I. Introduction
Warranty & indemnity (W&I) insurance has become widely used in the transaction market during the past decade. Although statistics are hard to come by, estimates indicate W&I insurance is used in approximately 60% of Dutch mid-market M&A transactions and almost all private equity exits within the Netherlands. Declining M&A deal volume intensified competition between insurers, leading to lower premiums and further increased use. Due to continued pressure on deal volume we expect this trend to remain upward in 2023.
This blog post covers:
- Main aspects of W&I insurance (II)
- Advantages of taking out W&I insurance (III)
- Disadvantages (IV)
- Process and timing (V)
- Coverage and policy (VI)
- Related costs (VII)
II. Main aspects of W&I insurance
To start, W&I insurance covers damage resulting from breaches of representations & warranties and under the general tax indemnity given in the context of a transaction.
Traditionally, W&I insurance operates alongside the transaction documentation, and the process requires involvement of the insurer and all parties to the transaction. The parties to the transaction first negotiate the transaction documentation, followed by the insurer and the to be insured party negotiating the W&I policy, which sets out the terms, limitations and exclusions of the insurance.
A W&I insurance policy can be taken out by the purchaser (a buy-side policy) or by the seller (a sell-side policy).
Under a buy-side policy, which is most common, a purchaser claims directly against the insurer under the policy, as opposed to claiming against the seller under the transaction documentation. Any discussions or legal proceedings will be settled with the insurer instead of with the seller. A buy-side policy usually also limits the insurer’s rights to subrogate and claim reimbursement for settled claims from the seller. Parties have become more and more accustomed to ‘non-recourse’-policies, under which the insurer is unable to seek any reimbursement from the seller, with the exception of fraud.
Under a sell-side policy, a seller claims against the insurer under the insurance policy for any covered losses following from claims made by the purchaser against the seller. The purchaser and the seller settle any discussion or legal proceedings pursuant to the terms set out in the transaction documentation, with the seller being backed by the insurer, benefitting from its financial strength and its experience with legal proceedings.
III. Advantages of taking out W&I insurance
Within the context of private equity transactions the main advantage of taking out W&I insurance is that it permits the seller to have a ‘clean exit’. W&I insurance is able to materially limit or extinguish the seller’s transactional liability, and consequently to reduce or replace any hold-backs, escrows or financial guarantees. A ‘clean exit’ allows a seller to receive and use the transaction proceeds immediately at completion or, in case the seller is a private equity fund, to distribute the proceeds to its investors, which has a positive impact on the fund’s performance.
W&I insurance can also be useful if:
- ongoing commercial relationships between the seller and the purchaser must be maintained post-transaction (e.g. when a seller remains involved with the business post-transaction);
- the parties to the transaction cannot agree on (the scope of) the warranties or the seller is unable to give market-standard warranties;
- the purchaser is concerned about the seller’s financial strength, or other elements that may hinder enforcement of a claim (e.g. a transaction involving a special purpose vehicle or unrelated sellers); and/or
- the purchaser requires recourse beyond the cap the seller is willing or able to accept.
In an auction process, W&I insurance could help a bidder to position itself favourably by showing that the seller’s risk of breach and the bidder’s recourse lie (mainly) against the insurer. The absence of retentions and escrows in turn may result in a seller considering a lower offer because it has immediate access to all proceeds.
IV. Disadvantages
Some of the main disadvantages of using a W&I insurance are:
- the process can be quite time-consuming for key staff and management and impacts the timetable of the transaction, due to (prolonged) discussions and negotiations with the parties to the transaction and the insurer regarding coverage and interplay between the transaction documentation and the W&I policy (see further under V. Process and timing);
- the policy will exclude certain matters, of which some are market-standard and some are deal-specific (see further under VI. Coverage and policy), whereby more often than not relatively late in the process the exact scope of exclusions becomes clear;
- it generally requires a comprehensive due diligence investigation by external advisers (see further under VI. Coverage and policy); and
- it can be costly, as, in addition to the premium for the policy itself, it introduces an additional workstream with involvement of third-parties and associated costs (see further under VII. Related Costs).
