Warranty and indemnity (“W&I“)
insurance has, over the years, become a popular means used by
parties in M&A transactions to bridge the gap between the
desired level of warranty coverage from a buyer perspective, and
the level of exposure a seller is willing to assume in respect of
potential warranty claims on the sale of a company or business.
As the W&I market has developed, a European/US hybrid
approach to W&I policies has emerged, whereby insurers in
Europe are willing to apply enhancements to their European style
W&I policies to adopt certain of the more typical US styles and
approaches. In this article we explore some of those enhancements
and ‘hybrid’ approaches, provide an update as to how
W&I insurance is being used in M&A transactions and we look
at some recent market trends.
Why use W&I insurance?
Every M&A transaction involves a certain level of risk for
both buyer and seller. Buyers typically focus great efforts on the
completion of due diligence on a target business, by which they
will seek to identify potential risks and to negotiate solutions to
such risks with the seller prior to signing the transaction
documents. As part of this process, the parties will agree a set of
warranties (i.e. contractual statements about the state of the
business) as well as terms setting out how any claim against the
seller for breach of the warranties should be dealt with.
The purpose of W&I insurance is to bridge the gap between
the desired level of warranty coverage sought from the buyer, which
they will typically desire to be as extensive as possible, and the
scope of protection that the seller is willing to provide, which is
likely to be much more limited in nature, to reduce the likelihood
of being subject to warranty claims in future.
W&I insurance is a mechanism by which liability for any
breach of warranty or indemnity under the transaction documents can
be invoked against a W&I insurer, who steps into the shoes of
the seller by providing cover for loss incurred on a breach of a
seller warranty or indemnity. Use of W&I insurance therefore
allows a seller to have a “clean break” from the target
business, whilst providing deal protection to a buyer in respect of
any unexpected liabilities that arise post-closing of the
transaction.
Coverage under W&I insurance policies
The default position is that insurance cover will extend to all
warranties under the transaction documents, aiming to provide
‘back-to-back’ cover with the protections set out in the
sale and purchase agreement. Policies can, however, be tailored to
address transaction specific requirements. Coverage will usually
extend only to unknown issues in areas that have been the subject
of due diligence by the buyer, giving comfort to the insurer that
the buyer has investigated the state of the business prior to
putting W&I insurance in place.
Exclusions from coverage
A W&I insurance policy will include a number of exclusions
from coverage. Whilst the extent of such exclusions may differ from
transaction to transaction and will be impacted by matters such as
the level of diligence carried out by a buyer and the outcome of
that diligence process, market standard exclusions across industry
sectors include:
- known risks identified during the due diligence process;
- fraud or misrepresentation of the insured;
- pre-completion re-organisations;
- forward-looking warranties;
- secondary tax liability and transfer pricing;
- purchase price adjustments and/or leakage;
- condition and title to real estate assets;
- environmental matters;
- cyber risks;
- consequential losses; and
- other seller obligations such as non-compete obligations.
Whilst additional coverage for some of the above matters can be
sought from the insurer, such enhancements to a W&I policy are
likely to be provided for an increased premium.
Many insurers also offer separate specific insurance policies to
cover matters such as environmental or tax liabilities which are
excluded from a W&I insurance policy.
Pricing of W&I insurance policies
A W&I insurance policy will stipulate a maximum level of
cover that the insurer will provide in the event of a breach of
warranty or indemnity, the premium charged by the insurer for the
insurance (typically calculated as a percentage of the maximum
level of cover provided) and a ‘retention’ or
‘excess’ amount for which the insured party will be liable
before the insurance cover can be invoked.
Pricing will depend on the key features of the deal including
the industry or sector that the target operates in, the
jurisdiction of the target and the enterprise value of the target
business. Choice of policy limit (which will dictate the premium
amount to be paid) will also depend on the amount of risk that the
parties are willing to take.
Whilst the majority of W&I insurance policies in the market
are taken out by buyers, the responsibility for payment of the
policy premium is typically a matter for commercial negotiation
between the parties.
Market trends
Whilst initially most frequently used in private equity
transactions, W&I insurance has now become prevalent across the
entire M&A market. Having experienced a period of sustained
growth over a number of years, the rate of that growth appears to
have slowed over the course of the last 12 months. This downturn is
more likely reflective of a period of reduced deal flow, rather
than being indicative of attitudes towards W&I insurance
itself.
One area in which we have seen increased activity in the W&I
insurance market, is the use of W&I products to bridge the gap
between the market approach to transactions in Ireland and the
US.
The standard approach to policy coverage in Europe and the US
has tended to differ in the following key areas:
Disclosure
- European approach: the transaction data room,
as well as any due diligence reports are deemed to be disclosed
against the warranties given for the purposes of the W&I
policy, effectively putting the purchaser on notice of all the
matters contained therein and excluding the ability to claim for
such matters under the W&I insurance. - US approach: neither the data room nor due
diligence reports are deemed to be disclosed (though the No Claims
Declaration used in a US transaction will refer to such reports and
confirm that they have been read).
Materiality /
Knowledge
- European approach: provisions of the
transaction documents relating to materiality and/or knowledge of
the seller are taken into account and are considered relevant for
the purposes of coverage under the W&I policy. - US approach: materiality and/or knowledge
provisions may be disregarded by way of a ‘materiality
scrape’/’knowledge scrape’ in the W&I policy,
effectively meaning that the warranties are deemed to be given
without any materiality and/or knowledge references.
Basis of
Damages
- European approach: damages are typically
calculated by reference to how the breach of warranty has affected
the value of the target company’s shares. - US approach: an indemnity basis of calculating
damage is common, allowing recovery for loss incurred on a dollar
for dollar basis.
Warranties
- European approach: all warranties in the
relevant transaction documents are reviewed by the insurer and
specific exclusions/amendments to that suite of warranties are
negotiated, which may lead to certain warranties being covered only
partially or excluded entirely from the W&I cover. - US approach: individual warranties are not
typically reviewed and negotiated.
De Minimis
- European approach: the de minimis amount
specified in the purchase agreement will typically apply equally to
the W&I policy. - US approach: the policy does not typically
apply any de minimis amount.
Underwriting
Process
- European approach: an extensive diligence
exercise is undertaken with the insurer including providing written
responses to specific underwriting questions. - US approach: a much more limited process is
followed, which is typically managed solely by the buyer.
As the market has developed, a European/US hybrid approach to
W&I policies has emerged, whereby insurers in Europe are
willing to apply enhancements to their European style W&I
policies to adopt certain of the more typically US styles and
approaches. Such enhancements will often (though not always) result
in a higher policy premium and are typically presented to clients
as a menu of options from which certain desirable enhancements to a
European style policy can be chosen. This is considered
particularly attractive to US buyers of European entities, who want
their W&I policies to be in a form which reflects the style
more familiar to them in the US market and which typically provide
greater protection for a purchaser.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
