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Introduction to warranty and indemnity insurance in M&A transactions

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What is warranty and indemnity insurance?

Warranty and indemnity insurance (W&I insurance) is a type of insurance in mergers and acquisitions (M&A) transactions that protects either a buyer (in the case of a buy-side policy) or a seller (in the case of a sell-side policy) from financial loss that may arise in the event that there is a breach of warranties and/or indemnities given by the seller in the sale and purchase agreement for the transaction (SPA).

The main forms of W&I insurance are:

Buy-side

Buy-side insurance is the most common type of W&I insurance. A buyer claims against a W&I insurance policy for loss arising in connection with breach of certain warranties and/or indemnities in the SPA.

Depending on whether there are any "gaps" between the coverage afforded by the W&I insurance policy and the warranty/indemnity package in the SPA, the W&I insurance may be "no recourse" to the seller (i.e. no gaps) or "limited recourse" to the seller (i.e. the seller bears liability for any gaps in coverage).

The premium for the insurance may be paid by the buyer or the seller (or a combination of both), depending on what is negotiated by the parties in the SPA.

Sell-side

Sell-side insurance is designed to protect the seller in the event that the buyer claims against the seller for loss arising in connection with breach of warranties and/or indemnities in the SPA. When this occurs, the seller claims against the W&I insurance policy and the buyer has no direct recourse against the W&I insurer.

The premium for the insurance is paid by the seller.

Sell-side flip

In a competitive sale process, a "sell-side flip" process is often used, whereby the seller initially engages a W&I insurance broker to procure indicative pricing and coverage terms from a shortlist of W&I insurers. Once the preferred bidder is selected, the broker then "flips" to work with the preferred bidder and the selected W&I insurer to place the insurance and negotiate coverage terms. In this case, the premium for the insurance is typically paid by the buyer.

Benefits of W&I insurance

There are a range of benefits to W&I insurance for both buyers and sellers as detailed below.

Buyer

  • Recoverability: Easier for a buyer to recover against a W&I insurer, rather than against potentially multiple sellers. Also reduces the need for a buyer to gain comfort over the sellers' financial substance, and can help to avoid lengthy litigation.
  • Extra scrutiny: Further due diligence conducted by the W&I insurer may uncover additional risks or issues.
  • Bid enhancement: In a competitive sale process, a bid with W&I insurance will be viewed more favourably by a seller than one without.
  • Increased protection: May help a buyer negotiate an increase to the maximum liability caps under the SPA, particularly for fundamental warranties.
  • Can facilitate acquisition finance: Can increase the likelihood of the buyer obtaining acquisition finance (as it reduces the risk profile associated with the transaction).

Seller

  • Immediate access to funds: Reduces the need for deferred purchase price or escrow / hold-back components, by providing recourse to the W&I insurer in the event of an insured claim. This is especially helpful in distressed asset sales (where quick access to funds is key), or private equity exits (where a financial sponsor may wish to close the fund that held the target business).
  • Clean exit: Minimises a seller's post-transaction tail of liability, allocating a known fixed cost to various risks of the transaction (in the form of the premium and/or deductible).

Both

  • Deal facilitating: Can remove deal-breaking risks from a transaction for both buyers and sellers, by introducing a third party (W&I insurer) to bear some of those risks.
  • Preserves relationships: Protects an ongoing relationship between buyers and sellers, particularly where management sellers are remaining with the target business post-completion (by providing third party recourse for claims that would otherwise be made against the sellers).

Typical exclusions

W&I insurance policies will typically exclude cover for losses that arise from:

  • known or disclosed risks, including matters that are the subject of a specific indemnity in the SPA;
  • forward-looking warranties;
  • warranties in areas where the W&I insurer considers that there has been unsatisfactory or narrow due diligence;
  • certain environmental or contamination issues;
  • bribery and corruption;
  • fines and penalties not insurable under law;
  • underfunding of pension plans;
  • misclassification of employees / independent contractors; and
  • transfer pricing, post-completion tax or stamp duty liabilities.

Specialist insurance options may be available to cover excluded risks - e.g., tax liability insurance, environmental liability insurance or litigation liability insurance.

Cost of W&I insurance

  • When is W&I insurance payable? W&I insurance is typically paid as a one-time payable premium at the time when the policy is taken out.
  • What is the typical amount of premium? The premium depends on a number of factors, including the amount of the de minimus (individual claims threshold), the amount of the excess/retention (aggregate claims threshold), whether there is a "tipping retention" and the extent to which it applies (see diagram below for further information), the length of the policy period, the size and complexity of the deal, the scope of the cover, the industry, and the quality of advisers involved. The premium is usually between 1.0 - 1.5% of the policy limit.
  • New breach cover: Warranties and indemnities are typically given by the seller at two points in time - at the time of signing the SPA and at completion. However, if an insured party becomes aware of a breach that occurs between signing and completion, the insured will usually not be able to make a claim under the W&I insurance policy, as such matters need to be disclosed to the W&I insurer at the time of completion. To address this risk, W&I insurers may agree to provide "new breach cover" to cover breaches of warranties that occur between signing and completion. The cover typically only lasts for 30 to 60 days, and is usually priced at an additional 10% - 20% of the premium.

