Increased competition among insurers and improved policy terms suggest the W&I insurance market is becoming more favourable to investors.
In real estate transactions, buyers and sellers naturally pursue conflicting interests when negotiating a sale and purchase agreement. On the one hand, sellers will strive to achieve the highest possible purchase price, and will also want to keep their liability exposure low. Private equity investors in particular will try to achieve a “clean exit” when selling real estate directly or indirectly, so that they can dissolve the selling entity quickly. On the other hand, buyers will want to minimize the purchase price. At the same time, they will know the asset only from their due diligence. Therefore, buyers will try to obtain a comprehensive set of representations and warranties from the seller. However, even if the seller gives such representations and warranties, asserting claims will often be unsatisfactory for the buyer because the selling entity lacks assets. The buyer will therefore insist on a security for his claims. These conflicting interests often put a significant burden on contract negotiations and can even turn into a deal-breaker.
Sell-and-buy-side W&I policies
Parties to a deal can secure the buyer’s claims in different ways, such as a purchase price retention or escrow accounts. In the current seller’s market, however, such structures are becoming increasingly rare. So-called warranty and indemnity insurances (W&I insurances), however, are becoming an increasingly popular method of securing the buyer’s claims. Either the seller or the buyer can take out such W&I insurances. If the seller takes out the insurance, the insurer reimburses the seller — similar to a liability insurance — for claims asserted by the buyer. Such policies have risks for the buyer, e.g., if the seller acts intentionally or violates his obligations under the insurance policy and the insurer refuses to reimburse the damage. Sell-side W&I policies, therefore, have almost no practical relevance, at least in real estate private equity transactions. The buyer’s preferred option is the buy-side W&I policy. Such policy grants the buyer a direct claim against the insurer in case of a damage. The buyer, therefore, does not have to assert any claims against the seller. Such policies also cover instances in which the seller has not disclosed the relevant facts and has therefore acted with gross negligence or even intentionally.
Due to the increasing popularity of W&I policies, the number of insurers offering such policies is also growing. The larger policy supply and the resulting competition among insurers has prompted better conditions for deal parties. In particular, these conditions concern the insurance premiums. While until recently premiums of more than 1% of the insurance sum were common, insurers have now started to offer premiums from 0.7% to 0.8 %.
Deductibles and “tipping-to-nil” concept
Insurers also have started recently to show more flexibility with respect to deductibles. While buyers in the past often had to accept deductibles of 0.1 % of the sum insured, the “tipping to nil” concept is now very common, often with amounts of only 0.05 % of the sum insured. Tipping to nil is merely a liability threshold — if the damages exceed the threshold, the insurer reimburses all damages, not only the amount exceeding the threshold (unlike a deductible). In some cases, insurers issue policies without any deductible or threshold at almost the same premium as was previously charged for policies containing such limitations.
Additional substantive improvements
Recent substantive improvements in W&I policy terms relate to, inter alia, the types of damages covered by the policy. Whereas in the past only direct damages could be insured, recent policies often also cover indirect damages, consequential damages and — essential in real estate transactions — lost profits in the form of loss of rent. This is the case even if such damage is excluded in the purchase contract. However, insuring damages calculated on the basis of a certain multiple of rent remains very difficult. Insurers are also becoming increasingly flexible with respect to limitation periods. Investors can now negotiate three years for normal warranties and seven years for legal ownership and tax warranties, regardless of any shorter limitation periods in the sale and purchase agreement. Finally, there are new developments on the insurer’s standard disclaimer of liability due to the policyholder being aware of the circumstances giving rise to the damage. Traditionally, German policies will not cover even remote risks identified in the due diligence; the same approach applies to risks that were apparent from data room. More recently, however, some insurers are willing to limit the identified risks to the items disclosed on the disclosure schedules attached to the sale and purchase agreement — as is common in US-style policies. However, the effort and costs required to negotiate these policies are currently considerably higher than for traditional policies.
Written form requirement for German leases
Despite increased flexibility in many areas, insurers are still struggling with some particularly important issues in real estate transactions. For example, warranties on the violation of the written form of leases are very often subject to a proviso that the policy only covers what the contractual parties wrote down in a document. The important warranty that the parties to the lease agreements have not concluded any oral side agreements is very difficult to insure.
Tax and environmental warranties
Another traditional downside of W&I policies is that tax risks are often inadequately covered. While a tax indemnity in a sale and purchase agreement usually also applies if the circumstances underlying a tax risk were apparent from the data room or already known to the buyer — for example based on his due diligence — a W&I policy uses a different approach. In principle, the policy traditionally will not cover even remote risks identified in the due diligence as shown above. The same approach applies to risks that were apparent from the data room. However, the market has recently changed slightly in this respect. Some insurers also insure “low risks” against an increased premium. The liability under section 75 of the German Tax Code or a trade tax risk resulting from an establishment in Germany may thereby also be insured. Insuring tax risks is now also possible, even if the sale and purchase agreement does not contain a tax indemnity (so-called “synthetic tax deed”). However, the premiums for this are considerably higher than for normal W&I policies and the aforementioned exclusions of liability also apply to them. Currently only separate policies can cover medium and high risks, the premiums of which vary widely on the nature and extent of the risk. The same applies for environmental risks, which can only be insured under standard W&I policies, if at all, to the extent that a comprehensive environmental due diligence has been conducted and the due diligence reports do not identify any risks. Whether the current overall trend towards more flexible policy conditions will also affect these issues in the future remains unclear.
When determining whether or not to take out a W&I policy, parties should always consider all circumstances of the specific case. Overall, the market is currently developing significantly towards investors due to increased competition among insurers and improved policy terms that come along with such competition.