W&I Insurance — the M&A Carefree Package?
Once there is agreement on basic commercial terms, warranties and indemnities often turn into the biggest stumbling block (and nerve wrecker) of a company sale. The buyer seeks to protect his investment, the sellers(1) want a clean exit. In come an extensive guarantee catalog and far-reaching indemnities(2), combined with a request for sellers to repay up to the entire purchase price if need be, and for an escrow of 10% and more as collateral. Out goes harmony and hopes for a manageable timeline and legal bills.
Against this backdrop, it is no surprise that warranties and indemnities (W&I) insurance has seen explosive growth since its wider introduction in the early 2010s. Initially considered a costly and time-consuming diversion by many sceptics, it has today become a standard instrument in close to 50% of eligible deals (which, in simplified terms, are most company sales with a transaction value over EUR 20 million).
Two important features that have become market standard in the past years have underpinned the rapid adoption of W&I insurance in M&A deals: Until some time ago, sellers were often the insured party, which means that in case of a warranty breach they paid first to the buyer and subsequently requested reimbursement from the insurer. Today’s policies are almost always so-called buyside policies which are taken out (and paid for) by the buyer(3). This setup ensures that any breaches are handled directly between the party with the damage (buyer) and the ultimate debtor (insurer) without unnecessarily straining the buyer-seller relationship, and it has the additional benefit of allowing expiry periods that are longer than agreed in the sale and purchase agreement (SPA).
Furthermore, it’s become customary for a W&I policy to be “non-recourse”, meaning the insurer cannot go back to the sellers to recover some or all of the payout. Any retention (which is a key instrument of the insurer to control its exposure — see below for details) is borne exclusively by the buyer. Except for fraud by a particular seller (for which recourse generally cannot be excluded) and any claims which the parties expressly agree to remain the sellers’ responsibility, today’s buyside W&I insurance largely removes the sellers from the “settlement picture”:
In its current format, the business proposition of W&I insurance sounds like an all-out win-win: The buyer gets the certainty of a solvent debtor for an extensive set of guarantees with generous expiry periods. The sellers get a clean exit without a contingent liability for unknown risks. Both enjoy substantially less tension, acrimony and all-nighters on the negotiations, and a more harmonious cooperation post-closing (e.g. in connection with the handover or where a seller in a managerial role continues working for the combined business). In almost all cases, the unloved escrow is binned for good, avoiding an initial deduction from the purchase price and the extra admin costs and efforts.
If you think something like this must cost a fortune, you’re in good company — but you’re wrong. The fee charged by the insurer (or consortium of insurers) in the European market rarely exceeds 1–2% of the so-called coverage limit, which is the maximum amount the insurer agrees to be liable for (in the US, premium levels are a bit higher). As the coverage limit generally does not need to be higher than 20–30% of the purchase price, the fee will hardly ever exceed 0.5% of the purchase price — much less than advisory costs for lawyers and bankers on an average transaction. So, what IS the catch?
Since there is no free lunch, the insurer does have some exclusions and limitations in its small print to keep its risk exposure under control. All of them can lead to a significantly different outcome from what especially the buyer might have expected in a traditional transaction without W&I insurance, but their impact varies significantly:
Only a potential impact: Unknown vs. known risks
The standard W&I insurance will only cover unknown risks, whereas known problems (where only the amount of the damage is unclear) are excluded. Understandably, an insurer will not want to pay for a (near-)certain damage (unless the fee is much higher). Thus, if an issue does arise during due diligence it is generally settled by a deduction from the purchase price, or the sellers agree to a specific indemnity, often in combination with an adequately sized escrow account. Note that in some cases insurance coverage may be available even for such risks, although this will come at a much higher cost (up to about 10% of the coverage limit). Where none of this works out, the deal might fail, but these cases are rare and certainly don’t argue against exploring W&I insurance for the large majority of transactions without such legacy issues.
