Warranty and indemnity insurance (W&I Insurance) is fast becoming a common instrument to de-leverage deal risk in the Australian M&A landscape. In the past, acquirers of W&I Insurance have typically been private equity funds, venture capitalists and other 'sophisticated' investors. This is changing with W&I Insurance becoming more common in all types of negotiated M&A transactions, with general corporates and individuals alike being lured by the benefits that such insurance has to offer.
What is W&I Insurance?
In a nutshell, W&I Insurance provides cover for losses arising from a breach of warranty (or in certain cases under an indemnity) in connection with a merger or acquisition. It is essentially the use of insurance capital (eg, an insurer's balance sheet) to facilitate a transaction by transferring the transaction risk from the seller or the buyer to the insurer.
Other forms of transaction insurance are available to cover known/disclosed issues; however, these are usually separate and distinct from the cover available under a W&I Insurance policy. These include:
- environmental liability insurance
- litigation insurance
- tax liability insurance
- contingent risks
- prospectus liability insurance
In this article we will focus on W&I Insurance in the context of M&A transactions.
The appetite for utilising W&I Insurance has increased tremendously over the past 3 years. During the global financial crisis (GFC), there was an increased use of W&I Insurance as the attitude to risk changed. Over the past 12 – 18 months as the debt markets have started to ease and deal flow increased, the use of W&I Insurance has also increased. This says Guy Miller, who is the Asia Pacific Legal Counsel at Aon's Asia Pacific M&A Group based in Sydney, is due to the fact that whilst the debt markets have tightened and there is a greater willingness to transact, the attitude the risk experienced in the GFC has remained.
Since Q4 2009 and through to Q4 2010, intermediary advisers Aon through its Asia Pacific M&A Group has closed well over 50 transactions across a broad spectrum of industries. In addition, Rick Glover who is the Regional Director-Asia Pacifc at Aon's M&A Group has confirmed that of the 50+ transactions across the Asia Pacific Region a number of transactions (as compared to previous years) were closed in Asia in 2010.
Globally there are, depending on the nature of the risk, between 7 – 9 insurers which provide W&I Insurance. Over the past 2 years the global W&I Insurance market has expanded to the extent that W&I Insurance can provide insurance cover of up to $400million for any single transaction risk. The flexibility of the policy means that W&I Insurance can be put together for a transaction as small as $5million.
There are many reasons as to why W&I Insurance is seen as an attractive proposition for both sellers (i.e. those persons who ordinarily give the warranties and indemnities) and buyers (i.e. those persons who ordinarily seek to rely on the warranties and indemnities). Some of the key reasons for using W&I Insurance in an M&A transaction are set out below:
- the 'clean exit' – one of the main reasons why W&I Insurance is so popular amongst private equity funds, venture capitalists and other 'sophisticated' investors is that the policy can be structured so that it effectively allows for a virtual 'clean exit' from the transaction (other than in specified circumstances e.g. fraud). This allows for any funds flowing from the transaction to be retained by vendors with little to no 'tail of liability' and in most circumstances without escrow terms which might have otherwise applied.
- disparities between seller and buyer expectations - the expectations of sellers and buyers are often at two different ends of the spectrum. Sellers wish to minimise their risk and liability by giving only a limited set of warranties that are heavily qualified and which have appropriate caps and limitations. On the other hand, buyers wish to extend the scope and ambit of the warranties given by the sellers with little or no qualifications, caps or limitations. This disparity is often a heavily negotiated deal point and can (in extreme circumstances) cause the deal to fall-over. The use of W&I Insurance can be useful to 'bridge the gap' of expectations in these circumstances by paying the insurer to bear the risk'.
- limited seller security or asset backing - where the security or asset backing of a seller is limited or uncertain going forward, W&I Insurance can allow a buyer to pay the insurer to underwrite the financial risk associated with the warranties and indemnities given by a seller. This can avoid the need to stage payments or hold funds in escrow for long periods of time.
- enhancement of bid proposal – in a competitive tender situation a potential buyer may be able to enhance its bid proposal by structuring W&I Insurance into the bid e.g. the buyer bid could propose very low caps and limitations on the warranties given by the sellers on the basis that the buyers intend to obtain W&I Insurance to provide additional coverage for breach of warranty over and above that given by the sellers pursuant to the transaction documents. This can be an attractive proposition for a seller, particularly if other bids do not offer such advantages.
- protection of family assets –W&I Insurance is sometimes used as an asset protection strategy, ensuring that proceeds of a sale to an individual are not able to be clawed-back and to ensure that an individual is not involved in or liable for payment of costly litigation to defend claims for breach of warranty.
- assist to retain seller goodwill – having a W&I Insurance policy can, in certain circumstances, assist a buyer to retain the goodwill of the seller – this may be particularly important in situations where the seller is still involved in and key to the operation of the business (e.g. where the seller is still a key manager) or if the seller and the buyer have other post-completion trading relationship. This is because a policy can be structured so that claims for breach of warranty are made directly against the insurer and not the seller personally.
- distressed sales – W&I Insurance can be used to provide greater comfort in a distressed sale situation. The benefits are obvious in the case of a distressed seller looking to provide greater comfort and security to buyers. Although not overly common, W&I Insurance has been used by receivers and administrators who are not usually in a position to give any warranties about the assets being sold, however, most insurers will only have appetite for such a policy if appropriate due diligence has been undertaken.
