Warranty and indemnity (W&I) insurance is on the rise. Although there are variances in coverage and forms between jurisdictions, its primary purpose is to transfer, to a third-party insurer, the risks associated with a seller's breach of warranty or liability under an indemnity in an acquisition agreement.
W&I insurance has been around for many years, but we are now seeing its increasing take-up, particularly in Asia Pacific, Europe (notably the UK) and the US.
This article answers two of the more common questions we are asked by participants in key markets: what are the trends in the market, and what does the future hold?
What are the trends in the market?
Key markets are becoming increasingly interrelated, with prevalence in the US pushing European insurers to offer certain US-style policy features, and Asian insurance giants looking to support investment in European and US markets.
The Australian market is now one of the most mature and competitive W&I markets in the world. The use of W&I insurance as security for breaches of warranties and indemnities in Australian deals has surpassed the use of any other form of security and the demand for W&I insurance shows no sign of abating.
While there is a stable of insurers who have been offering W&I in the Australian market for some time, new entrants continue to enter (offering both primary and excess cover) . This has resulted in Australian premiums remaining some of the lowest in the world and enabled insured's to access a broader coverage offering. There is now sufficient capacity in Australia to build a tower that provides coverage of AUD1 billion for a single transaction.
There is a demonstrated claims history in the Australian market with claims in respect of financial statements warranties, material contracts warranties and tax warranties being the highest frequency claims. This claims history is giving insureds more comfort in the product and where W&I insurance was traditionally the domain of a PE buyer or seller, and viewed with some scepticism by industry or founder parties, we see much less reluctance from non-PE market participants in taking up the product.
Auction "sell-buy-flip" processes (where W&I insurance is put on the table by a seller as a non-negotiable part of the deal from the outset) are a relatively common deal structure. Increasingly, insurers are engaging in these processes with a seller from an early stage to provide some sell-side guidance and at times underwriting with multiple bidders in a contested auction so that W&I underwriting runs in parallel with the deal process to facilitate the deal timetable.
As a result of the mature and increasingly globalized market, coverage positions are adapting and we are seeing an increasing number of insurers who are willing to accept more US-style coverage positions (including due diligence reports and data rooms not reading down the warranties and US-style disclosure letters) (with premiums adapted accordingly) and tipping retentions are also now commonly seen in policies, particularly in respect of title and tax warranties.
Given the substantial amount of private-equity money chasing a relatively small number of quality targets, Asia has seen a sustained seller-friendly market. A large number of competitive auction processes continue to be undertaken, the vast majority of which now require bidders to agree to buy W&I insurance as part of their bid submissions.
A number of M&A deals also involve founders of family-run businesses who are not completely exiting the business and will have three- to five-year earnout-type option periods to sell down their remaining minority stakes. These minority shareholders/sellers often stay on for the medium term to run the businesses in which they have just sold a controlling stake. As it makes no commercial sense for the buyer to sue the seller in those circumstances, many of these transactions are now using W&I insurance to transfer potential liability from the seller to the third-party insurer. This, in conjunction with a waiver of subrogation from the insurer, removes much of the commercial tension in the event of a claim for breach of warranty or under an indemnity.
There is also a growing frustration with the delays associated with the opening of escrow bank accounts. W&I insurance can obviate the need for escrow holdbacks of the purchase price to provide for potential warranty claims. This is a valuable solution to an increasingly common problem that further increases demand for the product.
Europe and the UK
Perhaps the most consistent trend is − and has been for some time − the increasing take-up of W&I insurance. It is frequently being used in deals and, in many respects, is now mainstream. Though initially driven by private equity funds, the product is now increasingly taken up by corporates. Geographically it is widely used in transactions in the UK, Germany, the Netherlands, the Nordics and the CEE, and has been gaining increased traction in France, Spain, Portugal and Italy.
As with a lot of classes of business, it is a very competitive area. In recent years, a number of new markets have opened up (there were four major new entrants into the market in 2018), yet some have also left (two major players in 2018). It is not uncommon to see experienced teams of underwriters leave big insurers to set up managing general agents using mainly Lloyd's paper. This has allowed syndicates to operate in the space without having to hire dedicated underwriting teams, thereby increasing competition and exerting downward pressure on pricing – although new players are finding it increasingly difficult to find capacity.
As the relevant markets become more sophisticated and competitive, insurers are becoming more pragmatic and light-touch, with an increasing pressure on insurers to limit the number of exclusions that they have and to extend the scope of their coverage (often towards the wider coverage position that is standard in the US). The market is also segmenting, with a rapid rise of specific tax risk insurances and real estate transactions attracting their own set of premiums. Insurers are also looking to move into the SME (small and medium-sized enterprises) space.
Market growth claims are inevitably on the rise but this is recognized as instilling confidence in the product. Financial statements and tax remain the most commonly breached warranties, with employment warranty breaches becoming more prevalent recently; this can be explained by an increase in the number of insured transactions in jurisdictions with more robust labor laws, such as France and Spain).
