While the use of warranty and indemnity (W&I) insurance has become relatively commonplace in the U.S. and European M&A markets over the last decade or so, it has struggled to gain a meaningful foothold in ASEAN during the same period. However, recent deal flow suggests ASEAN is now catching up. In this client briefing, we take a look at what exactly W&I insurance is, the benefits it can provide, common exclusions under W&I policies, and the potential pitfalls to watch out for when using it. We also consider some of the drivers of the recent rise in the use of W&I insurance in the ASEAN region.
What is W&I insurance? In an M&A transaction, W&I insurance typically provides cover in respect of breaches of the warranties and indemnities in the sale and purchase agreement (SPA). Such a policy can be taken out by either the buyer or the seller.
If the W&I insurance is provided by way of a seller purchased policy the buyer will have no contact with the insurer and will make any claims against the seller directly. The seller will then make a claim under its insurance policy to the extent that the policy covers the claim.
In the case of a buyer purchased W&I policy, the buyer will make claims against the seller up to the amount of any agreed liquidity cap and then claim against the insurer for any amounts over the said cap (up to the amount of the cover limit which the policy provides). In limited circumstances, the buyer’s only recourse may be against the insurer under the W&I policy – for example, where the policy covers the full amount of any claim – although this is unusual.
Benefits of W&I insurance W&I insurance is used for a number of reasons including the following:
|Clean exit||One of the key attractions of W&I insurance for a seller is the ability to transfer liability for future claims to the insurer, such that it can know that, barring a claim for fraud or some other fundamental breach of the SPA, it has no further liability after completion. This allows the seller to make a clean exit. In the case of a fund, this can allow for the prompt distribution of the sale proceeds to investors. In the case of an individual, it can give peace of mind.|
|Passive sellers||Where the seller(s) include one or more parties who have had no involvement in or knowledge of the day-to-day affairs of the target they are often reluctant to be on the hook for warranty or indemnity claims. In such circumstances W&I insurance can be a useful tool for meeting the buyer’s expectations in terms of financial cover for claims, while allowing the passive seller(s) to avoid liability, other than for fundamental issues such as title and fraud.|
|Extended cover||W&I insurance can be utilised to provide cover in respect of specific claims up to a level which is above that which the seller is prepared to accept. This is most commonly the case for matters that have been identified as particular concerns in the due diligence process.|
|Payment comfort||Where the buyer has concerns as to the ability of the seller to meet potential liability in respect of any warranty or indemnity claims then W&I insurance can help to allay these concerns. This is particularly the case where, for example, the seller is a special purpose vehicle. Historically, such concerns were typically addressed by way of some form of escrow but this still usually had limitations in that (i) the escrow may be limited in time; and (ii) the buyer may still be required to litigate the relevant claim before it can claim on the escrow.|
Common exclusions under W&I policies Notwithstanding the increasing use of W&I policies in M&A deals, buyers seeking to rely on such insurance should be aware that W&I policies are not a perfect solution for all claims under an SPA. Notably, such policies will typically specify a number of standard exclusions and, whilst the range of such general exclusions has been shrinking in recent years, there are still a number of key exclusions that one can expect to encounter. These include:
|Forward looking warranties||Warranties of this nature will nearly always be excluded. Examples of such warranties include the target company and/or the subsidiaries achieving post-completion profit targets or outstanding litigation being settled at a certain amount or by a certain date.|
|Results of due diligence||Any matters which are revealed as a result of the buyer’s due diligence are generally excluded. However, there has been movement on this position over recent years. Some policies will now cover specific risks where the insurer is comfortable that it can reach a satisfactory underwriting position on the risk involved. The flip side of this is that the premium payable for the policy will consequently be higher.|
|Disclosures||Warranties that have been disclosed against in the disclosure letter, or otherwise, by the sellers are again generally likely to be excluded. However, as set out above, this position has started to change over recent years and some policies will now cover specific risks.|
|Penalties and fines||Insurers will not provide coverage in respect of any penalties or fines which the target company has incurred or will incur. Generally, it can be very difficult to quantify such penalties or fines, so providing cover would carry large amounts of risk for insurers. Also, in many instances, it would be illegal for insurers to provide cover in respect of penalties and fines arising from criminal activity.|
|Specific warranties||Historically, insurers would not provide coverage in respect of specific risks such as leakage warranties or environmental warranties. However, insurers are increasingly starting to cover such risks. In some instances, if an extension in cover under the general W&I policy is not available, the insured will have to obtain a separate insurance policy in respect of the said specific warranty.|
|Price Adjustments||Any price adjustments which are made as a result of the preparation of completion accounts will not be covered by W&I insurance. If this is likely to be an issue for buyers then a ‘locked box’ mechanism may be preferable.|
Duration of W&I insurance cover The term of the cover provided under a W&I policy will usually be reflective of the claims period under the SPA. In general, this will be two years under the general warranties and seven years under the tax warranties. However, this of course varies from deal to deal.