Types of W&I Policies
Setting up the correct policy structure is important to ensure that the original objectives for taking out the policy are satisfied and where possible enhanced. Essentially, W&I Insurance can be structured as either a buyer-side or seller-side policy although there are many variants to this which can provide coverage over and above (or below) that which is contained in the transaction documents.
Up until a few years ago, insurers had a strong preference toward seller-side policies – this was because insurers were keen to align the interests of the insurer and the insured. However, due to market demand this is changing with buyer-side policies becoming an ever increasing part of the W&I Insurance market.
A seller-side policy is appropriate in circumstances where the seller is willing to give warranties on terms (e.g. qualifications, caps and limitations) acceptable to the buyer or where a seller may wish to limit recourse in respect of claims for breach of warranty.
In a seller-side policy, if the buyer makes a valid claim and the seller has a legal liability to indemnify the buyer for the loss, the seller would then turn to its insurance policy for cover. In these circumstances, the seller must co-operate with its insurers in respect of the claim (e.g. defence and investigation). One of the advantages of a seller-side policy is that the buyer does not need to be involved in the negotiation of the policy and also doesn't need to know about the existence of the policy as it is a matter between the seller and the insurer.
A buyer-side policy is appropriate in circumstances where the buyer does not have confidence in the security or asset backing of the sellers (i.e. in lieu of escrow or other deferred payment arrangements) or where the sellers wish to make a 'clean exit' or where it is known or envisaged that the sellers will not be in existence during the relevant warranty claims period (e.g. fund or company being wound-up).
In a buyer-side policy, the seller has no liability (other than in the case of fraud etc) to the buyer in respect of a claim for breach of warranty and this is usually specifically excluded under the transaction documents. If there is a claim for breach of warranty, the buyer makes a claim directly against the insurer (and not via the seller).
In our experience, buyer side policies are the preferred policy structure for private equity exit scenarios.
The buyer-side policy also introduces an interesting dynamic in negotiating a deal. Traditionally the sale contract is the only instrument between the parties managing respective risk. A buyer-side policy allows the insurance policy to be used as an alternate risk-mitigation device between the parties. This often raises an interesting and complex conundrum around whether the insurance policy is back-to-back with the sale contract or not.
Determining premiums for W&I Insurance is not an exact science – this is because the risks associated with providing such insurance is dependent on many variables and the wording of the relevant transaction documents and related insurance policy.
As a guide, the current insurance premium payable is roughly 1 per cent to 2 per cent of the insured limit. This represents a significant reduction in premium to the pre-global financial crisis days where insurance premiums payable were generally in the order of 3 per cent to 5 per cent of the insured limit. The reduction in premium is a significant contributing factor to the increasing popularity of W&I Insurance.
Factors affecting level of premium
The key variables which can affect the premium payable on a W&I Insurance policy include:
- size of the deal, generally smaller deals will result in the premium being a higher percentage of the purchase price
- level of excess or amount that has been 'co-insured'
- whether liability for claims is 'first dollar' (i.e. tipping) or 'deductible'
- claims expiry period, however, this becomes less relevant if greater than 24 months (the logic here is that generally claims will be made after a full audit cycle)
- veracity of disclosure process and the use of reputable legal, financial and investment banking advisers throughout the sale process as well as the quality of their reports and their willingness to allow the insurer access and reliance in relation to the reports
- level and scope of cover to be provided e.g. specific indemnities and cover for known liabilities, tax liabilities and purchase price adjustments around EBIT and NTA are generally expensive or not willing to be insured
- whether appropriate and commercial caps, collars (de-minimis thresholds), limitations and qualifications have been negotiated e.g. a contract that is too buyer friendly will cost more to insure
- whether knowledge of warrantors is severable
- governing law of transaction documents
- industry sector of target
- geographical location of target
The importance of disclosure
The veracity of the disclosure process and the use of reputable legal, financial and investment banking advisers is often key to giving insurers and underwriters comfort that a full and thorough disclosure process has taken place.
More often than not, insurers are faced with tight deadlines to determine the risk associated with issuing a W&I Insurance policy and the premium which should be payable. This means that customarily they will not undertake a full due diligence process in the same manner in which a buyer would and therefore need comfort that an appropriate process has been put in place to flush out and identify all facts, matters and circumstances that would or may be regarded as a breach or potential breach of the warranties in the transaction documents.
Key indicators of thorough disclosure process are as follows:
- full and proper disclosure of all material documents relevant to the business.
- all senior management and their direct reports given the opportunity to read, consider and make due and proper inquiries about each of the warranties given under the sale agreement to ensure that all matters which may be in breach of the warranties are disclosed in writing to the buyer. A certification to this effect should be obtained from each person involved in this process.
- use of a virtual or physical data room to track documents disclosed.
- list of all documents disclosed accurately identified with a copy of each document listed in an index that is annexed to the sale agreement.
- formal Q&A process undertaken in writing, with all questions and answers being annexed to the sale agreement and signed for the purposes of identification. Any verbal Q&A sessions with management should also be transcribed to writing.
- detailed disclosure letter prepared which identifies any specific disclosures against the warranties.
If a full and proper disclosure process has not taken place, the premium is likely to be higher or, in some cases, the insurer will refuse to issue the policy.
Although W&I Insurance is not appropriate or necessary for each and every transaction, sellers, buyers and their advisers should be cognisant that such insurance is available for utilisation as an additional tool to enhance a buyer's or seller's position in a negotiated M&A transaction. The flexibility of the product and correct and strategic use of it can facilitate any M&A process.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.