Australia: Warranty and indemnity insurance - trends and practice points

Warranty and indemnity (W&I) insurance is an insurance product developed for the mergers and acquisitions (M&A) market. The product insures against the risks of a breach of a warranty or indemnity (typically the tax indemnity) in a share or asset sale agreement. Properly implemented, it is intended to transfer the risk of financial loss associated with a claim for a breach of an insured warranty or indemnity from the seller to the insurer.

Policies may be procured by either a seller or buyer. The vast majority of W&I policies in Australia are buy-side policies. A buy-side policy provides the buyer with direct recourse to the insurer for a breach by the seller of an insured warranty or indemnity. Premiums can be paid by the buyer or seller (or both) and typically form part of the price negotiations between the parties to the transaction. Premiums on W&I insurance policies in Australia are negotiable but tend to be between 1% and 1.3% of the quantum of the insured risk.

Sell-side policies are indemnity policies between the seller and the insurer providing coverage in the event that the buyer makes a claim against the seller for a breach of an insured warranty or indemnity. Premiums are typically paid by the seller and the buyer is sometimes not aware of the existence of a sell-side policy.

The commercial circumstances of the transaction and the reason for procuring W&I insurance will usually determine whether a buy-side or sell-side policy is more appropriate.

Why use it?

There are a number of reasons to purchase W&I insurance. It can often be used in negotiations to break deadlocks in the allocation of risk. For example:

Clean exit Private equity funds and other sophisticated investors may view W&I insurance as a tool to facilitate a clean exit and provide greater certainty of the extent of any liability exposure associated with the transaction. However, the seller still has exposure for loss suffered as a result of a breach of an insured warranty or indemnity if the breach is caused by the fraudulent conduct of the seller as: (1) such matters are excluded from coverage in sell-side policies; and (2) although covered in buy-side policies, insurers will have a right (under the policy) to subrogate and pursue the fraudulent seller directly (buyers may also have a direct right of action against the seller pursuant to a carve-out to the no recourse provisions in the sale document).
Credit risk W&I insurance may provide a buyer with confidence in its ability to recover for a breach of warranty or indemnity (as the insurer's balance sheet will effectively replace any perceived credit risk associated with the seller). This may remove the need for an escrow or deferral of purchase price.
Debt The existence of W&I insurance may provide a prospective financier of the buyer with the comfort it requires to provide the debt component of a purchase price.
Enhance bid A buyer may enhance its proposal in a competitive tender process by structuring W&I insurance into its bid. For example, the bid could propose low caps and broad limitations on the warranties on the basis that the buyer intends to obtain W&I insurance to provide additional coverage for breach of warranty (over and above that which will be given by the sellers in the transaction documents).
Founder / Management/ Joint Venture If the seller or its representatives (e.g. a founder) are employed by the target post acquisition, the buyer may want W&I insurance so that it can make a claim directly with the insurer, effectively preserving the relationship with the founder / management team who are likely still managing the business. The same principle applies to joint venture parties.
Insolvency Liquidators and administrators may want to provide greater comfort to purchasers of distressed assets by offering W&I insurance as a component to the transaction.
Jurisdiction A buyer entering a new jurisdiction may want certainty about its ability to recover for breach of warranty or indemnity under the transaction documents. Equally a seller exiting a jurisdiction may want certainty about its liability exposure in that jurisdiction.
Multiple sellers A buyer may be concerned with its ability to recover on a claim against multiple sellers particularly in circumstances where they are located in different jurisdictions.

Timetable

The process and timeframes involved in putting a W&I insurance policy in place can vary depending on the timing of its introduction into the transaction process. Specific brokers that have specialised knowledge in the W&I insurance product line are engaged by a party to the transaction (e.g. the buyer or seller or their advisers) to go to market and obtain terms from various insurers in Australia and the international insurance markets. Timeframes for the negotiation and finalisation of W&I policies are often tight. Typically, the underwriting process can follow a timeframe similar to the one set out below:

1 Engage broker as soon as W&I insurance appears likely Day 1
2 Broker issues Underwriting Submissions to multiple W&I insurers Day 2
3 W&I insurers submit Non-binding Indications of Coverage Day 4
4 Broker and proposed insured select preferred W&I insurers based on price and proposed cover approach Day 5
5 Proposed insured executes Underwriting Agreement that covers the W&I insurers costs of underwriting, up to an agreed cap Day 7
6 W&I insurer submits underwriting questions and first draft insurance policy, including a warranty spreadsheet (indicating the level of proposed coverage for each warranty/indemnity) Day 9
7 All parties underwriting call between broker, the proposed insured (including its professional legal and financial advisors on the transaction), the W&I insurer and its legal advisors Day 10
8 W&I insurers, broker and proposed insured negotiate and agree warranty and indemnity insurance policy Day 14

Approximate timeframes only

Steven Torresan of Risk Capital Advisors (RCA), a leading insurance adviser / broker focussed solely on transactional insurance risks, says:

"Any party contemplating the use of W&I insurance should speak to their insurance adviser / broker as early as possible in the transaction process. Whilst RCA has successfully structured W&I insurance policies in very short time frames (e.g. 3 to 5 days from start to finish), early engagement with an experienced broker enables potential underwriting issues to be quickly identified and addressed. RCA plays a pivotal role in managing W&I insurers throughout the underwriting process to ensure coverage under the W&I policy is maximised and implemented without any delay to the existing deal timetable".

