The role of insurance in protecting buyers and sellers against risk of warranty breaches
Warranty and indemnity insurance (W&I) (also known as representations and warranty insurance), increasingly features in M&A deals around the world. Initially prevalent in certain domestic markets, such as the UK, the US and Australia, it is now seen in a growing number of jurisdictions including Central Europe and south-east Asia.
In our experience, W&I can help buyers and sellers allocate risk on a deal in a way that is commercially acceptable to both parties, but care must first be taken to close potential gaps in cover.
W&I insurance contractually transfers a certain amount of risk inherent in acquisitions or disposals of businesses. Broadly, if used effectively, it protects the buyer or seller of a business from loss that may otherwise arise as a result of a successful claim for breach of a warranty under the sale and purchase agreement.
The conclusion of satisfactory policy terms is key. We have noted recent developments in the scope of policies that a would-be insured would be advised to consider early.
For example, while recovery under a W&I policy will be subject to a number of customary exclusions, there remain differences among underwriters' approaches. It is vital that those differences be apparent upfront. A marginal saving in premium may be a false economy if exclusions materially change between initial selection of the insurer and final policy negotiations, particularly if that occurs shortly before signing is scheduled.
The absence of "new breach" cover may also detract from the ability to recover loss. If there is a gap between signing and closing and, under the sale and purchase agreement, the seller is not liable for breach of warranty occurring after signing, the buyer will (if it proceeds to closing) bear the risk of any loss arising from breach. A W&I policy will exclude recovery for known liabilities (which are typically flushed out by requiring the insured to make a clean "no claims" declaration, and increasingly, "bring-down" or repeat warranties at closing which are disclosed against). This may be a real concern for buyers. We have seen underwriters (for example in Australia) willing to bridge this gap in cover for a limited period at an additional cost.
Growing trend of W&I
Despite potential gaps in cover under a policy, even in jurisdictions that have long been accustomed to W&I insurance, there has been a noticeable surge of interest in its use (for example in the US) over the past 12-18 months. This may be explained by:
- a fall in the cost of W&I insurance. When compared to deal value, typical transaction premiums now range from around 0.8-1.6% (in more established markets) rising to around 3% in less established markets or more litigious jurisdictions such as the US. We have also seen a willingness by some underwriters, particularly on large deals, to reduce the premium to take into account the policy excess or deductible reflected in the acquisition agreement;
- an increase in principals and their advisers experience as the use of W&I gains momentum and the process for putting W&I in place improves, becoming more aligned with the transaction timetable; and
- an increase in successful claims, with underwriters, in our experience, taking a sensible approach to recovery under policies.
Challenges and potential pitfalls
W&I insurance is not suitable for all transactions:
- local law regulatory issues may restrict the ability to insure a target and should be considered at an early stage;
- off-the-shelf policies must, as mentioned above, be negotiated and aligned to the transactional documents to avoid a gap in cover; and
- smaller deals may not justify the expense of premium, broker fees and adviser costs.
We recommend that a risk/benefit analysis be considered in all cases and policy terms obtained early on to avoid a compromising bargaining position shortly before signing.