Whilst warranty and indemnity (W&I) insurance has been available for some time, its use in private company acquisitions has become much more established in the past few years. The increasing need for sellers to achieve clean exits, general caution in the markets and the relatively cheap cost of W&I insurance have made it more attractive than other "deal-deadlock" solutions such as placing sale proceeds in escrow (which locks in the seller's funds) or bank guarantees (which can be administratively time-consuming, expensive and require security). Our article answers some of the questions we are commonly asked.
What is W&I insurance?
An insurance policy covering losses incurred as a result of a breach of the warranties and/or claim under the tax covenant on M&A transactions. The intention is, as far as possible, to provide coverage 'matching' the warranties and tax covenant in the share purchase agreement (SPA) so that the seller is able to access the sale proceeds immediately and manage its risk profile, but the buyer is not disadvantaged and has the ability to recover from a financially viable insurer.
Why use W&I insurance?
Negotiating the warranties and their associated limitations is one of the most contentious parts of an M&A transaction. Although there are many scenarios in which W&I insurance is used, in most cases, the underlying reason for taking out insurance is that it eases this basic risk allocation exercise. Recently we have seen it used by:
- a private equity investor who wanted to protect key personnel on an MBO from claims;
- a buyer where the long-term financial strength of the seller was questionable and the seller wanted limited warranty exposure;
- a target group selling off non-core subsidiaries and wishing to keep the remaining group clean of contingent warranty claim risk; and
- sellers who wanted a clean exit to enable immediate reinvestment of proceeds.
Who can take out W&I insurance?
Although most people are perhaps more familiar with the concept of a seller taking out insurance to cover warranty claims, over the last few years we have seen a marked increase in the number of W&I insurance policies taken out by buyers, particularly on auction sales where they have sought to enhance their bid by reducing the seller's retained liability.
At what stage in the process should I start thinking about insurance and how long will the policy last?
Policies can be purchased at any point in the deal process and can even be put in place after completion. Typically however, they are taken out contemporaneously with completion and run concurrently with the limitation period(s) in the underlying SPA (usually two to three years for non-tax warranties and seven years for tax claims). W&I insurance can also be used to bridge a timing gap if, for example, a seller has reduced its period of risk in the SPA to less than the market norm. Here, W&I insurance coverage can be negotiated to extend beyond the period agreed under the SPA and give the buyer the usual period of protection.
What will I be able to recover?
The amount that the buyer or seller will be able to claim under the insurance will depend on the amount insured and the amount of the 'excess' or 'retention' under the policy. This excess will often equate to the amount of the agreed minimum claims threshold in the SPA. On a buy-side policy, once the minimum claims threshold has been reached, typically the buyer can pursue claims against the seller for amounts up to the threshold and the insurer for the remainder (up to the insurance policy limit). On a sell-side policy, the seller is liable to the buyer for the whole amount (up to the negotiated maximum limit in the SPA) and will then seek recovery for amounts over the excess against the insurer.
Is it possible to have no risk under the policy?
Although it is theoretically possible to obtain an insurance policy which covers all risks and which provides either the seller with no exposure at all under the warranties or the buyer with no obligation to pursue the seller for the agreed threshold amount (with the associated risk of non-payment), most insurance companies are unwilling to offer cover on this basis (or at least at a reasonable premium). Insurance companies generally require the seller to be exposed to a small degree of risk to ensure the veracity of the disclosure process against the warranties and that the negotiation of the warranties takes place on a commercial and arms length basis.
What won't the policy cover?
In addition to the excess provision, other typical exclusions to standard cover include: liabilities arising out of anything disclosed or otherwise within the knowledge of the insured party, for example excluding recovery for anything in the due diligence report (to the extent the insurer is granted access to it) or issues covered by specific indemnities in the SPA (although, depending on the issue and risk, known tax or other liabilities can sometimes be covered separately); fines and penalties which are uninsurable by law; forward-looking warranties; product liability and environmental issues (which can be covered by separate, specific policies); pension underfunding; and anything arising out of fraud or dishonesty.
How much will it cost?
In the last year we have seen premiums ranging from between 1% to 1.5% of the amount covered (both buy side and sell side policies tend to be priced on the same basis). In setting the premium, insurers will take a number of factors into account, most notably, the amount of the agreed excess and the scope of the cover (broad, wide-ranging warranties/indemnities, a lower excess and fewer exclusions are factors likely to result in a higher premium). In addition, insurance premium tax is due and applied depending on the domicile of the insured. Therefore, a UK insured person will pay an additional 6% tax on the value of the premium.
Will the process impact my timetable?
If the insurance process is started in good time then it usually runs in parallel to the main deal. Initial soundings can be taken from a broker as early as heads of terms stage, with indications of premium and excess amounts being available from individual insurers within 2 or 3 days of receipt of a draft SPA. The underwriting process can take slightly longer as it will entail a review of the documents, a negotiation of the policy terms and, on buy side deals, due diligence by the insurer's advisers. To ensure coverage from completion, our experience is that you should allow for the process to take two to three weeks.