The W&I insurance policy incepts on signing and coverage becomes unconditional following satisfaction of certain conditions in the policy (e.g. completion of the transaction). The W&I policy will not cover matters relating to a breach of an insured obligation that were within the knowledge of specific transaction team members (of the insured) before the inception of the W&I policy. From inception, the insurer takes on the risk of a breach of an insured warranty or indemnity subject to any matter disclosed in a no claims declaration (Completion NCD) given to the insurer by the insured on completion.

New Breach Cover

Warranties and indemnities are typically given at the time of signing of the sale agreement and repeated again at completion. If the insured obtains knowledge of facts and circumstances giving rise to a breach of an insured obligation that occurred in the period between signing and completion and that breach did not constitute a breach of a signing warranty, the matter will be excluded from coverage as the insured will be obliged to disclose this in the Completion NCD. Additionally, the no recourse provisions in the sale agreement may preclude the insured from making a claim against the other party (other than in the case of fraud where that carve out exists). This potentially leaves the insured exposed for "New Breaches" arising in the period between signing and completion.

To bridge this gap, we are seeing an increase in the appetite of insurers to provide coverage (separately priced) to the insured for any breach of a warranty or indemnity where the event first occurs and is discovered by the insured between signing and completion (New Breach Cover). New Breach Cover will often cover a specified period of time between signing and completion (e.g. 15, 30, or 60 days) with an option in the policy for the insured to pay an additional premium to extend a covered period further. This approach is particularly common where the period between signing and completion is uncertain (e.g. the satisfaction of a condition precedent is unknown as it is contingent on third party involvement).

New Breach Cover can be relatively expensive (e.g. 10% to 20% of the premium payable under the W&I insurance policy) depending on the time period between signing and completion, the insurer's overall view of the due diligence process and the risk profile of the target business and transaction generally. The insurer is taking on risk for a period in which there is no vendor disclosure process, the buyers due diligence has completed and the target company is still being operated by the seller.

Torresan says:

"New Breach coverage terms and pricing differ between W&I insurers and it is important to understand whether this coverage is a key requirement before a W&I Insurer is appointed. Whilst appetite from W&I insurers to offer New Breach coverage has increased in the past 12 months, most W&I insurers are still reluctant to offer New Breach coverage for longer than 60 days except in special circumstances."

New Breach Cover is not always offered by insurers and is sometimes commercially unattractive because it is costly. In such circumstances, the parties may seek to carve out "New Breaches" from the releases under the transaction documents so the seller continues to be liable for those "New Breaches" or negotiate a condition precedent to completion in the sale agreement that no breach of warranty has occurred before completion.

Underwriting process

Deborah McBrearty of HCC-Global, a leading provider of warranty and indemnity insurance, notes that:

"The underwriting process for W&I has evolved dramatically in the past five years or so. Insurers (such as HCC) have acknowledged that service and reliability are key in terms of making W&I insurance a commercially attractive solution in the M&A context. Thus we have invested in high quality teams of underwriters and worked hard to streamline our risk assessment processes. The underwriting process should be non-invasive and runs in tandem with the deal itself".

This resonates with our own experience of the underwriting process (both in acting for the insurer or the insured) with great value attributed to assessing risk in "real time" within the parameters of the transaction timetable.

Legal matters

From a legal perspective, some of the risks addressed in the underwriting process and policy negotiation include:

1 the scope of the consequential loss exclusion (where, in any event, there is some uncertainty in Australia as to the scope of "direct" and "consequential" loss)
2 the definition of "fairly disclosed" and its application in the context of a policy exclusion
3 caps, thresholds and de-minimis levels, and
4 the scope of the limitations of liability, warranties and disclosure regime in the sale document and their application in the policy.

To secure the best coverage an insurer will want to see that the buyer has conducted a thorough due diligence, the transaction has been negotiated on arm's length terms (as the parties would have in the absence of W&I insurance) and the sale document is balanced and not overly buyer friendly. A detailed disclosure letter identifying specific disclosures against the warranties is also helpful.

Quality of due diligence

Evidence of a robust due diligence includes:

1 the appointment by the buyer of reputable professional advisors engaged to carry out a scope of due diligence appropriate for the transaction
2 the availability of recent comprehensive legal, financial, tax and commercial due diligence reports
3 the exclusions and assumptions to the due diligence reports not carving out issues of material importance
4 data room access with evidence of fulsome disclosure by the seller of all material documents relevant to the business
5 comprehensive responses by the sellers to requests for information from the buyer during the transaction process, and
6 comprehensive disclosure by the insured in its responses to the insurers underwriting questions.

In relation to the insurer's assessment of the due diligence process, the W&I insurance policy does not replace diligence. Underwriting is a process, often carried out in compressed timeframes, of assessing the quality of the diligence program by the buyer and not an independent risk assessment of the underlying substantive risks (other than where specific issues are identified). The risks that are insured are the unknown risks that remain after a robust due diligence process has been conducted.

Scope of coverage

In the event that the insurer is not comfortable with the appropriateness of the due diligence conducted on the transaction, it has a number of options available to it, including that it may:

1 undergo comprehensive Q&A session(s) between the insurer and the insured to attempt to fill in gaps in diligence
2 exclude or qualify coverage in relation to specific matters
3 only partially cover specific warranties or indemnities, or
4 increase the premium or adjust the retention component of the policy to address the perceived risk.

W&I insurance is a valuable tool in M&A and is increasingly being used to bridge a negotiating gap in risk allocation between sellers and buyers. A good understanding of the role played by the product and the underwriting process will enable the parties to gain the greatest commercial advantage from the product.

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.

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