Typical terms

For Australian M&A deals:

  • the de minimis (individual claims threshold) is typically 0.1% of the target group's enterprise value;
  • the excess/retention (aggregate claims threshold) is typically 1% of the target group's enterprise value; and
  • the policy period typically mirrors the warranty claim period in the SPA - e.g., 18 to 36 months for general warranties, and seven years for tax warranties.

Risk structure of W&I insurance

The diagram below shows a typical structure for a single-layer buy-side W&I insurance policy. Introduction to WI insurance (diagram 1)

  • Under a fixed retention structure, the buyer is not able to claim against the W&I insurance policy for any amount below the excess/retention amount.
  • Under a tipping and retention structure, a "tipping point" is set below the excess/retention amount. The buyer (as the insured) bears all loss suffered until the excess/retention amount is exceeded. At this point, the insurance covers any loss above the tipping point. For Australian M&A deals, the "tipping point" is commonly set at 25% - 50% of the excess/retention amount, although it can extend up to 100%. Tipping retention structures are considered by W&I insurers on a case-by-case basis and are more expensive than a fixed retention structure.

Time for procurement

The process for procurement of W&I insurance usually runs in parallel with the M&A deal process, although W&I insurance may also be obtained after completion. Below is a typical timeline for procurement of W&I insurance in a competitive sale process, where a "sell-side flip" is involved.

Thumbnail > Insight> Introduction to WI insurance (diagram 2)

Current trends

Will W&I insurance work for my deal?

Deal size: W&I insurance is typically available for transactions valued in the A$5 million to A$1 billion range. However, most W&I insurers will have a minimum premium, which, for smaller deals, is often more than the deal value can sustain (even where the cost of the premium is shared between buyer and seller). Minimum premiums currently range from approximately A$200,000 - A$250,000. Hence, W&I insurance is usually only financially viable for deals exceeding A$10 million.

Pricing: The Australian market has seen a surge in the volume of M&A activity in recent times, and a corresponding surge in the interest of parties wishing to utilise W&I insurance on their deals. This has resulted in an increase in premiums over the last 18 months, plateauing in Q4 2021 as W&I insurers reached their capacity, reducing availability at the lower end of the market and pushing up premiums. Premium rates increased from approximately 1.0% of the policy limit in 2020 to 1.5% of the policy limit in 2021. Nevertheless, broker reports indicate that prices are expected to stabilise in 2022, with a reduction in pressure on insurer capacity, an expansion of insurer deal teams, and new entrants into the market.

Timing: W&I insurance is traditionally more difficult to obtain in the financial year-end periods of May/June and November/December, when there is typically a boom in deal volumes and it can be more difficult to attract interest from W&I insurers, especially for smaller deals.

Industry: W&I insurance is traditionally more readily available for deals in the real estate, infrastructure, logistics, technology, fast-moving consumer goods, and retail sectors. W&I insurers have typically been reluctant to provide insurance (and pricing is correspondingly higher) in highly regulated sectors such as financial services, telecommunications, and oil and gas, although this has started to change in recent years.

Due diligence: To obtain optimal W&I insurance coverage, an insured must be prepared to engage in a thorough due diligence process. An unsatisfactory level of initial due diligence may lead to the W&I insurer doing one or more of the following to adjust for the relevant risk:

  • Require "top-up" due diligence to be conducted.
  • Decide to exclude or limit coverage in relation to certain matters.
  • Provide only partial coverage in relation to certain warranties or indemnities.
  • Increase the premium or excess/retention payable.

Current key focus areas for W&I insurers include:

  • Employment matters, such as workforce classification, correct application of modern awards, industrial instruments and employment-related tax. W&I insurers now expect reviews of a sample of employees (5% - 10% of permanent and casual employees) to confirm compliance with awards and enterprise agreements.
  • COVID-19 impacts, especially in relation to valuations, multiples paid and management accounts, as well as impacts on customer/supplier contracts.
  • Cyber risks and data handling, especially with the increase in ransomware attacks as more employees work from home during the pandemic.

For more information about whether W&I insurance may be suitable for your deal and assistance with any W&I insurance-related inquiries, please contact a member of our M&A team.

All information on this site is of a general nature only and is not intended to be relied upon as, nor to be a substitute for, specific legal professional advice. No responsibility for the loss occasioned to any person acting on or refraining from action as a result of any material published can be accepted.

Key
Contacts

Author

Paul Mayson

Special Counsel

Author

Jennifer Goh

Senior Associate