Peace of Mind – An Introduction to Warranty and Indemnity Insurance
July 28, 2023
Warranties and sellers’ liability
On any business sale, a buyer will require the seller of the business to provide a series of warranties. These are statements of fact provided to the buyer and are typically split into three categories:
1.Fundamental warranties – these cover the seller’s ownership of the shares in the target (assuming a share sale rather than an asset sale) and the seller’s ability to enter into the transaction.
2. General warranties – whilst the general warranties will vary from deal to deal depending on the nature of the business, they will typically cover areas such as accounts, compliance with laws, material contracts, employment, litigation, IP, IT and real estate.
3.Tax – these cover a number of areas relating to the target’s tax position.
The standard position on a uninsured transaction is that, if a warranty is breached and the buyer suffers a loss as a result of that breach, the buyer will be entitled to make a claim against the seller for that loss. Whilst sellers will seek to limit their liability for warranty breaches in the transaction documents (for example, by imposing financial caps and time limits on claims), they nevertheless remain liable for warranty breaches post-completion and for a material amount of time (typically up to seven years for tax breaches). This may prevent sellers from fully utilising their sale proceeds and thus from making a clean exit from the business.
W&I insurance
Under a warranty and indemnity (W&I) insurance policy, an insurer steps into the seller’s shoes and becomes responsible for any loss that the buyer suffers as a result of a warranty breach (or for any claim under the tax covenant). On the vast majority of policies, the buyer will be the insured party – so, if a warranty is breached, the buyer’s primary recourse will be against an insurer and the buyer will not be required to make any claim against the seller.
This has clear advantages for both parties. For sellers, a W&I policy enables them to reduce their liability under the SPA (often to as low as £1) and thus make a clean exit from the transaction; for buyers, they have the comfort of having an A-rated insurer stand behind the warranties. Buyers can also improve their coverage under a W&I policy vs. what is available under the transaction documents – for example, they can agree with the insurer to have longer claim periods than in the sale agreement or to apply a different measure of damages.
On a private equity transaction where management sellers are rolling over into the new structure, a W&I policy will also remove any need for the PE investor to bring a claim against the management team in the event of warranty breach. This will allow management to concentrate on running and growing the business without the distraction of a warranty claim.
Policy features
There are a number of policy features that sellers should be aware of:
- Limit – this refers to the sum insured under the policy. Typically, this will be c. 20% to 30% of the purchase price, but some buyers may wish to take out insurance for the full amount of the purchase price (particularly on smaller deals). If there are concerns about title to shares (for example, if a buyer is acquiring shares from a large group of individual shareholders), buyer may also choose to take out top-up or standalone title cover for the full amount of the purchase price. In the event that the sellers do not have title to the share sales or if there are undisclosed encumbrances, this ensures that the buyer is fully protected up to the full amount of the purchase price;
- De minimis – in order to bring a claim under a W&I policy, the amount of the claim must exceed a de minimis amount (typically the same as the de minimis under the transaction documents or less). However, if the buyer’s due diligence review has employed a higher threshold for materiality, the de minimis under the policy may be increased accordingly;
- Retention – similarly to a sale agreement, a W&I policy will include a basket (referred to as the “excess” or “retention”). So, in order to make a claim for loss, not only must each individual loss exceed a de minimis amount, but the policy will only pay out once the buyer’s overall loss exceeds the retention. The retention will normally be set at 0.5% or 0.25% of the purchase price. However, insurers may agree for the retention to “tip” to nil, such that, once the amount of loss exceeds the retention, the policy will pay out the full amount of loss suffered (including the retention). On a non-tipping deal, the parties will need to agree who will be responsible for the buyer’s loss up to the retention amount (i.e. whether this will be borne by the seller or whether the buyer just accepts that it can’t recover that amount);
- Pricing – premiums are calculated as a percentage of the limit insured under the policy. The rate will depend upon two factors:
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- The nature of the target – generally, the more complex the target business is, the greater the risk profile and therefore the higher the premium. Insurers will consider what the business does, how many employees it has, the jurisdictions in which it operates, etc.; and
- General market conditions – when deal volumes are high, there will be less capacity in the market and premiums will therefore increase. Conversely, when deal volumes are lower, there is less demand for policies and pricing will decrease accordingly. To give an example, the end of 2021 saw very high deal volumes, with a number of insurers running out of capacity to underwrite M&A transactions, which in turn led to a material increase in pricing.