V. Process and timing
The process of taking out a W&I insurance policy can be initiated by either the seller and the purchaser together or by each of them independently, and at any time during the transaction and even after the transaction has already closed. However, generally, the insurance policy is in place at signing and becomes effective at closing of the transaction.
The process for taking out a W&I insurance is typically managed by a broker and, if it has been well prepared, generally takes two to three weeks.
Typically, after agreeing to non-disclosure obligations, a broker will request (drafts of) key transaction documentation, the investment memorandum and financial statements, and submit these documents to one or more insurers. The insurer(s) will review the provided documents and usually submit an indicative, non-binding offer.
If the broker has received multiple offers, the to be insured party selects an insurer. The selected insurer will require access to the transaction documentation, the disclosure letter, financial statements of the target, the data room and all available (vendor) due diligence reports (on a non-reliance basis). After execution of an expense agreement, the insurer will verify the documents (usually assisted by external counsel), which is commonly referred to as the ‘underwriting process’. In the expense agreement, the party seeking insurance typically agrees to compensate the insurer for a certain fixed amount of the external legal fees incurred by the insurer in relation to the underwriting process.
The insurer may ask for additional information on the transaction, the due diligence process and the negotiations on the warranties through a written questionnaire and/or by an underwriting call (with its legal counsel). If the additional information gives the insurer sufficient comfort, the insurer will share its coverage proposal with the to be insured party and its broker, who will then review and commence negotiations with the insurer on the terms and conditions of the W&I policy.
When all is set and done, the policy will stipulate the scope of the covered warranties and tax indemnity. At the policy’s start date, the insurer will require the insured party to issue a ‘no claims declaration’ which confirms it is not aware of a breach of any of the insured warranties or tax indemnity.
In the context of an auction, a seller may initiate the process and present a W&I insurance policy to the potential buyers by ‘stapling’ it to the auction draft of the transaction documentation. At a certain point in time during the auction process, (negotiations on) the policy will ‘flip’ to (and ultimately be taken out by) the purchaser.
VI. Coverage and policy
General
Different levels and types of coverage are available, ranging from (i) ‘coverage as from the first EUR 1’, with exclusion of any of seller’s liability under the transaction documentation, through to (ii) ‘top-up insurance’, whereby the seller’s liability is capped at a certain amount, with the insurance covering any claims in excess.
Although W&I insurance follows a more or less standard procedure, the policy is tailormade and negotiating the terms and exclusions of a W&I insurance policy should be done prudently. The insured should try to obtain back-to-back coverage with the warranties and the indemnities given under the transaction documentation. However, insurers will often exclude or limit the scope of certain risks and negotiate other terms or definitions than those agreed between the parties. Any discrepancies in coverage under the transaction documentation and the policy can lead to an allocation of risk not adequately reflecting the parties’ intentions. Therefore, it is important to be clear – both at the start and during the process – which party is to take on any risks that will not be covered by the policy.
Exclusions
Standard coverage exclusions from the W&I policy are:
- known facts, matters or circumstances, or those that have been disclosed in the transaction documentation or in the due diligence process, such as issues covered by a specific indemnity or exceptions to the warranties;
- issues arising between signing and closing and that are known to the insured party;
- forward-looking warranties;
- post-closing adjustments to the consideration or leakage;
- certain tax risks (such as transfer pricing);
- pension underfunding;
- certain environmental risks;
- criminal fines and penalties;
- bribery and corruption;
- cyber liability;
- third-party liability (tort); and
- physical condition or design of real properties.
Although the contents of the data room and issues arising between signing and closing are typically excluded, some insurers are willing to forego these exclusions for an additional premium. The same goes for some of the other exclusions listed above. Coverage may also be available on a stand-alone basis through specialised insurance.
Finally, there is no coverage in the event of fraud, misrepresentation, intentional misconduct or recklessness by the insured. However, in the event of a buy-side policy, any of the aforementioned on the part of the seller is covered.