Only a fringe concern: Due diligence
To minimize its risk, the insurer will almost always require extensive due diligence, to be performed by reputable external advisers (esp. lawyers and auditors) who review the business in detail and prepare a comprehensive report on their findings. The exercise may not just delay the transaction and increase costs but also turn some previously unknown risks into known issues — which are thus excluded from coverage and could, in the worst case, jeopardize the entire transaction (see above). But: In today’s highly professionalized M&A market, where even for smaller deals a certain deal hygiene is considered part of the purchaser’s fiduciary duties, a seller will rarely be able to find a buyer who will take the asset blindly. In contrast, in the great majority of cases the peace of mind offered by W&I insurance by largely removing the seller’s liability risk and the unburdening of warranty negotiations will easily outweigh the extra effort.
Always a big potential impact: Specific exclusions and retention
More relevant for the risk-benefit analysis of W&I insurance are two other tools that insurers use to limit their exposure: Exclusions for certain “notorious” risks and the so-called “retention” or “excess”. The former refers to several potential sources of trouble that can cause substantial damage if they materialize and are hard or extremely costly to uncover in due diligence. They may include, for instance, parts of the asset base that could not be adequately reviewed in due diligence, violations of some “consequence-prone” laws (esp. anti-corruption and anti-money laundering), certain environmental issues, forward-looking statements, and specific accounting and tax problems like transfer pricing. In addition, purchase price adjustments and leakage (if agreed) are generally excluded from coverage — which merely states the obvious as these mechanisms are not part of the warranty and indemnity regime in the first place.(4)
Quite frequently the insurer’s fine print also narrows the scope of some warranties by including a knowledge qualifier, which means a breach is only covered if certain person(s) with close ties to the company were aware of the issue.
Retention/excess refers to a certain minimum damage amount that the buyer must bear herself before the insurance kicks in. The rationale for this is two-fold: one, exclude any warranty violations which generally do not materially change the deal’s outcome. Two, create some “attachment” of the sellers to the warranties negotiations, although with today’s non-recourse standard, such attachment is largely limited to the sellers’ desire not to appear reckless and avoid future friction with the buyer.
In addition to the excess, insurers may require a minimum damage resulting from an individual warranty violation (so-called “de minimis”) that is above what’s agreed in the SPA. As before, the intention is to remove certain damages from coverage that, while not a deal mover for the parties, can quickly turn the policy into a loss-maker for the insurer both from a liability and claims handling perspective.
Legal implications
The huge popularity that W&I insurance has gained over the last years shows that neither the excess nor the other “fine print” is seen as a major deterrent undermining its value. This makes sense when looking at the “psychological” benefits of a W&I policy, i.e. the peace of mind, deal-facilitating and pacifying effects, as these remain largely uncompromised. Yet it appears that besides the aforementioned “soft factors”, many buyers expect some real, tangible value for the premium paid: making their bid more attractive and nonetheless be fully compensated if the purchased business turns out different than expected, just like in a traditional bilateral liability regime with a proper escrow.
Whether these expectations are justified (or, in fact, undercut by the coverage limitations) ultimately is not a legal, but a commercial question, which we’ll look at a bit more closely below. From a purely legal perspective, two points seem worth highlighting: For the sellers, W&I insurance will almost always be a no-brainer because of the far-reaching removal of the liability risk — unless the warranties are limited to capacity and title, which is generally the case in minority sales by non-operational shareholders and buy-outs of publicly listed companies (for which in consequence W&I insurance is generally considered unnecessary). Similarly, the buyer may see the extra effort and cost of W&I insurance as a waste of time and money under some specific and rare circumstances, for instance if the representations that are most important to the buyer are excluded from coverage (or materially qualified).
Commercial implications
The business model of an insurer can only work if the premiums earned exceed the claims to be paid on damages as well as the claim handling and other operating costs (so it can cover its cost of capital and make a profit). This means that, since the premium for a W&I policy rarely exceeds 2% of the coverage amount, the average payout per policy must stay well below approx. 0.5% of the purchase price (assuming a typical coverage limit of about 25% of the purchase price).
If you’ve been involved in M&A for a while, you might think: How is this possible given that in the old days, before W&I insurance, an escrow of at least 10% was common and not few buyers made a sport of hiring expensive lawyers and forensic accountants to conduct a detailed post-closing review of the business and the guarantees in order to funnel at least a portion of the escrow back to them, often successfully? On top, doesn’t the insurer face significant moral hazard given the separation of risk generation (sellers negotiating the reps and warranties) and coverage (insurer paying for breaches)?
