The Benefits of Warranty & Indemnity Insurance Explained

Warranty & Indemnity (W&I) insurance is rapidly gaining momentum in Asia as a risk mitigation tool in Merger & Acquisition (M&A) transactions. BMS’ Martijn de Lange and Aris Wong discuss benefits of W&I insurance and why it is instrumental to M&A transactions.

What is W&I Insurance?

M&A transactions come with risks and uncertainties. Caveat emptor, or the principle of 'buyer beware' places onus on buyers to conduct due diligence on the company or assets to be acquired (Target).

While due diligence helps to identify the risk profile of the Target, it does not always expose all risk. Buyers, therefore, require sellers to provide a set of representations and warranties (R&W) on material facts relating to the Target. Examples are:

• Target’s financial statements have been prepared in accordance with applicable accounting standards and fairly present in all material respects the Target’s state of affairs;
• Target has filed all tax returns and paid all taxes due
• Target is not involved whether as claimant or defendant or other party in any claim, legal action, proceeding, suit, etc.

If unknown risks surface post-completion 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 W&I insurance.¹

Below, we’ll explain the benefits of doing this.

Financial security

W&I insurance offers financial security by transferring risk of financial losses arising from breaches of R&W from deal parties to an insurer.

After completing an M&A transaction, there may be breaches of R&W. Examples include:

Breaches of R&W may result in significant financial losses. Statistics have proven that such breaches are not theoretical: claims notifications are now made on around 1 in 5 W&I policies.²

In absence of a W&I insurance policy, the buyer would claim against seller for any financial losses arising from breaches of R&W. However, buyer has no guarantee that seller would pay out any claims post-completion. The seller, on the other hand, might be concerned about post-completion risks and liabilities. A W&I insurance policy addresses these concerns.

The costs for obtaining such financial security are relatively low. In Asia, the average premium for a W&I insurance ranges between 0.6% and 2.5% of the policy limit (typically 25% of the transaction value). Let's give an example to make this clearer:

Artificial Asia, a robotics firm, intends to acquire 100% of the shares in its main competitor, Robotic Solutions, from its parent entity Rob Robotics. The purchase price is USD 40m. In the purchase agreement, Rob Robotics gives a set of market standard R&W and indemnities to Artificial Asia.

Rob Robotics’ financial position is challenging, and Artificial Asia is concerned about financial recourse in case of breaches of R&W. To alleviate these concerns, Artificial Asia’s lawyers suggest procuring a W&I insurance policy with a policy limit of USD 10m. A broker assists with the procurement of the W&I insurance policy and recommends an insurer based on analysis of pricing, coverage and claims track record, among other things. The all-in costs for the policy are USD 120,000 (1.2% of the policy limit). Considering the deal size and potential financial exposure, the costs to obtain financial security are comparatively quite low.³

Smoother deal negotiations

R&W and indemnities negotiations often turn out to be the most challenging part of any deal. Buyers and sellers are each represented by an army of lawyers and advisors and they all want to have a say in what should be agreed upon in the purchase agreement. This can result in prolonged deal negotiations and in some cases, even cause parties to pull the plug on the transaction completely.

This is where W&I insurance adds tremendous value. Although insurers would require buyer and seller to negotiate ‘at arm's length’, an insurer (as third-party) takes over the risk of losses arising from breaches of R&W. This helps take contentious points off the negotiation table. Insurers normally cover a set of market standard R&W and indemnities that should be acceptable to both buyer and seller.

Further, W&I insurance helps to bridge gaps between dealmakers on allocation of unknown risks. Buyer and sellers typically have conflicting, subjective and self-interested views on how to account for risks. W&I insurance addresses these challenges by putting an independent price tag on those risks.

This all means that W&I insurance plays a pivotal role in facilitating deal negotiations and closing deals more seamlessly.

Optimal claim experience

Except for dispute lawyers, no one really likes conflict. Buyers and sellers are no different.

In the absence of a W&I insurance policy, the buyer can only make a claim against the seller for any losses arising from breaches of R&W. This is not ideal. There may be broader business interests involving the buyer and seller (e.g. the seller remains a client of the Target). Or the Target’s management is acting as seller and retains an interest in the Target’s business after the deal. It is also improbable that a seller often deals 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&W. Reputable and well-established insurers back such policies. They have solid track records of dealing with claims fairly, collaboratively and transparently. This compares favourably with 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 dissatisfaction.²

Efficient process

One might wonder how long it takes to put a W&I insurance policy in place and whether it will lead to any delay of the M&A transaction process.

W&I insurers work on tight deadlines to ensure their involvement does not adversely impact the transaction timetable. However, they need time to review the purchase agreement for the Target (with a near-final set of R&W), disclosure letter (in a near-final form), and due diligence reports.

A W&I insurance policy can typically be placed within two to three weeks and the various stages of the process are outlined below:

W&I Insurance | Conclusion

W&I insurance is an invaluable risk mitigation tool in modern-day deal making. It offers financial protection against unknown M&A risks at competitive premiums. It plays a pivotal role in facilitating deal negotiations, and deals are getting closed more seamlessly. It ensures an optimal experience in case of claims for breaches of R&W and it can be put in place within a relative short time period.

We hope you enjoyed the read. If you want to learn more about how W&I insurance unlocks value in M&A transactions, please click here.

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 highly experienced and dedicated teams in Asia, London and Canada have facilitated hundreds of transactions across the globe. Please feel free to contact us for a confidential discussion.

¹In North America, this is commonly referred to as Representations & Warranties Insurance (RWI).