An emerging trend in acquisition transactions globally is the use of warranty and indemnity (W&I) insurance – specifically, in transactions involving private equity and strategic buyers. While global M&A in 2019 was lower in both volume and value compared with 2018, 2019 saw a 51% increase globally in usage of W&I insurance. In Asia, there has been a steady increase in usage of W&I insurance between 40% and 65% year on year since 2015.(1)
This article provides an overview of W&I insurance and is divided into three sections:
- the first section explains the key commercial terms commonly used in a W&I insurance policy;
- the second section highlights the benefits of using W&I insurance; and
- the third section analyses some of the key points to be considered while using W&I insurance.
Concept and key commercial terms
In an acquisition, the seller typically provides extensive representation and warranties on various aspects depending on the type of acquisition and corresponding indemnities to protect the buyer against financial losses arising out of a breach of such representation and warranties. The key objective of W&I insurance is to provide financial protection to the insured (either the buyer or seller) against unknown financial losses arising out of a breach of the representation or warranties provided by the seller and covered by the W&I insurance policy. W&I insurance does not offer protection for breach of covenants or for issues or risks that are known to the buyer, including as a result of the due diligence exercise. Key commercial terms used in a standard W&I insurance policy are summarised below.
Underwriting fee
The process of obtaining a W&I insurance policy starts with insurers providing a non-binding indication of interest that contains key commercial terms that will be part of the policy, followed by an underwriting process that requires payment of a non-refundable underwriting fee (typically between $15,000 and $50,000). The underwriting process is initiated only after confirmation of acceptance of the non-binding indication of interest and payment of the underwriting fee. Parties should approach multiple insurance brokers to compare quotes and key terms of a policy.
Insured
W&I insurance can be obtained either as a sell-side policy or, as is more common, a buy-side policy. In a sell-side policy, the insured is the seller and in the event of a claim, the buyer makes a claim against the seller and the seller in turn claims under the policy. In a buy-side policy, the insured is the buyer and in the event of a claim, the buyer can claim directly under the policy. Depending on the deal structure, a buy-side W&I insurance policy can be used to cover financial losses, including seller's fraud.
Coverage
Coverage (commonly referred to as the 'limit of liability') represents the insurer's aggregate liability for payments to be made under a W&I insurance policy. Insurers under W&I insurance policies pay for financial losses(2) covered under the policy that exceed the retention (explained below) and are within or up to the aggregate coverage set out in the policy. In a sell-side policy, coverage is available up to the seller's liability under the transaction document. In a buy-side policy, coverage is available up to the entire purchase price. However, policy coverage generally represents a percentage of the purchase price and is commonly anywhere between 10% and 30% of the purchase price. Any coverage exceeding $40 million per transaction is usually insured through syndication, with one insurer as the lead insurer.
Term
Coverage is usually provided for up to three years for business warranties and seven years for tax and fundamental warranties, unless the time limits under the transaction document are more favourable, in which case the time limits under the policy mirror the time limits provided under the transaction document. Where there is no limitation period for fundamental warranties under the transaction document, insurers usually cap the coverage of fundamental warranties under the policy at seven years.
Premiums
The premium is a one-time fee paid at the time of execution of the policy and ranges anywhere between 0.9% and 3% of the coverage purchased. Parties should negotiate and agree which party is responsible for bearing and paying the premium and the underwriting fee – this is entirely a commercial decision and there are no set standards. The quantum of premium payable depends on multiple underwriting considerations, such as the sector in which the target operates (eg, sectors such as telecoms, oil and natural gas are considered high risk) or geographies in which the target operates (eg, if the target operates in jurisdictions that are sensitive from a political or regulatory standpoint).
Exclusions
All W&I insurance policies contain exclusions (ie, items that are not covered under the policy). While some exclusions are specific to the transaction, sector and geographical area, most exclusions are standard exclusions provided by the insurer as part of its non-binding indication report. Typical exclusions include:
- warranties marked as 'excluded' or 'partial cover' in the warranty spreadsheet;
- any actual knowledge prior to the date of the policy or closing of the transaction (this typically includes the entire data room, all disclosures by the seller and diligence findings);
- any exemplary or punitive loss or damages, criminal fines or penalties; and
- any adjustment provisions (including purchase price adjustments, amount of leakage and tax liabilities).
