With record high private equity deal activity in 2021, several deal trends have emerged – warranty and indemnity insurance being one such trend in private equity driven M&A deals. This is due to the solutions offered by the productfor various deal situations. A warranty and indemnity (W&I) insurance is an insurance product which provides insurance coverage to parties in an M&A deal from the liability of indemnity claims under the purchase agreement. These indemnity claims may arise out of unknown matters post-closing and typically pertain to the business of the target company as well as the securities or assets bought by the acquiring company. 

Typical W&I insurance driven deals 

Financial sponsors and private equity players seek to maximise returns and focus on value creation. Therefore, clean exits within the investment horizon with maximum returns and minimum liability exposures, are key deal drivers for private equity investors. These considerations are further amplified when dealing with portfolio companies which evolve through several funding rounds, thereby having diverse investor groups as shareholders with the promoters’ shareholding having been considerably diluted. In such situations, allocation of liability on account of breach of warranties or claims for indemnity payments among the selling shareholders becomes a key issue. and challenge for the investors’ exits by secondary sales or strategic buy-outs.

Further, given that private equity funds have definite fund lives, there is an additional limitation to providing robust recourse packages to potential buyers who would need long term indemnity coverage and a counterparty with realisable funds. The selling SPV is generally liquidated for making distributions of the entire sale proceeds to the investors of the fund. It becomes more challenging for the buyer in the event of the fund liquidation, as there is absolutely no recourse once the fund has been liquidated. For this reason, the buyer regularly requires financial protection for its potential warranty and indemnification claims.

To address this conundrum, buyers seek purchase price hold-backs, escrows, bank guarantees and fund commitment letters. However, each of these is not ideal for selling private equity funds which seek full access of purchase consideration without any limitations on distribution. In insured M&A deals, the requirement of escrows and hold-backs is obviated, allowing the selling shareholder to access its full consideration.

Where financial sponsors are buyers, W&I insurance products offer a viable recourse to them as investors find it hard to make claims against the target company or the promoters. This is because investors may wish to preserve valuation of the portfolio, their own market reputation and maintain amicable relationship with the management to ultimately have the ability to monetise their investment.

W&I Insurance costs and key terms 

Increase in PE play in M&A transactions, emergence of customised products providing coverage for bespoke risks of new age businesses, development of an experienced ecosystem of underwriters and advisors providing solution-oriented counsel are some of the key factors that have resulted in giving W&I insurance a boost in India. With the development of the W&I insurance market, the value proposition of the product is stronger due to reduced ‘deductibles’ (including nil deductibles for title risks) and lower insurance premium. 

The key terms which are negotiated in the W&I policy are: 

  • De-minimis, being the monetary threshold for an indemnity claim to be insurable. This is often offered at 0.1% of the enterprise value. Claims which fall below the de minimis must be borne by the insured. Once a claim meets the de minimis, the entire amount can be claimed. 
  • Retention amount, being the aggregate amount upto which insurable claims are not reimbursed by the insurer. W&I insurance usually has a ‘retention’ of 1% of the enterprise value. However, newer products offer as less as 0.5% retention with a higher premium amount. In the alternative, they offer other permutations such as 1% retention tipping from 0.5% of the enterprise value. If the retention is ‘tipping’, the insured would recover from the lower amount once the initial retention is exhausted. 
  • Insurance limit ranges from 10% to 30% of the enterprise value. However, higher coverage is possible depending on availability of towers for excess coverage.
  • Insured period is negotiated, which is usually offered from 7 years to 12 years for title warranties, 7 years for tax warranties and 3 years for business warranties. 
  • Warranties are negotiated to exclude any forward looking risks sought to be covered. 
  • Damage limitations pertaining to coverage of costs, expenses and consequential losses are negotiated.
  • General exclusions are negotiated for broader known risks based on due diligence findings. 
  • Specific exclusions are agreed to during the negotiation of the warranty spreadsheet, which sets out the scope of coverage of each warranty.

Typically, the premiums charged ranges between 2.5% and 4% of the insured amount. Additional costs for underwriting and other expenses range from USD 30,000 to USD 65,000. The usual general exclusions from coverage are product liability claims, environmental claims, known risks, breach of covenants, transfer pricing compliances etc. Usually, the underwriting process and finalisation of insurance policies take 2 to 3 weeks from the initiation of the underwriting process.

Efficient process of risk underwriting 

To explore the viability of a deal to be an insured deal, the insurance terms offered by the insurers for a transaction are consolidated for a comparative analysis by the broker in a non-binding offer for the client setting out the terms that the insurance product offers (such as, insured amount, retention amount, premium, coverage periods and indicative exclusions). This initial process can be completed quickly enables the parties to get a fair assessment of the recourse which the W&I policy is likely to offer. The visibility offered by the non-binding offer assists the parties to negotiate terms under the purchase agreement on treatment of uninsured warranties, scope of disclosures and scope of losses for making indemnity claims and other recourse gaps. 

Since underwriting involves upfront payment of fees, usually parties prefer to initiate the underwriting process when there is certainty to the deal after deal signing. However, the underwriting process can be completed even prior to the deal signing provided due diligence reports are available for the underwriters. 

Other developing trends 

There is a trend of underwriters offering better coverage in W&I insurance products. Coverage is even being offered for conventional exclusions such as data privacy warranties, provided basic data privacy diligence is done. Similarly, better protection for intellectual property issues pertaining to copyrights, design and software is available if basic diligence on ownership, open source dependency and third party claims is done. 

Solutions exist not only for secondary sale exit scenarios, but also for exits by ways of IPOs. Specialised products such as Public Offerings of Securities Insurance (POSI) have been introduced to cover against any actual or alleged wrongful acts of a company, its directors and its officers, arising from any claim stemming from the prospectus issued. For private equity led IPOs and listings in which the investors also get characterised as ‘promoters’ by SEBI, thus making them responsible for any misstatement in the prospectus, POSI provides a solution to the liability allocation challenges. 

Specialised products are also available to address typical dampeners such as general exclusions for liabilities emanating from environmental and political risks, policies with sliding scale limits of retention which offer lower premium provided the coverage gradually reduces over the insurance period and fund wind up insurance. With various insurance players foraying into the W&I insurance market in India, insurance towers or syndication is also becoming common for large cheque deals. In such situations, the primary insurer bears the initial limit of liability and the excess insurers provide excess coverage. As W&I insurance becomes a mainstay in the deal making environment, we could see a trend of many funds using W&I insurance on all transactions undertaken, as opposed to only those perceived to be ‘riskier’ in nature.