New Zealand continues to see extensive use of W&I insurance, beyond its traditional private equity base. The product and its benefits are becoming better understood, and there is increased competition from new underwriters and brokers entering the market. Premiums remain sharp, even in lower value transactions.
New Zealand is a land full of SMEs, and some underwriters are seeking to carve out a niche by writing risk below the minimum risk territory of some of the more established underwriters. There are, of course, challenges in playing in this part of the market: the advisors are often not specialist M&A practitioners, and parties are less likely to conduct full-scope due diligence investigations. This can make it hard for underwriters to assess the risk.
A number of W&I underwriters have also reacted to the (public) failings of certain companies to correctly accrue employee entitlements. As such, general exclusions for failures to comply with specific legislation are becoming reasonably common.
New Zealand is also seeing some changes in the recourse position between buyer and seller. Nil recourse had been the standard position for many years; however, more recently, this has sometimes given way to limited recourse – for example, with the seller remaining on risk for an amount equal to the excess under the W&I policy, or in respect of specific indemnities.
In the US, the use of W&I insurance − known as representations and warranties (R&W) insurance − has become ubiquitous. There are very few transactions (other than small deals or transactions for very specific assets) where the use of R&W insurance is not at least strongly considered. As a result, the use of the product and the underwriting process has become a more natural and standard part of negotiating and implementing a transaction.
The significant increase in the number of markets in the US over the past two years has also led to a significant increase in the level of competition between markets and pressure to limit exclusionary positions. Further, while there were historically certain sectors or industries that insurers would not underwrite for, the use of R&W insurance has expanded to many such sectors (among them healthcare, life sciences, oil and gas, and financial services).
While the use of R&W insurance historically focused on the private equity market (with corporates less inclined to use the product), that is no longer the case. Corporate buyers now understand that seeking to do a transaction without R&W insurance puts them at a strategic disadvantage, particularly in the auction context.
There is also an increase in deals with no seller retention; in other words, public style deals where the only recourse is to the R&W policy. This has led to the use of R&W insurance in public deals as well, something that was not seen a couple of years ago.
What does the future hold?
Ultimately, given increased competition, increased comfort with the product in the market, increased coverage and lower premiums, and demonstrated claims history we expect the use of W&I insurance will continue to rise. The continued entry of insurers to the Australian market lends further weight to this.
We expect that as the product further matures, the M&A market and deal advisers will continue to adapt their processes and become increasingly sophisticated users of the product, resulting in even further streamlined underwriting processes where use of W&I insurance becomes more common than not.
As a standard W&I policy becomes further commoditized, the use of synthetic and specific risk policies is an area where we expect to see significant growth as insurers, brokers and advisers develop the product further. W&I insurance has been used to a limited extent to date in insolvency and public market deals but we expect these to be key areas of growth in coming years particularly public market deals where acquirer boards seek some comfort for warranty and indemnity breaches as part of their corporate governance processes.
A number of insurers have entered the Asian market and then exited quite quickly. This is an unfortunate experience for their insureds, and can cause doubts about the value and benefits of the product itself.
We nevertheless expect certain insurers will begin to stand out from the crowd as long-term supporters of the Asian market. This, coupled with a rapidly growing knowledge base among the Asian brokers, gives us reason to expect the increasing take-up of the product will continue for some time.
Europe and the UK
In short: it's anyone's guess! However, it is likely that the increased competition and take-up of the product will have a continued meaningful impact on the drafting and negotiation of both policies and purchase agreements. Indeed, the use of W&I insurance has already led to some level of commoditization of certain policies and purchase agreements, with less negotiation around the terms of coverage, along with the representations and warranties and the indemnities.
This commoditization will continue to push transactional insurance into new spaces, such as light-touch SME deals and specific risks. Insurers will continue to develop sophisticated approaches to deal with claim-heavy warranties (such as financial statements and tax) and litigation insurance is posited as a future product development.
In order to streamline the underwriting process, we expect the market − or, at least, part of the market − will eventually move to a market-standard suite of generic (non-target-specific) warranties. Significant time and resources would be spared if all sale agreements contained consistent language on warranties such as title and capacity, audited versus non-audited accounts, compliance with laws, and third-party intellectual property breaches. Although we may never reach this contractual utopia, we expect the market will shift toward it. This may help reduce the time and costs associated with underwriting the product, further increasing its take-up.
As the use of W&I insurance continues to grow, the market has become focused on the sustainability of the product, which includes consistency and predictability in claims handling. Insurers have begun to refine their coverage approach based on the claims data that has developed from years of prior policies put in place, and though competition in the markets has led to broadening coverage for lower rates, we expect the markets will need to balance competitive aggressiveness in underwriting and coverage with claims considerations for the continued long-term success of the product.