In brief

Warranties and indemnities generally take up considerable negotiation time in sale contract negotiations, with buyers' and sellers' expectations of post-completion liabilities often misaligned. This is where warranty and indemnity (W&I) insurance may assist - offering the parties an alternative method of mitigating their respective risks in respect of breaches of warranties and indemnities contained in a sale contract.

W&I insurance has gained traction in real estate transactions in recent years and with greater understanding of this risk mitigation tool in the market, its use will likely grow as buyers and sellers alike come to realise the benefits of using W&I insurance in their transactions.

This alert provides an overview of W&I insurance and sets out the key issues that parties should consider when deciding whether to use W&I insurance in their next real estate transaction.

What is W&I insurance?

W&I insurance is an insurance policy that covers losses arising from a breach of warranties and indemnities in a sale contract. Depending on who is seeking the benefit of the policy, W&I insurance can be structured to indemnify either the buyer under a buyer-side policy or the seller under a seller-side policy.

Buyer-side insurance

The buyer:

  1. agrees under the sale contract that it will have no recourse (subject to agreed exceptions) in respect of breach of the vendor warranties contained in the sale contract; and
  2. is insured for losses it suffers as a result of a breach of vendor warranties (subject to agreed limitations) given under the sale contract.

Under this type of policy, the buyer is able to claim directly against the insurer for any warranty breaches.

 

Note: Buyer-side policies are more common and comprise the substantial majority of the W&I insurance policies written in the Australian market.

Seller-side insurance

The seller providing warranties is insured for any losses (including costs incurred in defending or investigating the claim) it suffers as a result of the buyer bringing a valid claim for breach of warranties (subject to agreed limitations) under a sale contract.  Under this type of policy, the buyer makes a claim against the seller for any warranty breaches who then makes a claim against the insurer.

Note: Seller-side policies may be useful where the buyer is unwilling to accept W&I products. If the policy does not cover the relevant loss, however, then the seller is still at risk.

What are the key benefits of W&I insurance?

W&I insurance is an attractive risk mitigation strategy in real estate transactions as it assigns risk to a third party insurer.

The following table summarises the key benefits of W&I insurance for buyers and sellers:

 

W&I Policy   Benefits  
For buyers Benefits include:
  • financial security behind warranties, particularly where the vendor is an SPV;
  • address collection concerns or enforcement issues involving an acquisition from a distressed seller or receiver, a liquidated seller, a disparate group of sellers or an overseas seller with no domestic assets;
  • assist with financing by giving lender additional comfort (particularly where lender takes a charge over the policy); and
  • protect relationships between buyer and seller in such instances where management sellers or vendors "roll over" equity and co-invest with the buyer. If maintaining the relationship between the buyer and the seller is important, then a buyer-side policy may be appropriate in such circumstances given that claims are made directly against the insurer.
For sellers Benefits include:
  • achieve 'clean exit' under a sale (particularly important for private equity sellers);
  • avoid escrow / retention amount or parent company guarantees;
  • allow distribution of sale proceeds in full;
  • enhance deal value as a more fulsome warranty package can be offered;
  • alleviate concerns where the seller is an individual(s) who may be unable or unwilling to stand behind warranties;
  • alleviate seller's concerns where buyer is particularly litigious in nature; and
  • protect passive sellers.

 

Distressed sales

W&I insurance is particularly attractive where the seller is in administration or receivership and as a result, not in a position to provide any warranties or indemnities on a recourse basis in a sale transaction. Such sellers are effectively selling on an "as is where is" basis with limited or no contractual protection able to be offered to the purchaser.

Is W&I Insurance a suitable tool in your next real estate transaction?

To determine whether W&I insurance should be used in your next real estate transaction, it is important to consider the following items.

Item Points  
Coverage What is covered? W&I policies generally cover the losses arising from the breach of warranties contained in a sale contract. Ideally, the policy will provide 'back-to-back' cover against sale contract warranties. It is important to carefully consider the wording of a W&I insurance policy to minimise the mismatch between the policy's coverage and the warranties contained in a sale contract. What is usually not covered? W&I policies will not necessarily match the warranties contained in a sale contract and there are certain carve outs which are generally excluded from W&I policies, including:
  • Known breaches or known issues fairly disclosed to the buyer;
  • Environmental or contamination issues;
  • Structural defects;
  • Criminal fines and penalties;
  • Bribery and corruption;
  • Purchase price adjustments;
  • Accuracy of forward-looking financial information (e.g., financial projections or forecasts);
  • Transfer pricing;
  • Secondary tax liabilities;
  • Consequential loss; and
  • Level of seller's knowledge (i.e., sometimes insurers may insist on only covering certain warranties "to the best of the seller's knowledge" rather than giving unqualified cover, particularly for litigation warranties).
As such, careful consideration is required to the "non recourse" against seller provisions of the sale contract under which the purchaser agrees to release the seller in respect of the seller warranties (i.e., in short, exceptions to any "non recourse" arrangements against the seller will need to apply of the buyer wants the ability to make a claim against any exclusions under a W&I insurance policy).  
Timing Parties must consider the deal timeline and factor into account the time required to negotiate and obtain a W&I insurance policy (noting that the W&I insurance policy is customarily negotiated and signed contemporaneously with the sale contract). What is the process involved? The W&I insurance process involves the following stages:   
Engagement with broker: Where the prospective insured party selects a broker and strategises how to use W&I insurance.
    
