Warranty and indemnity insurance policies (“W&I Policies”) are becoming increasingly prevalent in the European market as an instrument to reduce the inherent risks associated with M&A transactions and to resolve impasses between sellers and buyers when negotiating sets of warranties in sale and purchase agreements (“SPA”).
W&I Policies can be structured to protect either sellers or buyers in respect of liabilities deriving from breaches of warranties given in the context of the sale of a company or business. The use of W&I Policies has significantly increased in the UK market in recent years and appears to be increasingly applied, albeit at a lower level, in other European jurisdictions such as France, Italy and Germany. In this newsletter we provide a brief overview of the typical uses and functioning of W&I Policies in the European M&A market with a particular focus on market practice in the UK.
Either a seller or a buyer may purchase a W&I Policy in order to obtain cover for the potential liabilities arising from a breach of the seller’s warranties given in an SPA.
A seller-side W&I Policy protects the seller under an SPA for innocent misrepresentations or failure to adequately disclose against the warranties. Under a seller-side W&I Policy, the buyer makes its claim against the seller based on the SPA and the insurer then pays on behalf of the seller. In this type of policy, there is no contractual relationship between the insurer and the buyer. W&I Policies can offer varying amounts of cover to sellers, ranging from only a portion of liability to 100% of liability for indemnification up to the relevant agreed liability caps for the warranties.
In a situation where a buyer requests a retention of part of the purchase price or an escrow arrangement in order to have some form of security for liability coverage, a seller may instead use a seller-side W&I Policy to assure the buyer that liabilities will be met. As a result, the seller may be able to gain access to the full amount of the sale proceeds immediately as of completion.
Passive shareholders, including ultimate controlling shareholders, warrantors, or mere financial shareholders who are not involved in the day-to-day management of the target sometimes use seller-side W&I Policies to cover their liabilities. For example, in the case of a private equity firm faced with a secondary buy-out, a clean exit without limiting the set of warranties offered to a prospective buyer would be possible with a W&I Policy. A private equity firm that holds a W&I Policy can then proceed with liquidation and wind-up procedures even in the event the indemnification obligations under the SPA are still actionable by the relevant buyer.
Family-based sellers also use these types of policies since they may be hesitant to put their separate financial resources at risk in the event of possible indemnification obligations under an SPA following the sale of their company or business.
Although cost may be a concern, seller-side policies are sometimes used by receivers and administrators in restructuring or in insolvency situations since receivers and administrators are typically not in a position to give a potential purchaser significant warranties regarding the assets being sold.
A buyer-side W&I Policy indemnifies a buyer for losses caused by breaches of warranties by the seller under an SPA. Under a buyer-side W&I Policy, the buyer makes its claim for indemnification directly against the insurance company without need for recourse to the seller.
Buyer-side policies allow the buyer to rely on warranties given by a seller whose ability to meet indemnification obligations in financial terms might otherwise be uncertain. Additionally, in situations where a dispute arises in negotiations as to the amount of the cap for liability that a seller is prepared to accept in a sale, the buyer may use a W&I Policy to obtain additional cover in order to meet its requirements despite the position of the seller.
Buyer-side W&I Policies are also sometimes used in competitive auction processes. In order to gain a competitive advantage, a bidder may offer the seller an opportunity to lower or eliminate its liability under the warranties to be given in the SPA.
Another situation in which buyer-side W&I Policies are used is in obtaining cover under the warranties in the SPA for a longer duration than the seller is willing to accept.
Procedure for Setting up a W&I Policy
Typically, a W&I Policy takes the form of a stand-alone document containing the terms of cover, exclusions and limits, which is negotiated simultaneously with the SPA.
W&I Policies are typically tailored in such a way as to mirror, as closely as possible, the warranties given in the SPA also in terms of qualifications, limitations and caps. It is therefore common practice that no significant difference appears between what may be claimed by the buyer under the SPA and what may otherwise be claimed under the policy. In general, the duration of the W&I Policy corresponds to the period of validity of the warranties under the SPA. However, as stated above, buyers may look for a longer duration as a matter of further protection.
A policy excess is often agreed upon in the sense that a certain amount (typically around 1% of the deal consideration) would in any event be payable by the insured party.
Common exclusions to the indemnification obligations under a W&I Policy include the outcome of any due diligence/disclosure letters, forward-looking warranties, breaches of warranties that are already known at the time of execution of the SPA, fines, fraud or fraudulent misrepresentations and penalties uninsurable at law.
