Australia leads the world in the breadth and depth of take-up of warranty and indemnity insurance in private M&A transactions. Risk Capital Advisors, the busiest arranger of warranty and indemnity insurance in Australia and New Zealand, reports that the last 3 years have seen a total of 170 transactions use the product: 45 deals in 2010; 70 in 2011 and 55 year to date in 2012.
In our practice, we see W&I insurance being used far more often than not in private M&A. The most common reasons are:
- a private equity fund is the seller and needs to ensure that purchase price will not be clawed back through W&I claims or that it does not need to maintain the special purpose selling entities post transaction
- there are multiple sellers from whom recovering W&I claims would be problematic and an escrow alternative is not commercially acceptable
- a Government or a governmental body is the seller and does not wish to have any post sale exposure to W&I claims
- a corporate is the seller and, on balance, would prefer to reduce purchase price by the cost of an appropriate W&I insurance policy rather than have trailing exposure to W&I claims for a number of years.
The following are answers to the questions we are asked most often in relation to W&I insurance.
How much does it cost?
Premium rates seem from our perspective to be at an historical low, ranging from 1.0% to 1.7% of the sum insured compared to 1.2%-1.5% in recent years and 3-5% in the pre-GFC period when the product was less commonly used.
The pricing is typically expressed as:
- cost of the first layer of insurance
- cost of the second layer of insurance
- extra cost if the insured wants a ‘tipping retention’ structure where, as explained below, the insurance responds to liability below the ‘basket’ threshold so long as that basket threshold is met
Where there is a heightened perception of risk – eg. in relation to tax claims in a company with a contentious tax history - the pricing for that risk is separated out and is much higher. Indeed, sometimes it is so high that it is commercially more sensible for the risk not to be insured and dealt with in a different way (a price adjustment or other risk allocation mechanism).
How much in total can I insure?
It seems that the maximum capacity in the Australasian W&I insurance market is between $300 and $400 million for a single deal. This assumes there are no specific heightened areas of risk sought to be covered which could lead to coverage in that area being more constrained.
This capacity limit puts some pressure on the ability in larger deals for claims limits expressed as ‘100% of purchase price’ to be completely insured. However, we find that this really only becomes an issue in relation to tax as title and capacity can typically be carved out if it is of concern and general claims are typically capped at less than 50% and more often at or below 30% of purchase price.
In relation to tax, we find that the key issue is the conflict between (a) a buyer philosophically not wanting to take any risk associated with tax on earnings the seller has enjoyed and (b) acknowledging the typically low risk of the target suffering tax claims which aggregate to hundreds of millions of dollars (particularly when historical EBITDA has been less than $100m).
Will the insurance policy cover me from the first dollar / what’s the deductible?
As mentioned above, the Australian market has developed a concept of a ‘tipping retention’ which, until recently, offered coverage from the first dollar once the basket threshold for claims under the SPA was satisfied. More recently, we have seen insurers prefer to cover only 50% of the liability below the basket threshold.
This layer of cover is more expensive than the higher layers but in the context of the whole deal is often acquired because of the benefit of reducing or eliminating entirely the highest risk liability for the seller.
Are there claims it won’t cover?
In the vast majority of cases in our experience, the full package of title and capacity; general; and tax warranties plus a tax indemnity are covered by insurance.
However, as with any insurance policy, a W&I insurance policy won’t respond to a matter which the insured had a duty to disclose. In Australia, that is a matter that the insured knows to be a matter relevant to the insurer’s decision whether to accept the risk and, if so, on what terms; or a matter which a reasonable person in the circumstances could be expected to know to be a matter relevant to the insurer.
In our experience, this can limit the use of insurance to certain known, specific liabilities which a buyer might customarily make the subject of a specific indemnity (eg. a known environmental liability or a known credit risk). It also requires care to be taken where a pattern of behaviour within a target may have created fertile ground for particular types of risk. This is typically something identified in due diligence and can lead to insurers baulking in relation to covering any warranty or indemnity which could relevantly be triggered.