Select insurer: Where the prospective insured party obtains non-binding indications from various insurers and selects a lead insurer. It is important to have sufficiently progressed warranties and indemnities and a clear scope of the desired coverage (including what (if any) complementary insurance products may be required) before going exclusive with an insurer, as later asks may be much more expensive or potentially excluded.
    
Underwriting call: Where the insurer reviews due diligence reports, provides underwriting questions and conducts the underwriting call with the prospective insured's deal team to obtain a better understanding of the scope of due diligence completed and any identified risks relating to the warranties and indemnities to be insured.
    
Policy negotiations and execution: Where the parties negotiate insurance coverage and execute the policy.
Sellers can expedite the W&I insurance process by co-ordinating buy-side insurance terms and coverage negotiated with a lead insurer on behalf of purchasers prior to going to market and then "flipping" the W&I insurance process to one or more buyers at a chosen point in the sale process.  
Due diligence How does due diligence affect W&I policies? The prospective insured must provide to the insurer legal due diligence reports and other specialist reports (on a non-reliance basis) and data room access so that the insurer can carry out its own due diligence. Good quality due diligence information and advisers who have the expertise that insurers would expect for the transaction are paramount. Prior to finalising the W&I policy (typically 2-3 days prior to signing), an underwriting call will take place whereby the prospective insured party's deal team will answer questions provided by the insurer. It is important to ensure the right deal team members are on the call (e.g., legal advisers, tax advisers, financial advisers and key deal team members) to be able to provide to the insurer comfort as to the overall scope of due diligence and any issues identified in due diligence. A legal team that is familiar with and understands what the insurer is expecting will assist in solving issues with the insurer with minimal extra due diligence required.  
Costs How much is the premium? The W&I insurance premium is a one-off cost that is calculated as a percentage of the total amount insured (as opposed to deal value). In Australia, New Zealand and the United Kingdom, this is usually 1% - 2%. In other Asian jurisdictions, this is usually 1.2% - 2.5% of the insured amount. Which other factors may influence the cost of policy premiums? Any factor that poses a heightened level of risk is likely to increase the cost of the insurance premium. Some factors which may affect the level of premium that is payable include:
  • Business risk: the geographical location, political regime or industry sector;
  • The policy period, the de minimis and basket thresholds, the aggregate cap on liability under the W&I insurance policy and the scope of coverage;
  • Complexity of transaction;
  • Whether cover is required for specific indemnities;
  • The robustness of the due diligence exercise and the nature of any issues identified in the due diligence process; and
  • The identity and competency of the professional advisers involved in the transaction.
Are there any additional costs? Additional costs include:  
1. Retention / excess: Generally calculated at 1% of deal value (but in some cases may be reduced for a higher premium). This is the portion of risk that the seller is generally expected to bear before the W&I insurance policy responds. A "tipping" retention policy can commonly be obtained for a higher premium where coverage under the policy "tips back" to a lower percentage of deal value (say, 0.5% of deal value) after insured claims exceeding a higher retention (say, 1% of deal value) have been accepted.
    
2. Tax: Insurance premium tax which can be up to 20%, depending on the jurisdiction.
    
3. Underwriter's fee: Typically between $5,000 - $30,000 to cover due diligence costs, though sometimes deducted from the premium.
    
4. Broker's commission fee: Often included in the cost of the premium and calculated at approximately 17% - 20% of the premium.  
Who pays the costs?   A commercial issue to be agreed between the parties. The seller may agree to contribute towards the W&I insurance costs in recognition that its exposure to contingent risk for breach of warranty and indemnity claims is reduced through the use of W&I insurance.  
Limitations of coverage What is the policy limit?
  • Generally 10% - 40% of the deal value. A higher level of insurance can be obtained in respect of fundamental warranties (i.e., ownership of property or shares).
  • The actual cap depends on the negotiations between the buyer, the seller and the W&I insurer and any apportionment for retention and transfer of risk.
  • A seller-side policy can insure up to the full limit of liability agreed in the sale contract or a lesser amount (which is usually the first 10%-40%) where the sellers are willing to bear the remainder of the risk. This policy usually covers defence and investigation costs. 
  • For a buyer-side policy, buyers can choose a level of coverage which provides them with the appropriate level of coverage that they require.
  • Certain transactions require a limitation of coverage in excess of the deal value (e.g., where purchase price is $1 in a distressed transaction). In such cases, the definition of loss under the policy should not be driven by a diminution of the value of shares but be based on the actual loss suffered by the buyer.
De Minimis / Basket   Generally reflects the amounts under the sale contract (i.e., the buyer cannot make a claim unless each individual claim is for more than a certain amount (de minimis) and all such claims in aggregate must be for more than another amount (basket)). As mentioned above, W&I insurance policies are commonly written on a "tipping retention" basis, whereby the insured is provided with coverage in respect to an agreed % of the basket amount (i.e., 50%) in circumstances where individual claims which exceed the de minimis threshold also exceed the agreed basket. Duration of Cover Generally reflects the duration of warranties under the sale contract.  
Assignability of policy Can a W&I policy be assigned? Yes, the policy is generally assignable within the insured's group of companies in any post-acquisition restructuring without needing to obtain the prior consent of the insurer. It is also possible to have "additional insureds" (i.e., the target company) so that there is no need to assign the policy after it has been entered into. A seller-side policy however cannot be assigned to a buyer.

With more widespread use of W&I insurance, the process of obtaining this insurance may become more streamlined, the costs may reduce and new hybrid products are likely to be introduced to the market - making this product a more attractive risk mitigation tool in real estate transactions.