UK: Buy-Side Warranty And Indemnity Insurance – Increased Coverage Gaps

As warranty and indemnity insurance continues to offer bespoke policies in an ever competitive market, we consider the key considerations for buyers at the outset of a transaction and the common gaps in coverage.

Background

The popularity of warranty and indemnity insurance has continued to expand in M&A transactions across Europe, the United States and, most recently, Asia. In summary, warranty and indemnity insurance offers coverage for losses arising from warranty and indemnity claims under a sale and purchase agreement / tax deed of indemnity and can be in the form of either a buy- or sell-side policy:

  • Sell-Side – The seller is the insured party and the buyer will claim directly against the seller for any losses. The seller will recover insured losses from the insurer, who may control any defence or settlement of such claim.
  • Buy-Side – The buyer is the insured party and the buyer will claim directly against the insurer for insured losses above the capped liability of the seller (which can be a nominal £1 cap).

The Growth of Buy-Side Policies

Buy-side insurance policies have become increasingly popular, most commonly in relation to private equity transactions, indirect real estate disposals and distressed sales. The benefits of warranty and indemnity insurance for sellers include offering a clean break, the opportunity to distribute sale proceeds immediately following completion and removing or reducing the requirement for retention of sale proceeds in escrow. In auction processes, a buyer may consider offering to obtain a buy-side policy in order to make its bid more attractive in a competitive marketplace. While buyers also benefit from security of settlement of an insured claim, by mitigating the risk presented by a seller with insufficient funds to settle claims or a seller who is likely to be wound up shortly following completion, buy-side insurance policies can leave material gaps in coverage which may offset the value of the policy.

Level of Coverage

While insurers may be willing to cover 100 per cent of the equity value, this level of coverage and the accompanying premium will cause the buyer to decide the percentage of equity value that is sufficient to cover foreseeable losses in the business. While lower coverage is common in real estate SPV transactions, a higher level of coverage (e.g. 20 per cent of the equity value) is more likely for trading businesses such as tech or pharmaceuticals businesses. On some of the highest value transactions, this percentage cover can be less.

Auction Sales – 'Stapled' Insurance

'Stapled' warranty and indemnity insurance is increasingly being used in auction processes. This involves a broker nominated by the seller ultimately pre-packaging a warranty and indemnity insurance policy and then being engaged by the buyer. The imposition of a broker on a buyer can be difficult for a buyer, who may have its own preferred broker relationship. The indicative premium can be of limited value to a prospective bidder with the seller approaching its preferred broker as opposed to sourcing a policy with the broadest coverage for the lowest premium. In addition, the pre-packaged policy may not take into account particular risk areas within the business which are identified during legal, financial and commercial due diligence. It is questionable as to whether this trend will continue or whether we will see increased push-back from buyers who engage their preferred broker.

Increasing Coverage Gaps

Warranty and indemnity insurance will not cover the buyer for all possible losses which may arise. During negotiations, the insurer will pro-actively review the sale and purchase agreement to ensure that warranties are negotiated on an arm's length basis. In particular, the insurer will seek to exclude liability for the following:

  • Due Diligence & Disclosure – Insurance cannot be obtained as a replacement for conducting a full and thorough due diligence process or the seller undertaking a comprehensive disclosure process. This can be an issue for trade buyers when due diligence is conducted in-house, making it harder to demonstrate to the insurer that a full and thorough due diligence process has been conducted.
  • Forward Looking Warranties – Sellers and insurers will generally resist any forward looking statement contained within the suite of warranties.
  • Tax Liabilities – Insurers are particularly cautious with regard to tax warranties and will carve out any potential secondary tax liabilities and transfer pricing.
  • Fraud – Any losses arising from fraud or fraudulent misrepresentation will not be covered. It is important to ensure that the seller remains liable for such losses under the sale and purchase agreement.
  • Other Liabilities – Most insurers will seek to exclude liability for pension underfunding, consequential or indirect losses, high risk liabilities (e.g. environmental claims), fines and penalties, unaudited accounts and known risks and liabilities.

Gaps in cover seem to be increasing in recent years. Underwriters review warranty wording particularly closely and increasingly exclude or partially cover certain warranties. A seller might plug some of these gaps, but if not this can leave the buyer with insufficient protection. The question is whether such gaps will decrease as buyers push back and insurance returns to its original raison d'être – as a product to bridge gaps in liability.

Summary

While warranty and indemnity insurance offers comfort to buyers that they have a secure recourse for insured losses, buyers must negotiate the transaction with complete awareness of excluded liabilities. Once the presented risk is apparent, the buyer should consider whether it will accept the risk, seek to obtain additional coverage from the seller for excluded liabilities or ultimately reduce the purchase price to mitigate the exposure. On occasions, the greatest risk of loss may not be covered by insurance and the retention of completion funds during the claim period can adequately deal with the concerns of the buyer (providing the seller is willing to accept a holdback).

Buyers should enter into insurance negotiations with confidence and not necessarily accept draft insurance policies at face value. We have seen insurers continue to offer more bespoke coverage for lower premiums and broaden coverage to higher risk elements of the transaction in limited transactions. Warranty and indemnity insurance continues to be a fast evolving area and it may be that now is the time that it re-calibrates to provide wider buyer cover, as it once did and was originally intended to do.

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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