Warranty & Indemnity Insurance

04-Sep-2019

W&I Insurance: 101

Warranty and indemnity insurance (W&I Insurance) has become an increasingly common feature in M&A transactions globally in the last decade, including in New Zealand, and not only for the so-called ‘mega deals’.  Many transactions in the SME space are also now successfully utilising W&I Insurance. 

Burton Partners has extensive W&I Insurance experience, advising buyers and sellers on how to incorporate the product into transactions, as well as advising insurers in connection with the issue of W&I Insurance policies.

Basics:

The product has found favour as a tool that can assist in bridging the gap the buyer’s desire to secure a comprehensive set of warranties/indemnities and the seller’s desire to minimise its post-transaction liability. 

While W&I Insurance can be taken out by any party to a transaction, the vast majority of policies are taken out by buyers. 

In buy-side policies, the buyer is the ‘insured’ and obtains cover for loss that the seller would otherwise be liable for as a result of a breach of warranties or the tax indemnity under the sale and purchase agreement (SPA).  The SPA can be drafted in the usual manner, with the seller giving a suite of warranties and a tax indemnity in favour of the buyer, but with an additional clause whereby the buyer (i) waives its right to bring a claim against the seller for a breach of a warranty or the tax indemnity and (ii) instead agrees that its recourse will be against the insurer under the W&I Insurance policy (subject to various standard exceptions, such as fraud). 

In other words, with the buyer’s approval and in exchange for the payment of an insurance premium, the seller can transfer its liability tail under the SPA to the insurer. 

Sell-side policies are also available, whereby the insurer reimburses the seller for covered losses from warranty and indemnity claims brought by the buyer, but these are much less common.

Potential benefits for transacting parties:

• Clean exit:  Sellers can be paid out and have no ongoing liability for the warranties or the tax indemnity.  They can safely disburse or use their sale proceeds for other purposes. 
• Credit strength:  Buyers can take confidence from having an entity of substance standing behind the warranties and the tax indemnity. 
• No security needed:  Given the foregoing, the buyer shouldn’t need to seek a guarantee of the seller’s obligations or for funds to be held in escrow for an extended period to cover potential claims under the SPA.
• Enhanced execution:  Although the SPA must still be negotiated on an arms’ length basis, W&I Insurance tends to help parties cut through negotiations, increasing the chances of the deal being done.
• Financial investors:  The product is attractive to financial investors who have to sign the SPA as a seller (and provide warranties and the tax indemnity), even though they have not been closely involved in the operation of the target company.
• Competitive processes:  Buyers can incorporate the product into their offer in competitive processes, as a means to make their bid more attractive.
• Continuing relationship:  If the transaction is for less than 100% of the target company, it addresses the challenging dynamic that would arise if there is a breach of a warranty or the tax indemnity.  If such a claim arises, it can be dealt with dispassionately between the buyer and the insurer, preserving the ongoing relationship between the buyer and the seller.

Costs:

In New Zealand in recent times, we have seen premiums in the region of 1-1.25% of the sum insured, which is good value by international standards.  Bear in mind however that insurers do insist on a minimum premium, which has tended to make the product uneconomic on transactions south of $10 million.

As a W&I Insurance policy can benefit both buyer and seller, the premium is often shared (with the seller’s share being deducted from the purchase price on completion).   

Underwriting process:

Each W&I Insurance policy is tailored to meet the specific needs of the transaction, so it is advisable for an insurance broker to be engaged early in the transaction process, well before the SPA has been finalised.  An experienced broker will identify potential issues and work with the parties to avoid potential pitfalls. 

The broker and insurer will provide feedback as the process unfolds, reviewing iterations of the SPA and the various due diligence materials, with a view to addressing issues and being able to provide fulsome cover (ie. back to back with the final SPA, so far as possible).

The underwriting process, which can be completed within a couple of weeks, will focus on:

• The quality of due diligence:  W&I insurance is designed to cover unexpected claims – the genuine ‘unknowns’.  It is not intended to be a substitute for the buyer conducting appropriate due diligence investigations.  In the absence of appropriate due diligence, the insurer cannot assess and price the risk they are being asked to take on.  In our experience, insurers are increasingly reluctant to take a ‘view’ on issues and will pull out of a deal if the basics are not covered.
• Arm’s length negotiation of the SPA:  Despite the intention to obtain W&I Insurance, the parties must still negotiate the SPA on an arm’s length basis, as if the seller remains on risk.  During the underwriting process, the insurer will seek to form a view as to whether the SPA is broadly on market standard terms, or if it appears that the seller has agreed to unusually extensive warranties or has failed to obtain standard limitations on claims.  If the insurer considers the SPA overly buyer-friendly, it may refuse to provide cover, materially reduce the level of cover or increase the premium.   

An outcome of the underwriting process will be the various exclusions included in the final policy.  Having reviewed each warranty and indemnity individually, the insurer will determine whether it wishes to cover, exclude, or partially cover each of them (taking into account the views it has formed during the underwriting process).  In addition to potentially excluding specific warranties, there are also a number of risks that insurers will generally exclude, such as transfer pricing, environmental issues, product liability, secondary taxes and professional indemnity.  Other insurance products are often available for these risks.  Parties should anticipate these areas and discuss where the liability for such risks ought to fall.

If you are interested in exploring how W&I Insurance could be incorporated into your transaction, please free to contact Nick Lovegrove or Hayden Smith.