Warranty and Indemnity (W&I) insurance has become increasingly popular in business sale and purchase transactions. It provides cover to the buyer and/or the seller for losses arising from a breach of a warranty or indemnity by the seller in certain circumstances. As many businesses begin to experience the economic effects of COVID-19, questions are being asked as to how insurers are treating policy applications for M&A transactions. This blog will look at the impact of COVID-19 on W&I policies. For more information on W&I insurance generally, read our FAQ.
With the exception of certain heavily impacted industries such as travel, hospitality and leisure, there are no indications of any significant change to the appetite of insurers to provide coverage to M&A transactions. However, there is an industry-wide reluctance to cover express COVID-19 warranties and indemnities. Many insurers are applying exclusions for losses arising from or in response to COVID-19. These can vary depending on the insurer but many of the exclusions will be notably broad. It is important that both buyers and sellers understand what an exclusion covers and to ensure that only specific exposures relating to the business are covered. Any COVID-19 carveout should be tailored to a particular risk rather than a generic automatic exclusion. As such, it is recommended that parties ask the insurer what their position is in relation to COVID-19 exclusions at the very outset of discussions. Some insurers may be open to considering narrowing COVID-19 exclusions based on an evaluation of the risks presented to them.
The insurer will identify certain heightened areas of risk depending on either specific concerns regarding the target or the industry in which it operates. To the extent that the buyer is unable to evidence effective diligence in those areas to the insurer’s satisfaction, the insurer is likely to exclude coverage for some or all of the relevant areas.
As a prerequisite to providing cover, insurers will require more rigorous diligence to be carried out against the target. An insurer will want to be comfortable that the impact of COVID-19 on the target business is fully understood. In particular, insurers will want to see that the target business has put in place business continuity plans and that these have been thoroughly investigated and found to be robust. Evidence will be required to show that there has been a reasonable Q&A process between the buyer and the seller, evidencing that the buyer has made further enquiries into key risk areas with COVID-19 risks being a particular focus. The sellers will be required to make specific disclosures on the effect of COVID-19 on the target business. Sellers and buyers should ensure that they are in a position to provide all material information relating to the impact of COVID-19 on the target company, including:
- data on how the target business has performed since its last audited accounts, for example through the disclosure of management accounts;
- the impact on commercial contracts, for example, there may be indications that a counterparty is struggling to perform under a contract and there may be frustration or termination of such contracts;
- details on supply chain disruption, reduced workforces, facility closures or travel restrictions;
- cyber risks relating to employees working from home;
- details relating to any return to work plan for employees and any involvement from employee representatives or trade unions in those plans;
- the effect on real estate, for example, details of any lease terminations or rent holidays;
- information relating to any disputes or litigation arising from the disruption;
- details relating to funding, for example, whether the target has taken out any government loans available as a result of COVID-19; and
- the effect on any existing insurance policies.
It is important to note that under standard practice any losses arising from risks that have been disclosed will not be covered by a W&I policy as there is no breach where a risk is disclosed. However, If the insurer is satisfied that there has been both full disclosure on the part of the seller and thorough diligence on the part of the buyer, they are more likely to engage in a conversation regarding the extent to which any COVID-19 exclusions will apply.
Effect on negotiations
Insurers will take an interest in how the parties have allocated COVID-19 related risks in the acquisition agreement between signing and closing. The insurer will want to see that such risks are explicitly allocated to either the seller or the buyer rather than the risk being shifted onto the insurer. For example, Insurers will be keen to know about any negotiations around material adverse effect clauses and whether these are being used to address any future risks associated with COVID-19.
Ordinarily, any risks identified in the period between signing and closing of a deal will be excluded from a W&I policy as a matter of course unless interim cover is taken out. The speed at which the impact of COVID-19 is developing is causing most insurers to become alert to the risks of providing interim cover. Insurers will consider offering cover in these circumstances on a case by case basis. The length of time between signing and completion is likely to be one determining factor as there is indication that insurers are only likely to provide cover if the interim period is short. Insurers will also require there to be adequate protections in the policy. The terms will again be carefully considered and there are likely to be exclusions for material adverse effect clauses which would allow a buyer to exit from the transaction if the target business deteriorates between signing and completion of the deal.
Whether there is interim cover or not, insurers will, nevertheless, be looking to see that the buyer has taken steps during the interim period to determine the effects that COVID-19 has had on the target’s business. Certain mechanisms may need to be inserted into the acquisition agreement for providing the buyer with an update on the operational position of the target business during the interim period. For the insurer, this will help to ensure that known risks which are discovered post-signing but prior to completion will be excluded.