A reported increase in global M&A activity over the past 12 months has seen an increased uptake of Warranty & Indemnity (W&I) insurance products. We consider some of the current W&I, underwriting and claims trends and issues that can arise and what impact these can have on an insurer’s assessment and resolution of claims.
A reported increase in global M&A activity over the past 12 months has seen an increased uptake of Warranty & Indemnity (W&I) insurance products. We consider some of the current W&I, underwriting and claims trends and issues that can arise and what impact these can have on an insurer’s assessment and resolution of claims
What is warranty & indemnity insurance?
Broadly, W&I (or Representations and Warranties insurance, as it is known in the US) provides cover to a seller or buyer for financial loss or liability arising from a breach of contractual warranties or indemnities in an M&A transaction.
“Buy-side W&I” provides cover to the buyer for financial loss suffered as a result of a seller’s breach of warranty or indemnity. A “sell-side” policy in contrast provides cover to the seller/s where a buyer makes a claim against the seller for breach of a contractual transaction warranty or indemnity furnished by the seller.
Properly structured, W&I promotes economic certainty for buyers and sellers and assists sellers in achieving a clean and final exit on divestment of assets. It can also facilitate the closing of deals by removing roadblocks which often arise during the negotiation of contractual warranties in transaction documents.
The time pressures faced by W&I underwriters can be significant, as sellers push the pace of auction processes, reducing buyers’ due diligence time frames and demanding speed of deal execution. W&I is often considered only late in the deal process, giving insurers little time to undertake their own meaningful due diligence on the transaction and to prepare W&I documentation specifically tailored to the deal. One particular issue which can cause difficulties for buyers who are looking for cover that “wraps around” the sale and purchase agreement is that policy exclusions may need to be introduced where underwriters feel that there has not been adequate due diligence by the buyer on the transaction, or where the buyer is unable to obtain the information insurers require because the seller will not provide it. This can result in a misalignment between the transaction documents and the cover provided under the policy, possibly leading to gaps in cover.
The existence of W&I insurance may result in insureds being more willing to make admissions or reach settlements with their transaction counterparties in relation to warranty claims disputes without the insurer’s prior knowledge or consent.
A recent report issued by AIG1 analysed global claims data for W&I insurance for the period 2011 to 2014. Some of the key findings included:
- One in seven (14%) W&I policies issued by AIG between 2011-2014 resulted in a claim;
- The Asia Pacific region reported the highest claims frequency (18%); EMEA had the lowest (11.4%);
- Policies purchased by buyers were more likely to have a large loss - and in that regard, we note that policy terms on buy-side cover typically leave insurers with no or very limited rights of recourse against a seller (except in the case of fraud).
Emerging claims trends
Establishing breach of warranty or indemnity
The threshold question for insurers to determine when assessing indemnity is whether in fact there has been a breach of an insured warranty or indemnity. This requires a careful analysis of the terms of the transaction documents and the relevant factual background, having regard to the information and disclosures made available during the transaction due diligence phase.
A number of practical difficulties can arise. For example:
- Expert opinions will often need to be obtained at an early stage to establish whether there has been a breach of warranty. Accounting experts may be required to consider an alleged breach of warranty relating to financial statements, or taxation experts may be required in respect of alleged breaches of tax warranties. This can lead to significant costs and can justifiably elongate the claims process. Determining policy response in the case of larger or more complex transactions can be particularly time consuming and costly, especially where a detailed review of the underlying transaction due diligence materials is required.
- Insurers may be hampered by lack of access to relevant information or to key personnel involved in the transaction. This is especially the case on buy side policies, where a dispute arises between the buyer and seller and the insured is reluctant to share information or documents with insurers before indemnity is confirmed, due to concerns around waiving legal privilege in materials.
- As noted above, the existence of W&I insurance may result in insureds being more willing to make admissions or reach settlements with their transaction counterparties in relation to warranty claims disputes without the insurer’s prior knowledge or consent.