We are also aware that certain insurers will not, as a policy matter, insure tax liability associated with transfer pricing. We understand that this is largely because of the inability to get comfortable with the risk through diligence.
The policies also do not typically cover fraud (liability for which is typically not carved out under SPAs).
Is it hard to make a claim?
It is relatively rare in our experience. However, we understand that in the context of the 170 insured deals in the last 3 years plus those insured in prior years, there have been 19 claims made in Australasia. Risk Capital Advisors are currently managing 9 claim notifications across 7 transactions.
We understand that the process is typically easier than suing a seller many years after a transaction closed and, in many cases, as easy as accessing an escrow pot.
Seasoned M&A professionals will not be surprised to know that most warranty claims relate to accounts, tax or non-disclosure / fraud.
Who takes out the insurance policy?
In 80% of cases, it is the buyer. There are a number of reasons for this.
The key reason historically is that the buyer taking out the policy avoided a duty of disclosure challenge for sellers who, despite their best efforts, could not be certain that someone in the seller corporation or target business did not know about a matter covered by the W&I insurance. That issue has now been ameliorated significantly by the insurers agreeing to limit to the relevant knowledge to those on the deal team and in specific positions within the target business or seller.
Other reasons include the seller group wanting to be able to wind up the SPV selling entity within the warranty claims period which had the side effect of eliminating the party insured. This has been addressed through naming the buyer as the ‘loss payee’ on the insurance contract.
In the majority of cases where the buyer takes out the policy, the cost of the policy is to some extent reduced from the purchase price.
Does it slow down the sale process?
Not in our experience, if the insurance advisers are engaged early in the process and the diligence is conducted and shared in a timely manner. On the sell side, we engage with W&I insurance advisers at the point where we have very advanced or complete vendor due diligence and/or an early draft SPA. This allows for the early identification of issues and concerns and typically allows us to direct buyers to the insurance advisers who have already been able to consider the insured risk and relevant pricing.
On a tight timetable, W&I insurance can add a little bit of time but really only because there is not enough time in everyone’s days to accommodate another workstream. However, with the right planning, this can be avoided and certainly the professionals within the insurance advisers and the insurers themselves work very hard to ensure that planned timetables are achieved.
Does it add cost to the sale process?
Not to any material extent assuming there is no contention around scope of coverage. It is another workstream for the lawyers (in particular) to manage which adds some expense but it can also materially streamline the negotiation of the warranty provisions and the cost saved in relation to the SPA can (at least) cancel out the increase in time taken to manage the insurance process.
What do the insurers focus on / worry about most?
In our experience, the more robust the sale and negotiation process, the easier the deal is to insure from a W&I perspective. Where sellers cease to care about the warranty package, insurers become wary and slow. The quality and extent of diligence is also critical. Where there is vendor due diligence, the process is easier because the insurer typically gets not only the benefit of the “VDD” but also the buyer’s review. Where, say, a trade buyer does diligence in house and does not document that process in reports which insurers can deal with, the process is more difficult.
From a diligence perspective, we understand that insurers are (understandably) most focussed on:
- accounts and financial statements
- tax warranties and indemnities
- product warranties (and the interface with other insurance policies of the target)
- environmental risks
- OHS and related employee issues and
- transaction-specific or industry specific issues.
As alluded to above, from a documentation perspective, we see insurers most focussed on:
- the quality and breadth of due diligence having regard to the breadth of warranty coverage
- the size and structure of the claims basket (ie relative size of de minimis etc)
- the exposure (however limited) of the buyer or seller to claims (eg through absorbing some or all of the liability below the basket threshold) and the manner in which the SPA has been negotiated
We hope this update is helpful for those coming to W&I insurance for the first time in Australia or coming back to it after a few years. We are grateful for the assistance of Rick Glover, Guy Miller and Andrew Stubbings at Risk Capital Advisors for their input into this article as well.