Warranty & Indemnity (W&I) insurance is increasingly being used in M&A transactions across the globe. A recent global survey¹ from BMS Group showed that in the majority of cases (56%) the use of W&I insurance was initiated by the seller. In comparison, the process was initiated by the buyer in only 12% of the cases (with rest being mutually agreed)². It is thus fair to say that W&I Insurance currently is a seller-driven product. In this article, BMS Group’s M&A insurance brokers Martijn de Lange and Aris Wong discuss benefits that sellers can reap when using W&I insurance in M&A transactions and why it is rapidly becoming the norm.
What is W&I Insurance?
M&A transactions come with various financial risks. To protect against these risks, buyers conduct due diligence on the company or assets to be acquired (Target) based on information made available by sellers. However, it is impossible to rely on due diligence to uncover all risks, many of which can lie undiscovered for several years. Therefore, buyers typically ask sellers to provide a set of representations and warranties (R&W) on material facts relating to Target in the Purchase Agreement for the Target.
A few examples of such R&W are listed below:
If unknown risks materialise post-completion of the transaction, rendering R&W inaccurate, sellers are required to compensate buyers for any financial losses incurred. In modern day deal-making, this compensation could be insured against by using W&I insurance3. Oftentimes, seller will initiate or even mandate the use of W&I insurance by buyers.
Below, we’ll explain why.
Clean Exit
After completing an M&A transaction, there may be many breaches of R&W. Examples are:
Breaches of R&W could result in significant financial losses for the buyer. Statistics have shown that such breaches are not merely theoretical: claims notifications are made on 1 in 5 W&I policies4.
In the absence of a W&I insurance policy, the seller would usually be liable for such losses under the Purchase Agreement. Further, to ensure that there is financial security backing recourse from sellers, most buyers require escrow accounts or parent company guarantees. This may not be aligned with sellers’ commercial goals to seek an exit from the Target without post-completion risks and liabilities (‘clean exit’).
A W&I policy is the perfect instrument to achieve such a clean exit. It offers financial security for sellers by transferring risk of financial losses arising from breaches of R&W from sellers to an insurer. This reduces financial risk and alleviates the need for escrows and holdbacks.
You may wonder how much it costs to achieve such clean exit. Well, these costs are surprisingly low. In Asia-Pacific, the premium for a W&I insurance policy only ranges between 0.6 and 2.5% of the insured limit, which on average is 25% of the transaction value. Thus, a tiny investment can offer sellers security for large financial exposures.
Example
Red Stone, a real estate investment firm, intends to sell a commercial building in Southeast Asia to a competitor, Blue Rock. The purchase price is USD 80,000,000. In the asset purchase agreement, Red Stone gives a set of market standard of R&W and indemnities to Blue Rock.
Red Stone wants to achieve a ‘clean exit’ from the asset and does not offer financial recourse for losses arising from breaches of R&W. Instead, they require Blue Rock to purchase a W&I insurance policy.
A broker assists Blue Rock with the procurement of a W&I insurance policy with an insured limit of USD 20,000,000 and recommends an insurer based on comprehensive review of pricing, coverage and claims track record, among other things. All-in costs for a multi-year policy are USD 160,000 (0.8% of the policy limit).
Considering the amount of the transaction and potential liabilities, the cost of obtaining financial security is quite low5.
Smooth Deal Negotiations
Reaching an agreement on the scope of wording of R&W and seller limitations on recourse often turns out to be the most challenging part of deal negotiations. The seller and buyer typically have conflicting, subjective views on how to account for and allocate unknown target risks. Further, they are represented by lawyers and advisors, who in turn, hold their own views on what should be agreed upon in the Purchase Agreement. This can result in prolonged negotiations and sometimes even cause parties to pull the plug on the transaction.
This is where W&I insurance adds tremendous value to the transaction. It puts an independent price tag on tail-end liabilities, which helps to bridge gaps between deal parties on the allocation of unknown risks.
