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Warranty and indemnity insurance in corporate real estate

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Adam Bogdanor, Partner, Corporate Finance, explains what Warranty and Indemnity Insurance is, particularly for the Real Estate sector, why companies should be looking at this type of insurance and how the insurances are priced. He also explains how it all works as well as offering some practical tips for people looking to take out such a policy and understanding the latest developments. This short video explains all these things and much more.

 

Transcript

Interviewer: Adam, we’re here to discuss warranty and indemnity insurance. First of all what is it?

Adam: Buyers and sellers of significant real estate in the UK frequently buy and sell corporate vehicles rather than the real estate itself and the reason they do that is because stamp duty land tax is now 5% following the budget and it’s a significant tax to pay if you’re buying real estate. So real estate is frequently held in special purpose vehicle companies or unit trusts and therefore what buyers generally do is buy and sell the units in the unit trust or the shares in the company and therefore they don’t need to pay the 5% stamp duty land tax. If they’re buying shares in a UK company they will need to pay 0.5% stamp duty but that’s obviously much less than 5% and if they’re buying and selling shares in Luxembourg companies or Channel Islands companies they don’t need to pay any stamp duty at all.  Now warranty and indemnity insurance is there for cover by the buyers or sellers more often than not taken out by buyers and it covers them for the loss they would suffer if the warranties given by the sellers prove to be incorrect i.e. a breach of a warranty given by a seller or there’s a claim under the tax deal – tax covenant – and that’s basically a promise the sellers often give buyers that they will pay for any tax that the target vehicle suffers up to completion.

Interviewer: Why should someone be looking at this type of insurance?

Adam: Many sellers in the real estate sector are private equity funds and they are unable to take ongoing financial exposure to buyers in relation to warranties and tax deed claims.  Sometimes the fund needs to be wound up and often the seller itself will be a SPV vehicle and other than the property that it’s selling it will not have any assets with which to satisfy further claims. So it’s unable to offer buyers the financial covenants to back up potential warranty claims and tax claims.  Warranty insurance allows buyers to bridge that gap so buyers can claim against the warranty insurers and get a remedy that way if they have any warranty claims or tax deed claims rather than claim against the seller.  And it’s not uncommon in the real estate sector for sellers to have a £1 cap which means they give the warranties but they are actually not liable financially if there is a breach of warranty.

Interviewer: And how are the insurances priced?

Adam: Prices have actually been coming down so especially in the real estate sector you can generally find the pricing is around 1% of the cover sought.  Now the cover sought varies depending on the buyer’s appetite for risk but it’s not uncommon to maybe get 10% of the property value as the cover. What that means is that the premium would amount to 0.1% of the property value. The excess is also worth thinking about. It might be roughly of a similar order and the good thing about warranty and indemnity insurance policies is that the market does not expect buyers to face a deductible. By that I mean providing that the aggregate warranty and tax deed claims exceed the amount of the threshold or the excess it is possible to claim every penny from a warranty insurer providing of course the claim is valid in the first place. So there’s no need unlike your contents insurance policies for the policy holder to suffer the first loss.

Interviewer: So how does it all work?

Adam: The warranty insurance will cover the policy holder, normally the buyer, for loss suffered where they have a claim for breach of warranty. So instead of claiming against the seller they will simply claim against the insurers and the insurers will pay out if the warranty claim is valid as if they were the seller under the share purchase agreement for the breach of warranty or the tax deed claim. And the warranties will cover issues such as the corporates, title to the shares, litigation, tax and some limited property specific issues as well. In other words it will cover what you would normally expect the warranties to cover.

Interviewer: What practical tips would you give anyone looking at getting one?

Adam: I think it’s important to allow enough time for the process. Normally warranty insurers can work in a 5-10 working day period. So 1-2 weeks. The back clock only really starts when the warranties are substantially finalised so they’ve been negotiated and the due diligence reports are substantially finalised too. So the mistake you often make is they think that it can all be done in 1 or 2 weeks when there are all sorts of gaps in due diligence. The warranty insurers are not there to cover gaps in due diligence so really they want to see reports that are pretty well advanced before the underwriting process can really become advanced.

Interviewer: There have been some recent developments haven’t there on changes?

Adam: There have been indeed.  One of them is that warranty insurers, whilst they won’t cover specific facts and circumstances known about – for example if there’s pending litigation that everyone knows about they won’t cover that in a warranty insurance policy – they are nowadays prepared to cover known risks if they are sufficiently low risk and that’s something that never used to be the case. In fact you can get separate policies which can cover the low to medium risk items where they can’t necessarily be covered by the warranty insurance because they are known about and they are slightly higher risk but the warranty insurers can get themselves comfortable that they are less likely than 50%, so you can get separate insurance for that. That’s one of the things that can be done.  Also you can get so called synthetic warranty insurance policies which is where the insurers cover warranties as if they were given by the seller where the sellers aren’t prepared to give warranties at all even with a very low cap.  Now they traditionally have been given in the distressed M&A scenarios whereby there’s a target or a seller that’s in administration or an insolvency type process or in financial difficulties.  Nowadays it is possible, although it will cost more in terms of premium, to get that sort of policy where a seller or target are not distressed but they are simply not prepared to give any warranties at all.

Interviewer: Are there any other aspects to this insurance which you think are important?

Adam: I think probably it’s important to understand that many of the delays that occur are a result of gaps in due diligence particularly on financial and tax diligence. So it’s very important to make sure that the financial and tax diligence covers all the areas that a buyer would normally expect. It’s also worth saying that warranty insurance has become very, very common in the corporate real estate space when you’re buying and selling real estate for corporate vehicles and therefore buyers should be prepared for sellers to take a zero recourse position which would require the buyers to take out warranty insurance. I think lastly I would say that we have very strong relationships with the warranty insurance brokers and therefore do ask BLP early on in the transaction about warranty insurance and we can help you.

Interviewer: Adam, thank you very much.

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