Given the above, it is not possible to give definitive pricing for W&I policies. Currently, for a UK operational business, we would expect rates of between 0.8% and 1.2% of the limit insured, but this will vary from transaction to transaction (and could be higher if the market deemed the business to be higher risk).
It is important to note that insurance premium tax may also be payable. Whether it is payable, and at what rate, will depend upon where the insured entity is incorporated. For example, in the UK, insurance premium tax is levied at a rate of 12% of the premium; in Jersey, by contrast, no tax is payable.
With regard to who pays the premium, this will be a commercial decision between the parties and will ultimately depend on negotiating position. There is an argument that, as the W&I policy materially reduces the seller’s liability, they should bear some of the cost, and buyers will often expect the sellers to pay the premium, or a portion of it.
- Underwriting fee –the selected insurer will typically charge an underwriting fee to cover the costs that it incurs in underwriting the transaction. Depending on the transaction, these fees can be between £10,000 and £30,000 (although can be as low as £3,000 or nil for some SME transactions). Underwriting fees are payable regardless of whether a policy is entered into.
Exclusions
A W&I policy will not cover all areas of a transaction. The key coverage point that sellers and buyers should be aware of is that W&I policies only cover the insured for unknown risks – anything within the knowledge of the insured (which will typically include materials in the data room, matters disclosed in the disclosure letter and the buyer’s due diligence findings) will be excluded from coverage. This also means that the W&I policy will not cover any specific indemnities in the sale agreement. If there are specific identified risks, it may be possible to insure these under standalone tax or contingent risk policies – this could remove the need for any indemnity in the sale agreement and thus further reduce the seller’s potential liability.
In addition to known risks, there are some other areas that policies will typically exclude (for example, certain tax matters, pension underfunding, defective products and services and condition of assets). As with the retention, there will need to be a commercial discussion to decide who will be responsible for any loss that a buyer may suffer in relation to these areas.
W&I process
Given the benefits that W&I policies can offer to sellers, it is often sellers that drive the use of W&I on transactions, particularly on auction sales. Sellers will now routinely provide that the ultimate buyer must take out a W&I policy and that their liability under the transaction documents will be capped at £1. Brokers will often initially be instructed by the sell-side to source cover for a transaction, before “flipping” their instruction to the buy-side when the deal goes into underwriting.
The W&I process will usually take between two to three weeks (although can move more quickly when required). A typical timeline may look as follows:
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Where a W&I policy is being used on an auction sale, the underwriting stage can be carried out on the buy-side (a “soft staple”) or on the sell-side (a “hard staple”). If the more common soft staple route is chosen, the initial terms received from the market will be made available to bidders to review. At that point, the broker’s instruction will flip to the bidders and the broker will work with bidders to select an insurer and then enter into underwriting. Conversely, on a hard staple, the seller selects the insurer. The chosen insurer will then provide an initial policy draft and coverage position, which will be presented to bidders. Bidders will then work with that selected insurer to finalise coverage. There are a few other points to note in relation to a hard staple:
1. The selected insurer will require vendor due diligence reports (at a minimum, legal, tax and financial) in order to provide a coverage position. If no VDD is being undertaken, a hard staple will not be available;
2. A hard staple allows the seller to retain control of the W&I process for longer. By selecting an insurer and seeing the initial coverage position, a seller can draft the warranty suite accordingly and thus cut down on gaps between the warranties being given and the coverage available;
3. The seller will need to agree to pay the insurer’s underwriting fee. If the policy incepts, the parties may agree that the buyer pays the fee, but if the policy does not incept for any reason, the seller will be responsible for the cost.
Conclusion
From its infancy 15 years ago, the W&I insurance market has grown quickly. Market participants are now well aware of the advantages it can bring to both buyers and sellers and W&I policies are now an integral part of the M&A process. As a global broker with a well-established and experienced transactional risks team, Lockton is regularly instructed by both selling management teams and private equity investors to source and place insurance on deals.
Get in Touch
For more information on warranty protection, please contact David Elphinstone, Senior Vice President and Solicitor at Lockton Companies LLP.
Or contact him via david.elphinstone@lockton.com.
If you’re interested in further information on a share sale, get in touch with us here
