Answering the most frequently asked questions on Warranty & Indemnity insurance, and explaining how it can help both the buyer & seller get their M&A deal across the line.
1. What is W&I insurance?
In an M&A transaction, warranty and indemnity insurance (‘W&I insurance’) provides cover for losses suffered in connection with warranty or indemnity claims. The policy of insurance can either be taken out by the seller or the buyer.
Under a seller policy, the buyer claims against the seller under a sale and purchase agreement ('SPA') in the normal way and has no direct claim against the insurance. The seller remains liable to the buyer under the claim, but the insurer will control any defence or settlement of the claim.
Under a buyer policy, the buyer typically claims against the seller up to the agreed cap under the SPA, and then claims against the insurance for liability above the cap (the cap is negotiated between the buyer and the seller, and could be as low as £1 on certain transactions).
2. Why insure?
W&I insurance can provide the following benefits:
- Clean exit for seller: The seller may be unwilling or unable to give warranties under an SPA – this may be as a matter of policy, because it wants to make an immediate distribution of the sale proceeds, or because there is no value in the transaction for the seller (typical users of the product being private equity or other institutional sellers, or a seller in a distressed sale situation). W&I insurance offers a buyer the comfort of a warranty package, while giving the seller the benefit of a clean exit.
- Bridging the gap: In some cases, the seller may be prepared to give warranties, but want to cap its liability at a level the buyer isn’t comfortable with. In this situation, W&I insurance can be taken out to increase the overall cover available for the buyer.
- Covenant strength: The covenant strength of a seller or warrantor can be a major concern for a buyer, especially if the seller is a special proposal vehicle (‘SPV’), a sovereign wealth fund, in financial difficulties or has little or no onshore assets.
- Unwillingness to sue the seller/warrantors: Certain deal dynamics may make it unattractive for a buyer to sue a seller or warrantor, e.g. where they have an ongoing management role or trading relationship. In this context, W&I insurance is helpful as liability sits with the insurers instead (however, insurers will generally require management warrantors to stand behind some warranties in order to keep them accountable).
3. What amount of cover can be obtained?
In theory, a buyer can usually get a policy which covers 100% of the purchase price paid under an SPA if it is willing to pay the premium. However, a buyer may well be comfortable with less cover and a reduced premium. For example, in the sale of a group which has mostly real estate backed assets, which may be considered less risky than a trading business a buyer may only seek cover equal to 10% of the enterprise value of the group.
4. What risks are excluded?
A W&I insurance policy will not cover:
- Known facts or matters identified by a buyer in due diligence or otherwise disclosed by a seller. However, increasingly (at the right price) insurers have been willing to underwrite specific policies insuring certain known facts or matters on a case-by-case basis if the risk is deemed to be acceptable by the insurer.
- Forward-looking warranties, such as the target company achieving post-completion profit goals.
- Certain tax matters e.g. transfer pricing and secondary tax liabilities.
- Civil or criminal fines or penalties that may not legally be insured against.
- Post-completion price adjustments and non-leakage covenants in locked-box deals.
- Certain categories of warranties, such as environmental warranties. If it is important for the buyer to obtain protection for these categories, it may need to brief, at an early stage of the transaction, specialist insurers who may be able to provide specialist cover.
Where there is a gap between signing and completion, insurers are generally prepared to cover matters arising during this period.
5. Who pays the premium?
Given it is the seller’s liability that is reduced, the cost of the premium is often borne by the seller, although this may be subject to negotiations if it is the buyer that is insisting on the policy. If this is agreed, the seller should, at the same time, cap the premium it is willing to fund to prevent a buyer seeking to obtain a ‘Rolls Royce’ policy at the seller’s expense. The seller will want to do this at an early stage, when the sale process remains competitive, and when it typically has greater bargaining power.
6. What premium and excess is normal?
In the current UK market, we are generally seeing premiums of between 1% and 1.5% of the insured value for sales involving trading businesses, and between 0.9% and 1.2% of the insured value for sales involving a property SPV. This is subject in each case to a market minimum premium of around £80,000, excluding any broker fees and applicable insurance premium tax.
We are also generally seeing excesses of between 0.5% and 1% of the insured value for sales involving trading businesses, and nil for sales involving a property SPV (in each case subject to a de minimus threshold).
7. What is the impact on due diligence and disclosure?
The use of W&I insurance is not a substitute for a thorough and complete due diligence and disclosure exercise. An insurer will expect that due diligence and disclosure, as well as negotiations regarding the warranties, are conducted between the buyer and seller at arms’ length and as though the deal did not involve W&I insurance. Any evidence to the contrary (e.g. a very limited due diligence report, a disclosure letter that is light on specific disclosures, or an SPA containing very extensive or un-negotiated warranties) may cause an insurer to refuse cover.
In any event, a seller will want a proper disclosure exercise to be undertaken because the insurer will usually retain:
- Subrogation rights against warrantors to the extent that liability under the policy arises from their fraud or dishonesty (see below); and
- Rights to pursue the policy holder in the event of fraudulent or dishonest statements.
Also, the buyer will want to diligence the transaction properly to deal with any potential issues upfront, rather than face the costs and uncertainties involved in making a claim after exchange or completion.
8. How is timing and process affected?
The insurer and its advisers will review the sale and purchase related documents and undertake due diligence in much the same way a buyer would. This additional review can be time consuming, and both the buyer and seller should build this into any transaction timetable and engage the insurer and its advisers at an early stage to allow time to negotiate an appropriate level of cover.
9. How long will the cover last?
Typically, the cover will match the claims period under the SPA; up to two years for general warranties and seven years for tax warranties.
10. What are some key drafting considerations?
The SPA and W&I insurance policy should be carefully reviewed and read together to ensure that there are no unexpected gaps in cover, and that any exclusions are carefully negotiated and drafted.
The following points may be relevant when negotiating the SPA and W&I insurance policy:
- The seller may want to link the maximum liability threshold of the seller under the SPA to the aggregate claims threshold under the W&I insurance policy. For example, if a policy will cover all losses above £200,000, the seller’s liability under the SPA should be capped at £200,000.
- An insurer may not cover every warranty given by the seller. If this is the case, the buyer may insist on the seller standing behind those warranties not covered by W&I insurance.
- Even if W&I insurance is used, any limitations of liability of the seller under the SPA should not apply in the event of fraud or dishonesty by the seller.
- If an insured party wants to assign the benefit of a W&I insurance policy (e.g. to a group company), this will need to be reflected in the policy drafting.
- A seller should insist that the right to subrogation against it should be waived by an insurer under any buyer-side W&I insurance policy. Otherwise, an insurer which has paid out money to an insured under a buyer-side policy may be entitled, as an equitable remedy, to step into the shoes of the insured and recover all or some of that money from the seller or warrantor.