Measuring loss or damage
In Australia, and in England & Wales, the general principle for the measurement of damages in the event of a breach of contract is to put the innocent party in the position it would have been in but for the breach. Under a share sale agreement, the measurement of loss is generally calculated as the difference between the value of the shares as warranted and the true value of the shares - being the difference between the actual value of the company and its value had the warranty been true.
Buy side W&I typically indemnifies an insured for the amount that the insured is contractually entitled to recover against the seller under the transaction documents by reason of the breach of the relevant insured warranty or indemnity.
Often, however, one of the most challenging aspects of the claims process is the precise calculation and determination of the loss and damage sustained as a result of the breach of an insured warranty. Most W&I policies do not prescribe a method of calculating loss for policy purposes. In practice, this can be a very complex process which may involve the insured and insurer each obtaining separate expert valuation opinions. Valuation experts may need to consider a large volume of materials from the due diligence materials, various models, methodologies and assumptions and undertake their own loss modelling. There are often significant discrepancies of views between experts.
In an environment of highly competitive deal terms and pricing, including very high EBITDA (enterprise value) multiples, these factors can give rise to significant uncertainty on quantum calculation and exposure for insurers.
The size of some transactions being underwritten by W&I insurers means there is a real risk of claims completely eroding the insurance cover. Insurers can combat or reduce this exposure by including policy terms such as EBITDA multiple exclusions and applying appropriate sublimits.
Local law and jurisdiction
Especially in cross border M&A deals, issues for insurers can arise where the determination of whether a breach of indemnity or warranty has occurred is made in proceedings to which the W&I insurer is not a party, or is otherwise unable to be meaningfully involved, but which may bind the insurers.
The issue is further compounded where the proceedings are commenced in a jurisdiction or forum different to the governing law and jurisdiction stipulated in the underlying transaction agreements and/or the W&I policy.
Examples of such scenarios include:
- Where the amount of damages claimed by the buyer exceeds the W&I insurance limits and, despite the nonrecourse provisions in the sale contract, proceedings are commenced against the seller based on local laws. For example in Australia where, as distinct from other jurisdictions, non recourse provisions are not uncommon, parties cannot contract out of the prohibition against engaging in misleading or deceptive conduct in business which is contained in the Australian Consumer Law. This legislation has been used in an attempt to sidestep non-recourse provisions in underlying transaction documents. Such departures from the agreed terms of the transaction documents significantly change the risk originally accepted and written under the W&I cover.
- Where the seller commences arbitration proceedings against the buyer for payment of an outstanding instalment of the purchase price, and the buyer in response alleges breaches of warranty or indemnity by the seller by way of set-off.
In both scenarios, unless W&I insurers have already paid out on the claim, insurers may effectively be precluded from participating in proceedings which will determine whether or not there has been a breach of warranty. There is also a separate risk that an attempt may be made to join the W&I insurer to the proceedings.
Another practical consequence of proceedings arising between the transaction parties may be to further inhibit or restrict an insureds willingness or ability to respond to the insurers’ requests for information for the purpose of assessing the claim.
The issues summarised above may be addressed by careful drafting of policy terms.
For example, the difficulties in relation to determination of indemnity can be minimised by appropriately tailored claims cooperation clauses. Particular attention may, however, need to be given to arrangements providing for the preservation of commercial confidence and any legal privilege in documents which insurers need to obtain, as this may be key to the determination of indemnity.
Measuring and determining loss and damage could be assisted by including a contractual methodology to be adopted in order to calculate loss. For example, that might involve arrangements similar to those seen undervalued policies, or the development of contractual formulae to be applied in order to determine loss calculation. Alternatively, the parties could jointly appoint an independent expert accountant to assess and determine quantum.
Local law and jurisdiction issues could be addressed by providing insurers with appropriate rights to participate in disputes relating to the underlying transaction and special claims cooperation regimes could be designed to address the type of scenarios outlined above.