Buyers considering W&I insurance should review exclusions carefully before purchasing the insurance policy and should negotiate with sellers alternate options such as escrow or general indemnification obligations to cover exclusions.
Retention
Insurers are liable to make payments under a W&I insurance policy only in excess of the retention (commonly referred to as the 'deductible'), which ranges anywhere between 0.5% and 1% of the purchase price. Retention can be either fixed retention or tipping retention. If a fixed retention applies, which is more common, the insurer will be liable only for amounts that exceed the fixed retention and the retention amount gets eroded by individual claims that are lower than the retention amount, until the entire retention amount is eroded. A tipping retention, on the other hand, operates more like a basket threshold and the insurer is liable for the entire loss once the amount claimed as loss exceeds the tipping retention threshold.
De minimis
Insurers are not liable to make payment under a W&I insurance policy unless the loss exceeds the de minimis threshold, subject always to the retention – this threshold typically mirrors the de minimis threshold under the transaction document. However, most insurers require the de minimis to be at least 0.1% of the purchase price for each claim.
Subrogation
Subrogation is a standard right of the insurer to proceed against the seller providing the warranties, after making payment in respect of a claim under the policy. From a seller's perspective, it is important to review the subrogation clause carefully and limit the insurer's right of subrogation to instances of fraud by the seller.
Based on data generally available on the usage of W&I insurance, private equity investors and other strategic investors appear to be its heaviest users – predominately in deals involving the sale of shares and as buy-side policies. Paragon reports that out of the total policies procured from it globally in 2018, 62.53% were procured by private equity investors.(3) Similar trends have also been noticed in India, where 73% of the total W&I insurance policies procured from Marsh & McLennan in 2020 were by private equity investors.(4) Some of the key benefits and reasons for procuring W&I insurance are summarised below.
Investor exits
In most acquisition deals involving investors, enforcement of indemnification obligations against the selling investor given the fund cycle and limitation period under the transaction document is always a negotiation point. Buyers typically require the exiting fund to either place a portion of the sale consideration in escrow or seek backstopping of the exiting fund's indemnity obligation by a fund managed by the same general partner as the exiting fund. In such scenarios, W&I insurance can offer an effective solution. Further, in targets that are investor owned or controlled to a large extent, W&I insurance can be an effective tool to limit and manage selling investors' risk exposure.
Limited escrow
W&I insurance reduces reliance on escrow arrangements – in terms of reducing the quantum of escrow amount to cover exclusions and retention. This flexibility is useful in the Indian context specifically, given that Indian exchange control regulations require escrow arrangements to be limited to 25% of the total consideration and a maximum of 18 months.
Easier claim and pay-out procedures
W&I insurance helps buyers to maintain their relationship with sellers by not having to enforce indemnity obligations directly against sellers – this becomes especially important where sellers (eg, promoters or management teams of the target) are absorbed into the buyer's organisation following the transaction or where the buyer and seller are both investors. Most insurers are generally mindful of their own market reputation and are less likely to needlessly delay or drag out the claim or pay-out process.
Bidding and stapling
In a bidding process, prospective buyers can gain competitive advantage by including W&I insurance as part of their proposal – thus managing the seller's exposure to liability by offering lower escrow holdback and monetary cap on liability. A rising number of sellers also insist that bidders obtain W&I insurance to enable sellers to ring-fence their liability – commonly referred to as 'stapling' W&I insurance to the transaction. In advanced markets such as the United Kingdom, 'hard stapling' (where warranties provided by the seller under the transaction documents are available only if the bidder obtains a W&I insurance policy) is more common in larger deals in excess of £250 million, while 'soft stapling' (where sellers cap their financial liability to a lower threshold and leave it to the discretion of the bidder to obtain W&I insurance) is more common for smaller transactions.
Nil recourse structures
Globally there has been a rise in 'nil recourse structure' transactions – that is, where the buyer's sole recourse for breach of representation or warranties under the transaction document other than for seller fraud or breach of title-related warranties (in which case there is a direct recourse against the seller) is limited to pursuing a claim against the insurer under the W&I insurance policy. Marsh JLT Speciality notes that deals where sellers cap their contractual liability to £1 are now becoming the norm across Europe, Africa and the Middle East.
