There are insurance policies for almost everything, so why not also for risks resulting from M&A transactions? It is nothing new that buyers and sellers may take out an insurance policy for risks in M&A transactions, but it is new that this is done more and more often.
Policies of that kind have been offered since the eighties but in Germany they were hardly known not to speak of them being common, for several reasons. In particular, the products were expensive and the whole underwriting process was lengthy and complicated. That just did not match with M&A transactions.
Times have changed. Nowadays, there are not only numerous insurance companies offering products but competition also had a positive influence on the price, the underwriting process and the time schedule.
What is insured?
The warranty & indemnity (W&I) insurance (aka representations & warranties (R&W) insurance), is a well-known product. It covers damages resulting from breaches of warranties and indemnities given by the seller in an M&A transaction.
However, not all risks resulting from breach of warranties and indemnities can be covered by such a "normal" policy. Certain warranties and indemnities such as environmental or tax issues are insured separately depending on their extent. Regularly, a "normal" policy does not cover damages the occurrence of which is probable after the due diligence process already.
What are the advantages?
The risks for sellers and buyers in connection with breaches of warranties and indemnities are shifted to a third party: the insurer. This is advantageous for both parties.
Economically, the seller is no longer the financially liable party. Principally, the buyer no longer needs cover for liability claims against the seller, e.g. through retention of part of the purchase price or deposit (holdback) of part of the purchase price with a trustee (escrow).
The seller is now able to immediately pocket the full purchase price. Such a “clean exit” is particularly important for financial investors acting as sellers. Also in the company succession sector, such a clean exit is in the sellers' interest. Who would want to be exposed to liability risks for years after the sale of his business at retirement?
Sell-side financial investors are often confronted with a further problem which can be coped with by shifting liability to an insurer: Financial investors are often unable to give typical seller's warranties in the operative sector. In most cases, such warranties can only be given by the management installed by the financial investor. Naturally, the managers' motivation to take on the seller's responsibility and give warranties is limited. W&I insurance can be a last resort in such cases.
W&I insurance can be attractive also in distressed transactions, i.e. if the target company and/or the seller are in a crisis. If liability arises on the seller's side, the buyer's default risk is higher naturally. In such cases, the seller can offer an alternative in form of W&I insurance and thus increase the target's attractiveness to potential buyers.
In controlled auctions, W&I insurance is a good instrument for the bidder to stand out from the other bidders despite otherwise comparable terms ("sugar your bid").
W&I insurance cover is also advisable to the buyer if he does business in foreign jurisdictions. Enforcement of claims may be difficult and combined with additional risks. The same applies in situations where the buyer is confronted with numerous individual private sellers, in particular in case several and joint liability is excluded.
Finally, the parties' expectations as regards the scope of the seller's liability are too far apart and, in particular, agreement on the liability cap cannot be reached. Such a gap can be bridged through a W&I insurance.
What is typically excluded?
Naturally, it is alluring for both the seller and the buyer to be no longer obliged to spend so many efforts in negotiating the warranties and indemnities since the liability risk is shifted to the insurer. The insurers cope with that challenge in different ways.
Regularly, the insurer requests a policy retention, which can be equal to the de minimis threshold and the basket threshold agreed by the seller and the buyer in the SPA but has a lower rank. This is a matter of negotiation and depends on several factors (e.g. scope of the guaranty, magnitude of risk).
Certain risks are regularly excluded from insurance cover, among them forward-looking warranties such as reaching a targeted financial success (turnover, profit) post closing. Risks known already, issues in connection with fines and penalties as well as fraud are also excluded.
Insurance capacity is limited. Some insurers can cover risks up to MEUR 50. Higher capacities can be provided on a syndicated basis only. Currently, the maximum capacity is deemed MEUR 300.
Who concludes the insurance?
W&I insurance policies may be taken out by either the seller (sell-side policy) or the buyer (buy-side policy). In practice, the overwhelming majority of the policies taken out are buy-side.
In case of a sell-side policy, the buyer enforces its claims against the seller, who then seeks indemnification from the insurer. This is a third party liability insurance cover in principle.
In case of a buy-side policy, the buyer enforces its claims directly against the insurer. This is an indemnity insurance cover in principle. In most cases, the seller is not involved in the claim handling. It is important to exclude recourse of the insurer against the seller except the damage results from fraud or bad faith of the seller.
Georg von Mangoldt from the broker Marsh says on the relationship between placed sell-side policies and buy-side policies: "We see a trend to buy-side policies. Almost 90% of the 50 policies we were able to place in Europe in the first half of 2013 were buy-side."
The respective policy outline is subject to negotiations. For instance, the buyer may "only" cover the risk beyond the liability cap (top-up cover). This is possible as regards the amount or the time for which the respective guaranties apply. Shifting the risk –almost– completely to the insurer (replacement cover) is also thinkable.
What is the procedure?
Insurers have become fast. A binding offer may be submitted after ten to 15 days only. Usually, the steps are as follows: In most cases, the first contact is made through a broker, who is able to give a rough estimate at short notice. When being provided with further documents (draft SPA, due diligence reports, annual financial statements, information memorandum), the broker request unbinding offers from suitable insurers.
The selected insurer will then conduct a thorough investigation (the underwriting); regularly, the insurer seeks support from external counsels. Often, the insurer will request additional information or meet with the respective deal team to discuss issues. The finally negotiated documentation is the basis for the binding offer from the insurer.
Georg von Mangoldt from Marsh says on the underwriting issue: "In Germany, we have only one specialized insurer at present, therefore, it is the more important to initiate competition through our access to the foreign market. Our experience with foreign insurers interested in German deals in the last years is excellent."
Insurance documentation mainly consists of the insurance certificate and the warranty spreadsheet, which states details on the cover for each warranty and indemnity made in the SPA.
What does it cost?
Usually, warranty insurance cover costs 0.9 up to 1.5% of the risk insured plus the applicable insurance tax. Depending on the insurer, the minimum premium is EUR 40,000. Therefore, insurance cover for transactions below MEUR 10 rarely pays. Broker's cost may have to be added. Insurers covering particular risks are significantly more expensive.
W&I insurance cover is a reasonable product for M&A transactions. Sellers' risks and buyers' risks which often result in a failure of the transaction can be transferred to an insurer without a huge investment in time at a reasonable price.
However, W&I insurance cover is not suited for any transaction. In minor transactions, the premium may be an argument against such cover. In each particular case, the specific risks should be weighed up against the offered cover for a reasonable balance.
The number of occurred events insured is relatively small but has increased since 2008. Georg von Mangoldt from Marsh says: "In our portfolio we have noticed an increased number of events insured, and in practice insurers prove to be flexible as regards claim settlement, so we are able to settle even major claims within few weeks."