Scope
Insurers determine insurance coverage on the basis of the due diligence investigation conducted by the purchaser. The insurer will generally expect that (i) the purchaser, with the assistance of professional external advisers, has conducted a comprehensive (legal, financial, tax and other) due diligence investigation in order to identify issues, followed by a proper disclosure exercise, and (ii) the parties have negotiated balanced transaction documentation in which any such issues were appropriately addressed (e.g. through a price reduction or assumption of risk by the counterparty).
W&I insurance does not replace (the need for) a due diligence investigation. If a particular area of risk has not been (duly) investigated, it will usually be excluded from coverage. If the insurer finds that the due diligence investigation has not been conducted properly or feels the transaction documentation is one-sided, the insurer may set restrictions on coverage, require a higher premium or even deny a policy. It is useful to understand early on what insurers expect in this respect, and to anticipate by conducting the due diligence investigation (including disclosure) and negotiations accordingly.
Limitations
The insurer will generally issue policy limitations, which include the following financial thresholds and caps:
- a de minimis, a financial threshold preventing small claims;
- a deductible (also known as ‘retention’ or ‘excess’), which is a fixed amount of loss that remains for the account of the insured; and
- a policy limit, which is the maximum liability for all covered losses (including defence costs of the insurer).
The de minimis in the policy typically matches the de minimis-threshold for individual claims in the transaction documentation, which is often between 0.1% and 0.25% of the transaction value for small to medium-sized deals within the EUR 10 to 100 million range.
The deductible typically either matches the ‘basket’ included in the transaction documentation or (for an additional premium) is set at a nominal value, such as EUR 1. The deductible often ranges from 0.50% to 1% of the transaction value in small to medium-sized deals, with lower percentages in larger-sized deals. Most insurers also offer policies with ‘tipping to nil’-deductibles, which reimburse all losses once the deductible level has been exceeded (and not merely the excess).
Policy limit is typically lower than the overall transaction value, as the insured may feel it is unnecessary to insure the full transaction value. The policy limit of a buy-side policy usually ranges from 10 to 30% of the transaction value (but limits up to 50% are not uncommon). A sell-side policy can cover up to 100% of the seller’s liability but is usually limited to only the first 10 to 30% of seller’s liability.
Time limitations may mirror those set out in the transaction documentation but can also extend the claims periods thereunder. The maximum term with respect to tax and fundamental warranties is usually seven years, while that of the general warranties is usually three years.
Other
More recently, insurers have been willing to offer so-called ‘synthetic insurance policies’, which exclude the seller entirely. Under such policy the insurer negotiates stand-alone warranties with the purchaser, outside of the terms of the transaction documentation. This type of policy is attractive to the seller (including, in case of bankruptcy, the trustee) as it will not need to be involved. A synthetic insurance policy is generally more expensive, and the insurer still expects a comprehensive due diligence from the purchaser. However, it may be the purchaser’s only option if the seller is unwilling or unable to become involved.
A financier of the transaction often requires the assignment of the rights of the insured (against the insurer) under the W&I policy for security purposes. If financing is used, the policy should allow for such assignment.
The premium for W&I insurance usually varies between 1% and 2% of the policy limit for transactions involving active businesses, and is generally lower for real estate transactions. Due to increased competition between insurers, the level of premium remains on a downward trend. The premium will depend on several factors, such as limitations on the warranties, deductible amount, sector and transaction complexity. The premium is usually payable at or within a few days after closing. Depending on the location of the insurer’s registered office, insurance tax may be levied.
The costs of taking out W&I insurance are not limited to the premium, as additional costs are likely to include: (i) the broker’s underwriter legal fees, which are either paid separately or included in the premium, and (ii) additional legal fees for negotiating the W&I policy, managing the W&I workstream and/or conducting additional/comprehensive due diligence.
Preferably at the start of the process, the parties should consider and agree on the allocation of the premium as well as any associated costs. The mere fact that a policy is taken out by one party does not imply it should bear all costs, as having W&I insurance in place in most cases holds benefits for all parties to the transaction.
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