1 What is W&I insurance?
Warranty and indemnity insurance (or representation and warranty insurance as it is known in the US) provides cover for losses suffered in connection with warranty or indemnity claims. In an M&A transaction, the insurance policy can be taken out by either the seller or the buyer, but is usually taken out by the buyer.
Under a seller policy, the buyer claims against the seller under the transaction documents in the normal way and has no direct claim against the insurance policy. The seller remains liable to the buyer under the claim, but the insurer will control any defence or settlement of the claim.
Under a buyer policy, the buyer claims against the seller up to any agreed cap on liability under the transaction documents and under the insurance policy for any liability above the cap – or, if the cap is £1 (or the warranties or indemnity is ‘synthetic’ – see below) the buyer’s only real claim is against the policy.
2 Why insure?
- Clean exit for seller:
The seller may be unwilling or unable to give warranties or a tax indemnity (eg as a matter of policy or because it wants to make an immediate distribution of the sale proceeds). Increasingly, on auction sales, sellers are seeking indicative terms from W&I insurers at the outset and then requiring the successful bidder to take cover.
- Bridging the gap:
In some cases, the seller may be prepared to give warranties, but may want to cap its liability at a level the buyer isn’t comfortable with. W&I insurance can be taken out to increase the buyer’s cover.
- Covenant strength:
The covenant strength of a seller or warrantor can be a major concern for a buyer, especially if the seller is a special purpose vehicle, in financial difficulties or has little or no onshore assets.
- Unwillingness to sue the seller/warrantors:
Certain deal dynamics may make it unattractive for a buyer to sue a seller or warrantor, e.g. where they have an ongoing trading relationship or where a management team have given warranties and are remaining with the business.
3 How much cover can be obtained?
It’s possible to get a policy that covers 100% of the purchase price - but this depends on the appetite of the insurance market and the willingness of the insured to pay the premium. Typically parties look for cover of 10% to 50% of the purchase price. This is because it’s rare to see a breach of warranty so large that the loss exceeds 40% of the price paid. A recent study shows that 92% of all claims notified are less than $10m1 in size, so picking a policy limit that is commensurate with the potential risk is key.
4 What risks are excluded?
A W&I insurance policy will not usually cover:
- Known facts or matters identified by a buyer in due diligence or otherwise disclosed by a seller. However, increasingly (at the right price) insurers have been willing to underwrite specific policies insuring certain known facts or matters on a case-by-case basis if the issue is deemed ‘low-risk’ by the insurer.
- Forward-looking warranties, such as the target company achieving post-completion profit goals.
- Certain tax matters e.g. transfer pricing and secondary tax liabilities but insurers may cover these on a case-by-case basis if adequate due diligence is available.
- Civil or criminal fines or penalties that may not legally be insured against.
- Post-completion price adjustments and no-leakage covenants in locked-box deals.
- The underfunding of pension schemes.
When engaging an insurer, the insured has a duty to provide a ‘fair presentation of the risk’ and should provide full details of the due diligence that has been undertaken. Helping an insurer understand how due diligence was conducted, the advisers that were engaged and the areas of focus is crucial in helping the insurer get comfortable with the transaction.
Insurers may also be able to provide cover for risks that would have previously been excluded, subject to sufficient due diligence and the insurer deeming the risk to be sufficiently remote. However, these ‘extras’ may command an additional premium. Examples include:
- ‘New breach’ cover – where the policy applies to a breach of a warranty or the tax indemnity that has occurred and is discovered in the period between signing and completion.
- Knowledge scrape – where warranties are given subject to the knowledge of the warrantors, the policy can be drafted to exclude the knowledge qualification.
- Materiality scrape – policies can be drafted to exclude materiality qualifiers when determining the quantum of a breach of warranty.
- Synthetic tax deeds and warranties – these are used where a seller has refused to provide warranties or a tax indemnity but the insurer will provide a tax indemnity or warranties via the policy instead. They will only available where there has been through due diligence and disclosure exercises as well as a well populated data room. A common use for synthetic warranties would be where a vendor in administration or receivership and is unable or unwilling to give warranties.
5 Who pays the premium?
The cost of the premium is sometimes borne by the seller, as its liability is being reduced. But this is often subject to negotiation and it is sometimes split between the parties. If the seller does agree to bear the cost, it may cap the premium it is willing to fund. The seller will want to do this at an early stage, when the sale process remains competitive and it typically has greater bargaining power.
6 What premium and excess is normal?
In the current UK market, we are generally seeing premiums of between 0.9% and 1.5% of the insured value for sales involving trading businesses, and between 0.7% and 1% of the insured value for sales involving a real estate special purpose vehicle, this is subject in each case to a market minimum premium.
We are also generally seeing excesses of between 0.5% and 1% of the insured value for sales involving trading businesses (although sales of private equity owned businesses may command an excess of nearer 0.25%) and nil for sales involving a real estate SPV (in each case subject to a de minimis threshold).
Retentions can also be structured so that they ‘tip’ meaning that where the aggregated loss exceeds the policy retention, the claim paid by the insurer will tip to an agreed lower amount. Policies may also have a ‘dropping’ retention where the level set will fall to a lower amount on the expiry of a certain time period (e.g. the non-tax warranty period).
7 What is the impact on due diligence and disclosure?
W&I insurance is not a substitute for a thorough and complete due diligence and disclosure exercise. An insurer will expect that due diligence and disclosure, as well as negotiations regarding the warranties, are conducted between the buyer and seller at arms’ length and as though the deal did not involve W&I insurance. Any evidence to the contrary (e.g. a very limited due diligence report, a disclosure letter that is light on specific disclosures, or transaction documents containing very extensive or un-negotiated warranties) may cause an insurer to refuse or severely restrict cover.
In any event, a seller will want a proper disclosure exercise to be undertaken because the insurer will usually retain subrogation rights against warrantors to the extent that liability under the policy arises from their fraud or dishonesty (see below); Also, the buyer will want to diligence the transaction properly to deal with any potential issues upfront, rather than face the costs and uncertainties involved in making a claim.
8 How long does it take to put a policy in place?
The insurer and its advisers will review the transaction documents and undertake due diligence in much the same way a buyer would. Typically an underwriter can put a policy in place within 5 to 10 business days provided they receive a good level of engagement into their underwriting process.
9 How long will the cover last?
The cover will usually match the claims period under the transaction documents; up to two years for general warranties and seven years for tax, title and capacity warranties. However, extended cover may be available.
10 What are some of the key drafting considerations
The transaction documents and W&I insurance policy should be carefully reviewed and read together to ensure that there are no unexpected gaps in cover, and that any exclusions are carefully negotiated and drafted.
The following points may be relevant when negotiating the transaction documents and W&I insurance policy:
- The seller may want to link the maximum liability threshold of the seller under the transaction documents to the aggregate claims threshold under the W&I insurance policy. For example, if a policy will cover all losses above £200,000, the seller’s liability under the transaction documents could be capped at £200,000.
- Even if W&I insurance is used, any limitations of liability of the seller under the transaction documents should not apply in the event of fraud by the seller.
- If an insured party wants to assign the benefit of a W&I insurance policy (e.g. to a group company or lender), this will need to be reflected in the policy drafting.
- A seller should insist that the right to subrogation against it should be waived by an insurer under any buyer-side W&I insurance policy. Otherwise, an insurer which has paid out money to an insured under a buyer-side policy may be entitled, as an equitable remedy, to step into the shoes of the insured and recover all or some of that money from the seller or warrantor.