While representations given still have to be negotiated at ‘arm’s length’, the fact that an insurer takes over the risk of financial losses arising from breaches of R&W helps take contentious points off the negotiation table.
All of this means that W&I insurance plays a pivotal role in facilitating deal negotiations, and thanks to it, deals are getting closed more effortlessly.
Optimal Claim Experience
Except for dispute lawyers, no one really likes conflict. Buyers and sellers are no different.
It is not ideal for buyers to make a claim against the sellers for any losses arising from breaches of R&W. There may be broader business interests involving the buyer and seller (e.g. the seller remains as a shareholder or a client of the Target) or Target’s management is acting as seller and retains an interest in the Target’s business after the deal. It is also unlikely that a seller will have extensive experience in dealing with claims, making the claims process less efficient.
With a W&I insurance policy in place, buyers and sellers avoid participating in drawn-out legal battles. Instead, they claim against their insurance policy in case of losses arising from (covered) breaches of R&W6.
Reputable and well-established insurers are backing such policies, with solid track records of dealing with claims fairly, collaboratively and transparently. This compares favourably to one-off interactions with sellers.
W&I insurance has been around for over two decades. Most W&I insurers have dedicated claims teams to ensure an optimal claims experience. A recent survey by BMS Group of insured clients showed satisfaction levels with claims handling are high, at a rating of 8/10 and no instances of dissatisfaction7.
Type of W&I Policies
In an M&A transaction, sellers can opt for two types of W&I insurance policies, as summarised below:
In practice, buyer side policies are more commonly placed than seller policies because the cover is wider, and sellers are not involved in the claims process. However, a buyer policy requires the buyer’s engagement and this is why many sellers initiate the process to procure W&I insurance on the sell-side in advance and then hand over or “flip” the process to the buyer (or preferred bidder) once the M&A transaction has sufficiently progressed. The W&I insurance policy is then taken out by the buyer as the insured party. This process is known as a “sell-side flip”. In a sell-side flip, the Purchase Agreement will stipulate that the buyer procures W&I insurance as part of the transaction. Often, this allows the seller to structure the transaction such that, except in the case of fraud, the buyer will have no recourse from the seller in case of a claim for a breach of R&W under the Purchase Agreement (known as ‘nil seller recourse’).
In practice, a sell-side flip has many benefits for sellers and buyers, including:
Conclusion
W&I insurance is an invaluable tool for sellers in an M&A transaction. It facilitates a ‘clean exit’ from the Target at competitive premiums, allowing the seller to distribute its funds or move on to the next acquisition with a peace of mind. It facilitates smooth deal negotiations, and deals are getting closed more effortlessly. It can also be put in place with a short turnaround.
As not all transactions are insurable and no two transactions are ever the same, sellers should approach a specialised M&A insurance broker to find out more about the feasibility of W&I insurance and how it should be structured.
BMS Group has a dedicated Private Equity, M&A and Tax team that supports you throughout the lifecycle of a W&I policy – from placement to claims. Our experienced and dedicated team have helped de-risk hundreds of M&A transactions across the globe. Please feel free to contact us for a confidential discussion.
We hope you enjoyed the read. If you want to learn more about How Warranty and Indemnity Insurance unlocks value in M&A transactions, please click here.
1 In 32% of the cases the agreement to buy W&I was a mutual decision of the seller and buyer.
2 BMS Group Private Equity, M&A and Tax Report – Redefining M&A Insurance for the 2020s. The full report is available here.
3 In North America, this is commonly referred to as Representations & Warranties Insurance (RWI).
4 BMS Group Private Equity, M&A and Tax Report – Redefining M&A Insurance for the 2020s.
5 This fictive example is indicative and cannot be relied upon.
6 Under a seller policy, a buyer claims against the seller first who in turn claims against the policy.
7 See: BMS Group Private Equity, M&A and Tax Report – Redefining M&A Insurance for the 2020s. The full report is available here.