W&I insurance: potential pitfalls When considering reliance on a W&I policy there are a number of considerations that the parties (and buyers in particular) should watch out for. A number of these factors are dependent on whether the policy is a buyer-side or seller-side policy. They include:
- Policy limit – the higher the policy limit of a W&I policy, the higher the premium payable. It is in the interests of both parties to have a high policy limit as this gives the buyer comfort that any claim will be met (up to a certain amount) and it enables the seller to strike a more favourable deal with the buyer as the buyer’s risk will be minimised. However, this needs to be balanced with the fact that the party paying the premium will want to keep such premium under control.
- Extent of coverage – as set out above, W&I insurance will not always cover specific warranties and indemnities. Buyers should check the carve outs of the policy carefully to enable them to evaluate the risk attached to any exclusions and to consequently decide whether to obtain an additional insurance policy in relation to the exclusion.
- Mismatch – the terms of a W&I policy must clearly match the provisions in the SPA. It is important that this is carefully checked to avoid discrepancies at a later date. For example, a W&I policy will specify that it will cease to apply if there is fraud on the part of the sellers. This will also potentially extend to misrepresentation, negligence or wilful deceit. The SPA will need to be aligned with these provisions.
- Period between exchange and completion – a W&I policy will not cover any issues that arise during the period between signing and completion. This is something of an anomaly of W&I insurance. If a particular issue arises which is a deal breaker for the buyer, then the buyer needs to have previously negotiated a wide termination right which it can rely on, or the seller needs to cover such risk. In practical terms the simplest way to minimise the risk is to keep the gap between exchange and completion as short as possible.
What is driving the increased use of W&I insurance across ASEAN?
|Private equity||As an increasing number of private equity firms that have made investments across ASEAN seek to exit those investments, they are bringing more pressure to bear on buyers to accept W&I policies as part of the deal. Driven by a desire to avoid long post-closing liability periods, which can prevent a timely winding up and distribution of the fund, the private equity firms were largely responsible for the growth in the use of W&I insurance in the United States and Europe. It is no surprise that they are replicating this behaviour in ASEAN.|
|Pricing||While the cost of W&I insurance is still generally higher in ASEAN than in the United States or Europe, in common with the United States and Europe the absolute cost in ASEAN has fallen significantly in recent years and the comparatively higher premiums payable in ASEAN are generally reflective of the higher risk associated with emerging markets. As such, buyers and sellers seem more receptive to the use of such cover.|
|Specific risks||Rather than just providing cover against the warranties and indemnities in respect of all general risks, W&I insurance can now include cover, where necessary, for specific risks such as litigation. Again this is adding to the attraction of such insurance.|
The number of market participants with experience of W&I cover in ASEAN is now significant. This includes insurers, brokers, bankers and lawyers. Experience developed in other markets, where the use of W&I insurance is more established, has percolated through to ASEAN’s markets. This has happened in a number of ways:
|Availability||W&I policies have become more accessible; insurers, brokers and underwriters have become more comfortable with the risks attached to W&I insurance and, having developed a significant body of claims experience in more mature markets, are increasingly comfortable that the product model works. As such, their confidence in offering such products in ASEAN markets has generally grown and more insurers are offering the cover.|
Conclusion W&I insurance is increasingly being used across ASEAN. As it becomes more accessible across the region and knowledge and confidence around its use grows, it is likely to continue to be used more frequently. While all parties should be aware of the pitfalls associated with it, these should not hinder its use as an often effective tool for managing some of the risks associated with M&A transactions.