One of the more interesting aspects of any M&A transaction is seeking to close the gap on the allocation of risk between a seller and a buyer.
Typically, in a share or asset purchase agreement, a buyer will want the warranties to be as far-reaching and broadly drafted as possible whilst a seller will seek to limit the scope of the warranty language so as to reduce the likelihood, and financial consequences, of a warranty claim. The warranty and indemnity ("W&I") insurance market which seeks to bridge this gap has become increasingly popular in the Irish M&A marketplace in recent years with the proportion of parties opting to employ W&I insurance steadily increasing.
W&I insurance has the advantage of benefiting both parties to a M&A transaction by allowing for any potential liability arising out of a breach of warranty and/or indemnity to move away from the parties involved to the insurance provider. It can facilitate greater deal protection for the buyer and help to achieve a seller’s desire for a clean exit post deal by avoiding any overhanging liabilities.
Some of the primary reasons for employing a W&I insurance policy, depending on the nature or terms of the transaction, include (i) allowing a seller to obtain a clean exit from the target business or to immediately unlock a greater proportion of its sale proceeds; (ii) reducing or removing the need to place any funds in escrow; (iii) enabling a buyer to avoid bringing warranty claims against a seller who remains with the management team of the target business; and (iv) providing a buyer with a strategic advantage in the context of an auction process, by reducing the seller's exposure and thus enhancing the value of the buyer’s bid.
What is W&I Insurance?
W&I insurance is a bespoke insurance mechanism which is triggered by a breach of warranty or indemnity (and, in certain cases, other equivalent provisions) in M&A transaction documents, and which responds by providing cover for any financial losses incurred. A W&I insurance policy can be structured to indemnify either the warrantor/seller (under a seller insurance policy) or the buyer (under a buyer insurance policy). At the moment, we find the most common type of policy is the buyer-side policy.
Key Features of W&I Insurance Policies
A W&I insurance policy is structured as a claims-made policy whereby the insurance provider effectively ‘steps into the shoes’ of the seller or warrantor. Each policy is bespoke and tailored to reflect the specific transaction requirements and terms of the underlying acquisition documents, the objective being that the policy provides full back to back cover and avoids any unexpected gaps in protection.
A typical W&I insurance policy usually covers unknown and unforeseen risks only and operates on the assumption that (i) a buyer has carried out appropriate external due diligence; (ii) the deal has been robustly negotiated on an arms’ length basis; and (iii) an appropriate disclosure exercise has been completed. In fact, negotiation of the terms of a W&I insurance policy is usually intrinsically linked to the due diligence findings and the specific terms of the underlying transaction documents.
Key W&I insurance policy conditions include:
- Level of Cover: Every W&I insurance policy is subject to a specific cap or limit, being the maximum amount payable by the insurance provider to the insured party under the policy for any loss suffered from a breach of warranty and/or indemnity.
- Premium: W&I Insurance is paid by the insured party via a premium which is typically calculated as a percentage of the total limit of insurance cover provided.
- Excess or Policy Retention: A W&I insurance policy will usually be subject to a ‘retention’ or ‘excess’ whereby a fixed portion of insured loss suffered must be borne by the insured party in the first instance, with the insurance provider’s obligation to pay only kicking in once this fixed portion has been exceeded. Sellers or management can often be asked to bridge some or all of that gap. Leaving aside the financial issue or the excess, a purchaser can often want management or the seller to take some risk so that they have ‘skin in the game’ in terms of making disclosures against warranties.
- Coverage Exclusions: Some market standard exclusions applied by insurance providers include coverage for criminal fines and penalties, pollution/contamination, fraud, dishonesty and deliberate non-disclosure of the policyholder. Insurance providers also often refuse to provide cover for warranties which are considered to be easily capable of breach, forward-looking in nature or those which relate to contingent liabilities.
W&I insurance should always be addressed in the early stages of a deal so as to contribute to a smoother transaction process and help to avoid any gaps in coverage. This will also assist in understanding the limitations of a W&I policy so that any uninsurable risks can be priced into the consideration/ bid price where appropriate. It is a very competitive market and, therefore, it is typical to obtain quotes from multiple insurance providers.
W&I Insurance Going Forward
The use of W&I insurance in Irish M&A transactions has grown in popularity in recent years and is slowly becoming an integral part of the Irish M&A toolkit.
According to Aon’s Global M&A Risk in Review Report (released by Aon plc in late 2018), from 2016 to 2017 there was a 34% growth in the number of deals insured globally, a trend which is also having an impact on the Irish M&A landscape.
The use of W&I insurance products allows buyers and sellers alike to change the way they view risk, and ultimately approach deals, and its increase in popularity is only expected to continue throughout 2019, particularly with global trends indicating a further decline in premium rates, an increase in insurance capacity and a greater desire amongst insurance providers to broaden coverage terms.
This article was co-authored by Corporate partner, George Brady and Corporate associate, Cait Murphy.