An important step for parties intending to use W&I insurance as part of an acquisition transaction is to understand and prepare for steps that must be taken to ensure that the process for procuring and using W&I insurance becomes smoother, including analysing some of the key issues that might arise from the use of W&I insurance. Key points to be considered while using W&I insurance include the points summarised below.
Diligence
Buyers must take necessary steps to carry out thorough diligence to make the process for obtaining W&I insurance smoother and efficient – this is a standard expectation of insurers. A copy of the diligence report and access to the data room is always provided to the insurer as part of the application for obtaining W&I insurance. Further, as part of the underwriting process, insurers typically conduct an independent limited diligence on the target and almost always have an extensive discussion with the diligence team to understand and evaluate the extent and method of scrutiny and the credibility of the team that carried out the diligence exercise to satisfy themselves of the quality of the diligence exercise.
Representation and warranties
The buyer's counsel must negotiate the schedule of representation and warranties carefully, after understanding the insurer's standard coverage and exclusions for representation and warranties. For example, W&I insurance does not cover representation or warranties that are broad, in the nature of estimates or projections, forward-looking or excessively qualified. Typically, and as a process, every W&I insurance policy contains a 'warranty sheet' that replicates all representation and warranties set out in the schedule of representation and warranties in the transaction document. This sheet is used to indicate whether a particular warranty is either covered, excluded or partially covered. It is important for the buyer's counsel to negotiate representation and warranties with both the seller's counsel and the insurer, to ensure that coverage for most representation and warranties is provided under the W&I insurance policy.
Indemnification, escrow and other remedies
W&I insurance cannot in most cases be a complete substitute for the seller's indemnification and escrow obligations, given the exclusions and gaps discussed previously. Parties should carefully negotiate and clearly lay out the claim process and the liability waterfall in the transaction document – W&I insurance can be the first recourse for breach covered under the policy followed by necessary assurances from the sellers in the form of escrow, indemnification and other standard protection to cover for the exclusions or gaps in coverage.
Erosion of coverage
Coverage under W&I insurance is provided for all breaches covered under the policy, without allocating separate monetary limits. A large claim – especially one involving fraud or title – can erode the entire coverage, thereby limiting the buyer's recourse to other claims under the policy. Parties should take this into consideration and find a practical solution.
Bargaining power
Parties intending to use W&I insurance should in general be mindful of the geographical area in which W&I insurance is intended to be obtained and the popularity of W&I insurance in that area – bargaining power provides flexibility in negotiation with insurers, making negotiations smoother. For example, in some markets, it is possible to exclude the data room from standard exclusions under a W&I insurance policy, subject to payment of a higher premium. In markets such as the United Kingdom, United States and Europe, where W&I insurance is commonly used, it is easier to negotiate terms of insurance with insurers, given the competition among insurers and availability of options.
W&I insurance can offer some practical and competitive advantages. However, parties to an acquisition transaction should carefully evaluate the costs and benefits of structuring a deal using W&I insurance – a high premium, retention, de minimis and exclusion might otherwise make W&I insurance cost inefficient.
As W&I insurance is used more frequently, key trends are likely to include:
- finetuning of the process for enforcement of claims – an increased usage of W&I insurance might result in a corresponding increase in the number of claims. Once this happens, insurers are likely to focus on the process of enforcement to bridge existing gaps; and
- W&I policy terms with further customisation and innovation to bolster increased usage of W&I insurance in emerging markets and further sophistication in advanced markets.
Endnotes
(1) Marsh JLT Specialty, "Transactional Risk Insurance 2019: Year in Review", April 2020 and "Insights into W&I Insurance Claims in Asia, What half a decade of tells us", April 2020.
(2) The amount of actual direct loss that the insured is contractually entitled to claim under the transaction document for a breach of representation or warranties that are not excluded under the policy and any related defence costs.
(3) Paragon, "2018 Mergers & Acquisitions (M&A) & Tax Insurance Global Review", April 2019.
(4) Marsh & McLennan Companies, "Warranty & Indemnity Insurance, Taking the risk out of your transaction".
Anmol Jain, associate, assisted in the preparation of this article.