In Europe, standard coverage under W&I Policies typically includes unknown or undisclosed risks, such as breaches of warranties arising due to events which were not already known by the parties at the time of execution of the SPA.
W&I Policies are used less frequently for coverage of already known or disclosed risks resulting from, for example, due diligence processes or negotiations of the SPA. Alternative contractual mechanisms such as adjustment price formulae or specific Euro-for- Euro based indemnification provisions are more frequently used in these cases. However, W&I Policies may be taken out (usually with higher premiums) in order to cover sellers and buyers from known or disclosed environmental, litigation or tax-specific liabilities.
Premium rates, limits and costs
The cost of W&I Policies takes into account such factors as the complexity of the transaction, the claims expiry period, the existing insurance standing of the applicant, the industry sector, the jurisdiction of the deal, the quality of the transactional process and the advisers involved.
The amount of cover sought in a W&I Policy depends almost entirely on the attitude of the applicant towards risk. Sellers may be interested in covering the total limit of their liability for the warranties under the SPA, while buyers may be more comfortable with limited cover. For European transactions, in the current market, it is quite common to arrange policy limits equivalent to 25-50% of the enterprise value. Typically, premium rates range between 1% and 3% of the cover purchased and are normally payable in full at the inception of the policy.
Arranging a W&I Policy
To begin the process of acquiring a W&I Policy, a broker would typically offer an initial assessment of the potential terms of the W&I Policy and, if it is decided to proceed, the broker would then refer the matter to a lead insurer. The insurer would then carry out a detailed review based on such criteria as the overall context of the transaction, the nature of the business sector involved, the set of warranties involved and the disclosure process. Copies of all relevant documentation such as the SPA and due diligence reports would normally be forwarded to the potential insurer for review.
Once this detailed review is complete, a specific cost quotation would normally be sent to the applicant. The terms would be tailored to the transaction through negotiation between the parties. A final policy would then be issued which would normally be executed upon completion of the transaction under the SPA.
UK market perspective
A number of contributory factors have led to the growth and prominence of W&I Policies in the UK market. These include, among other things, the general increase in risk aversion which has been enhanced by the current economic conditions, the growth of insurance underwriting in London which has been the principal home for W&I Policies, and the increase in insurer competition which has led to the growing reduction in premium rates. As such, the UK W&I insurance market is now more competitive than it has ever been.
UK premium rates and costs
Premium rates for UK transactions can generally be obtained in the region of 1% of the W&I Policy limit purchased. The premium is generally payable in full, for the entire period of the policy, when the policy is taken out or shortly thereafter. The insured will also often have to pay the insurer’s due diligence fees (typically between £2,500 and £15,000 plus VAT), though in the UK these are usually set off against the premium. In addition, in the UK the insured may have to pay an insurance premium tax which is payable on the total of the premium paid to the insurer and operates at 5%.
The minimum limit of insurance available is generally dictated by the minimum levels of premium payable to the insurer, typically £15,000 to £25,000. As a result, if the limit of cover is less than £1 million, the premium level tends to be uneconomical.
UK policy limits
With buyer-side policies, the buyer can choose the level of cover which provides the appropriate level of comfort required. Generally, a buyer will seek warranty protection through insurance at a rate of between 1% and 30% of the enterprise value. A buyer can of course seek to have the full amount covered, though this will depend on there being sufficient capacity in the insurance market. There are currently 6-7 underwriters in the UK which together offer capacity in excess of £100 million for primary coverage. This could be extended by using the full global insurance market which could offer a limit in excess of £200 million, although this would involve creating a syndicated facility. Generally in the London market, buyers seek an average limit of insurance of between £5 million and £10 million for deals up to £50 million, and £20 million or more for transactions above this level.
By contrast, a seller-side policy can insure up to the full limit of liability agreed in the SPA, plus defence and investigation costs.
Insurers typically require that the insured accept a certain portion of the risk through the policy excess. This policy excess is generally at least 1% of the deal consideration and will not normally become operative until the erosion of the minimum claims limitations negotiated under the SPA.
In addition, the policy will usually reflect the duration of the warranties given in the SPA, which may be of the order of up to a seven years post-completion for tax warranties and typically up to two years post-completion for general warranties.