Warranty and Indemnity Insurance – A useful tool for merger and acquisition transactions
Key component for a merger and acquisition (M&A) transaction
Invariably, except in exceptional circumstances, when a company is sold its seller will be required to give warranties in favour of a buyer in respect of that company’s commercial and tax history. The terms of warranties and indemnities are usually heavily negotiated and subject to case specific seller disclosure (for the warranties) and limitations of a seller’s exposure to a buyer in respect of any breach of a warranty and/or an indemnity.
What is Warranty & Indemnity insurance?
Warranty and indemnity (W&I) insurance is the generic name for insurance which provides for losses arising from a breach of warranty and/or, in certain cases, under an indemnity. Historically, a seller would take a W&I policy and often limit exposure capped at policy proceeds assigned for the buyer.
Both seller and buyer will as a standard consider whether W&I insurance has a place in respect of a specific M&A transaction. Most W&I policies follow a similar approach to risk and cover and are usually tailored on a case specific basis. Usually a policy will be structured to indemnify either the warrantors, or the buyer. Much will turn on who is seeking the benefit of the policy. In our experience there is a current trend toward a buyer obtaining W&I insurance direct.
Marketplace for W&I
The number of insurance brokers and insurers has, in each case, been a relatively small number. As the insurance market has matured a degree of market driven competition has evolved and with it policy approaches have become more focussed resulting in them becoming more competitive and with affordable premiums increasingly available.
Warranty and Indemnity Enhancements
As competition for W&I has intensified this has led to what are termed W&I policy enhancements affording bespoke insurance solutions being widely available. In particular, this has resulted in the availability for insurers to provide cover for matters which were previously uninsurable or were uneconomical to insure.
Enhancements newly available over the last few years
‘Synthetic warranties’, so-called because they are provided by an insurer under the W&I policy and not the seller under the share purchase agreement, are negotiated and agreed directly between the purchaser and the W&I insurer.
A requirement for synthetic warranties can fill a gap where a seller is not prepared to give commercial warranties, for example trustees and executors selling the shareholding of a deceased shareholder. In our experience, the availability of synthetic warranties on a particular transaction will depend on many factors including the type of assets/target business, the size of the transaction, and the quality and extent of due diligence information available. Although a disclosure letter is not used to disclose against synthetic warranties, insurers will still want to see that a robust due diligence exercise is undertaken by the buyer and that the seller makes available a well populated data room.
Insuring tax risks
For many years an area of risk insurers were not open to was taxation matters. This aversion has largely fallen away with insurers now more open, subject to due diligence, to insure tax risks arising in M&A transactions. While some tax risks may often be excluded, for example exposure to transfer pricing risks or availability of capital allowances/tax losses, even these risks may be insurable on a case by case basis.
Using ‘contingent policies’ insurers may accept risk to address known areas of uncertainty in tax matters that have been identified as part of a buyer’s tax due diligence. This is in effect a specialty insurance market within W&I insurance to address particular tax risks in the context of M&A transactions.
If the background supports a seller not being prepared to provide a tax deed to the buyer as part of a sale process, for example where trustees and executors are the seller party, insurers may be prepared to provide a standard ‘synthetic tax deed’ against which the buyer would be entitled to claim.
Extension of warranty survival periods
W&I insurers can offer extensions to the warranty survival periods under the terms of a W&I policy, regardless of the warranty survival periods that are agreed in the SPA. This is useful where a seller has a known short life expectation and does not want his or her estate to be tied down by being open to claims for an extended period.
Knowledge or materiality scrapes
A common area of negotiation on terms between seller and buyer will arise where warranties are qualified by the awareness of the seller. Some insurers will consider offering what is know in the market as a ‘knowledge scrape’ of the warranties under the terms of the W&I policy; effectively such an arrangement will, in respect of the warranties, dis-apply the general knowledge qualifier in favour of the seller for the purposes of the warranties. Another insurance device to support a transaction could arise in respect of any qualification as to materiality in the warranties where insurers may offer a ‘materiality scrape’. In effect, with the support of insurance, the materiality of a matter is disregarded for the purposes of enabling the buyer to make a warranty claim against the insurer.
It is common for a W&I policy to have an ‘excess’ or ‘deductible’. The ‘deductible’ is usually set at a certain minimum value of insured losses which must be reached before the W&I policy is engaged. While not standard, for certain transactions where insurers may have acquired good experiences over time, for example in the energy and renewables sector, insurers may be willing to offer nil excess policies, entitling the insured party to claim on and from the ‘first £’ of any loss.
US-style indemnity basis for recovery
English law has a standard starting place that recovery for any claim is based on a standard contractual basis which requires loss to be established most often linked to an actual reduction in the value of the company acquired pursuant to a share purchase agreement. As a result of cross border experience with the US, some W&I policies will, if agreed, now feature an indemnity basis of recovery. In effect, rather than the standard contractual basis, allowing claims to pay out without the need to establish loss on a standard contractual basis. In such instances, this will mean that a buyer will be able to claim for losses on a £ for £ basis (including costs associated with the claim) without having to prove a reduction in the value of a company concerned.
Points to takeaway
With the availability of enhancements and different types of insurance products, buyers are now deploying W&I policies tactically to maximise their chances of success in M&A auction processes or to bridge any gaps in the cover that has been negotiated with a seller. As many mid market company sales (and sometimes smaller SME higher value transactions) involve a competitive auction process, buyers can now significantly differentiate their bids on terms other than value by using W&I products, with options for additional enhancements, to limit a seller’s residual liability in the M&A transaction documents.
It should be borne in mind that enhancements will generally have a cost implication for the policy premium payable and can increase the extent of due diligence required as some insurers may take a more conservative approach where policy enhancements are called for.
Given the developing practice for W&I, where a party is considering the use of a W&I policy, it is important to take the right advice on the most appropriate insurers to approach and on what policy enhancements and/or tailored insurance solutions might be available.