Australia: Warranty and indemnity (W&I) insurance—bridging the gap in negotiations

Warranty and indemnity (W&I) insurance is an insurance product specifically developed for use in the mergers and acquisitions (M&A) market. The product insures a seller or buyer against the risks of the other party breaching a warranty or indemnity in a share or asset sale agreement. W&I insurance is a valuable tool for parties involved in M&A and is increasingly being used in negotiations to bridge the gap in risk allocation between sellers and buyers.

Such policies can be procured by a seller or a buyer, however the vast majority of W&I policies in Australia are buy-side policies. To determine whether a buy-side or sell-side policy is more appropriate, the financial and commercial circumstances of the transaction and the intended purpose of obtaining W&I insurance should be considered.

A buy-side policy provides the buyer with direct recourse to the insurer for a breach by the seller of a warranty or indemnity covered by the policy. Insurance premiums payable typically form part of the price negotiations between the parties to the transaction. In Australia, premiums can be paid by the buyer and/or the seller and the price is negotiable, normally agreed to be between 1% and 1.3% of the insured risk.

On the other hand, a sell-side policy provides coverage to the seller in the event that the buyer makes a claim against the seller for a breach of an insured warranty or indemnity. Premiums for sell-side policies are typically paid by the seller alone, as the buyer may not be aware of the existence of a sell-side policy.

Advantages

Purchasing W&I insurance can be an effective tool in negotiations to break deadlocks regarding the allocation of risk to the seller or buyer. Other key benefits of a W&I insurance policy include:

Clean exit

W&I insurance is often considered by private equity funds and sophisticated investors as an effective clean exit mechanism, which provides greater certainty of the extent of any liability exposure associated with the transaction. Despite this, the seller will remain liable for any losses incurred due to a breach of an insured warranty or indemnity where they have engaged in fraudulent activity.

Fraudulent activity is excluded from coverage in sell-side policies and, although covered in buy-side policies, insurers will have a right to subrogate and pursue the fraudulent seller directly. There may also be a carve-out to the "no recourse" provisions in a sale document, which gives the buyer a direct right of action against the seller.

Credit risk W&I insurance provides confidence to a buyer in its ability to recover losses for a breach of warranty or indemnity. The insurer's balance sheet will effectively replace any perceived credit risk associated with the seller, which may remove the need for an escrow or deferral of purchase price.
Preserve relationships If the seller or its representatives (e.g. a founder) are employed or engaged by the buyer post-acquisition, W&I insurance enables the buyer to make a claim directly with the insurer, effectively preserving the relationship with the founder and management team. The same principle applies to joint venture parties.
Multiple sellers It may be difficult for a buyer to recover on a claim against multiple sellers, particularly in circumstances where they are located in different jurisdictions. W&I insurance enables the buyer to make a claim directly with the insurer.

Timetable

The timetable for completing a W&I insurance policy is short and will often start with the transaction parties, or their advisers, engaging a specialised W&I insurance broker to obtain policy quotes from domestic and international insurance markets.

The W&I insurance policy begins on signing and its coverage becomes unconditional provided certain conditions in the policy (e.g. completion of the transaction) are satisfied. The policy coverage will usually not cover the full transaction amount and will not extend to matters relating to any breach of an insured obligation that were known by relevant transaction team members of the insured, before the inception of the policy. 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 normally given by the parties at the time of signing the sale agreement and again at completion. If the insured becomes aware of 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 W&I policy coverage as the insured is obliged to disclose the information in the Completion NCD. Additionally, no recourse provisions in a sale agreement may preclude the insured from making a claim against the other party. Consequently, the insured is potentially left exposed to new breaches that arose in the period between signing and completion.

Additional coverage can be obtained 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 limited period of days between signing and completion (e.g. 15, 30 or 60 days) with an option to extend the coverage period for an additional premium. Such cover can be expensive depending on the time period between signing and completion, as well as the quality of the due diligence process and the risk profile of the target business.

Underwriting process

To secure the best coverage, an insurer will require that thorough due diligence has been performed, the transaction has been negotiated and settled 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 friendly or unfavourable toward one party. It is also beneficial to have a detailed disclosure letter identifying specific disclosures against the warranties.

It is important to understand that having W&I insurance does not replace the due diligence process in a transaction. Underwriting is often a condensed process conducted within a short time frame, in which the insurer assesses the quality of the buyer's diligence program. Other than where specific issues are identified, there is no independent risk assessment of the underlying substantive risks of the transaction. The risks that will be insured under the W&I policy are the unknown risks remaining after a robust due diligence process has been conducted.

If the insurer is not satisfied with the quality of the due diligence conducted by the buyer, it may:

  • undergo comprehensive Q&A session(s) with the insured to attempt to fill in gaps in diligence
  • exclude or qualify coverage in relation to particular matters
  • partially cover specific warranties or indemnities, or
  • increase the premium or adjust the retention component of the policy to address the perceived risk.

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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