financial and legal) into the target rather than relying on the policy it is considering buying (and that the seller has carried out a thorough disclosure exercise – it will help in this context if the seller has retained some ‘financial skin in the game’). Insurers will expect that there has been a balanced negotiated agreement and that the due diligence exercise has been robust and complete. Indications that the due diligence process has been skipped or over rushed could lead to a high premium, lowering the scope of the coverage or denial of a policy entirely.
Key indicators of a thorough disclosure process include:
Knowledge qualification of certain warranties given by the seller plays an important role in the scope of that warranty given. The insurer will expect that a number of warranties (such as pending or threatened litigation) are given such qualification. Warranties qualified by knowledge is a position favourable for the seller. This limits the warranty by reference to the knowledge of the seller at the time the warranty was given. It is important to review the definition of ‘Knowledge’ in the SPA as, depending on the negotiations between the parties, knowledge may include the knowledge that certain parties would have after ‘due and careful enquiry’. If such wording is present, a breach of such warranty could be argued if the seller feigns ignorance to circumstances that would have been clear if it had made such enquires.
Insurers will also be unwilling to provide coverage against circumstances that were within the buyer’s knowledge before it entered into the transaction. A buyer cannot therefore enter into a transaction knowing that there was an issue in respect of which it intended to bring a claim. The practical implication of this is that a buyer will never be able to bring a claim in relation to a matter which was disclosed by the seller, or which it discovers during the due diligence process.
An insurer will need to consider and review a number of things when deciding whether to provide a W&l policy for a transaction. One successful claim could result in a multi-million pound pay out and potentially wipe out the insurer’s book of premium. Most critically the insurer will need to understand: the transaction, the nature of the negotiations re the warranties and the thoroughness of the disclosure and due diligence exercise.
The insurer will typically achieve this by instructing external legal counsel to:
Ideally, the documents (most notably the SPA) will be in a final form prior to the instruction of counsel; however, if the transaction negotiations are still on-going, additional cost may be incurred by counsel having to review and comment on updated draft documents.
Counsel will typically prepare a report for the insurer, summarising its position on the warranties, the due diligence/disclosure exercise and any material areas of concern.
Following this report the insurer will host an underwriting call (typically between 1 hour – 2 hours) between all transaction advisers on the deal and other relevant parties (e.g. other insurers if there are multiple layers of insurance). The insurer will seek clarification from the buyer and buyer’s advisers as to how they got ‘comfortable’ with transaction issues that have been discovered. These explanations will aid the insurer in determining whether there are any further risks to the deal requiring additional policy wording and ultimately if the policy can be offered and issued.
Following negotiations on the policy wording, the insurer and the insured will execute the policy and give the date at which the insurer is ‘on-risk’ for any claims that are received. This risk period will end on the limitation time period of the SPA (or policy if different).
W&l insurance is paid via a premium, payable in full when the policy is taken out. Typically a premium is calculated as a percentage of the total limit of insurance coverage (known as the ‘rate on-line’) ranging from 1-3% (but the average of buy-side premium has recently tended to be around 1.3% including insurer’s and brokers’ costs). Factors which may affect the level of premium include: amount of excess, limitations on the warranties in the SPA, industry sector, geographic risk (for example Australia attracts lower rates than the US), identity and credit worthiness of the parties to the transaction, complexity of the transaction and competence of the transaction advisers.
Yes, although a policy is typically bought prior to completion to ensure that the risk is covered as soon as the transaction has occurred, a policy can be bought after completion. This is viewed favourably by insurers (assuming the risk is unknown and insurance is not being sought for something that has been discovered) as it indicates that the parties were happy to complete without the insurance ‘safety net’ and thus suggests that a full due diligence has taken place.
Yes, a main advantage of W&l insurance is that it can extend the warranty coverage period past the limitations set in the SPA. This may provide additional comfort to a buyer that is unable to negotiate a longer period of warranty coverage against the seller. Typically, insurers will be willing to provide coverage on fundamental warranties for a period of 7 years, general warranties between 2-5 years and tax warranties to the statutory time limit for such claims.
Insurers will work to tight deadlines in order to minimise the commercial impact of the transaction; however, from initial indicative offering to policy inception a minimum period of around 7 days is required and typically will be 2 to 3 weeks.
Insurers will not cover all of the warranties in the SPA (note, different insurers will exclude different risks). Typical warranties that insurers may not cover include: bribery and corruption, certain environmental issues, certain regulatory issues and financial warranties (including ‘leakage’) and pensions underfunding. In addition, the policy will not provide coverage for certain tax risks such as those resulting from transfer pricing arrangements.
If insurers are unwilling provide coverage it may, however, be possible to purchase additional specialist cover for such warranties.
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