The insurer knows all this, of course, and in response, puts in place various protection mechanisms to keep its exposure at bay (see above). If these mechanisms fulfill their purpose and the insurer manages to keep the average payout at the targeted level, a buyer who expects to get value out of the policy that is broadly comparable with a bilateral warranty regime will likely be disappointed: Compared to a typical set of comprehensive guarantees, relatively modest limitations and a sizeable escrow an (average) “return” of less than 0.5% seems small. Can a buyer, therefore, expect to get more value out of the average policy than would be “healthy” for the insurer?
Information available in the public domain seems to suggest as much, at least for more recent years: AIG, one of the biggest M&A insurers and underwriters, reports that approx. 20% of policies underwritten in 2011–2019 received claim notifications. The UK insurance broker Marsh recorded a somewhat lower number for 2018 of about 11% following a strong increase over the preceding two years, but in the most important category of deals with a value >USD 1 billion the notification quota was as high as 17% even including earlier years. Not all of the notifications result in a payout of course, but there are indications that, at least for some insurers, payments have indeed been higher than they would have liked them to be.(5)
Does this mean W&I insurance can be seen as fully equivalent to a traditional reps and warranty regime from a value (risk transfer) perspective? Rather not. Even if the calculations and assumptions of some insurers have been aggressive in the years leading up to the pandemic, and pricing as a result was too low or conditions too generous, the continued popularity of the product and willingness of insurers to offer coverage at broadly similar (even if somewhat higher priced) terms shows that the “overshoot” in actual payouts relative to premiums was nowhere in the magnitude that would make them comparable to the potential “horse trading” over an escrow in prior days.
But keep in mind: W&I also offers some features with real commercial value which may not be adequately reflected in the overall payout statistics. For many buyers, having a solvent debtor for certain major risks and an above-market expiry period that allows sufficient time to explore and register potential claims may already offer sufficient benefit.
So…
W&I insurance should first and foremost be seen as a deal facilitation tool. For a typical M&A transaction where the parties are primarily focused on maximizing deal certainty and a smooth handover after closing, and where the buyer does not see warranties as a routine means of purchase price optimization, its value-add relative to the premium is substantial. No rule without exceptions, of course, especially where the insurance excludes an important risk. Yet even if there is a deal feature that might render W&I insurance unhelpful for a particular transaction, in almost all cases it will still merit at least an initial look. A specialized broker or underwriter will normally quickly tell you if M&A insurance might be possible on the deal you have in mind. Such an initial assessment will normally include the most important terms (in particular the coverage amount) and a rough cost estimate, and not require more than some readily available information (for instance, an information memorandum or a company presentation and some basic financial statements).
Notes:
1) There can of course also be just one seller, esp. in case of an asset deal, but since share deals with several selling shareholders are the great majority, we’ll stick to the plural for simplicity.
2) In simplified terms, guarantees relate to a certain status quo at signing and/or closing, whereas indemnities seek to compensate the buyer for certain negative developments or events post closing.
3) The sellers can help with arranging the policy of course, which happens regularly.
4) Systematically, these features belong to the deal economics: Purchase price adjustment mechanisms are frequently agreed in larger and more complex transactions to account for changes of certain liabilities, working capital and cash, which are only finally determined after closing based on a closing balance sheet. Leakage refers to non-arm’s length payments to a seller between the date of the most recent (guaranteed) financial statements and closing — which must be repaid by the recipient. Leakage rules generally provide protection to the buyer where a more comprehensive purchase price adjustment mechanism is to be avoided. See here for more details.
5) For instance, Marsh states that 84% of all formally registered claims resulted in a payout (see p. 7 of the report). Note that a “claim” is not the same as a notification (which is sent quickly based on a mere hunch to make sure no deadlines are missed, but may not result in a formal claim filing because, for example, the damage turns out below the retention amount), but it’s probably reasonable to assume that actual claims are not just a fraction of notifications either. Marsh gives this for the insurer rather sobering development a positive spin, seeing “evidence that W&I insurance is no longer just a deal facilitation tool but a proven risk transfer mechanism” (p. 1). The experience of higher than expected payouts is shared by AIG, which reports an increase in premiums in response to the high number of claims, as well as a greater focus on “limits management” to “ensure the long-term sustainability of the product” (see p. 2).
