Warranty and indemnity insurance: Covering risk in M&A transactions

Warranty and indemnity (W&I) insurance is now a common feature of Australia’s private M&A market. Traditionally the domain of private equity funds and institutional sellers, there has been an increasing uptake of this product by trade sellers and founders seeking to make a clean exit.

Background and context

A fundamental principle underpinning Australian M&A transactions is the concept of caveat emptor or “let the buyer beware”. Under this principle, a seller does not have a duty to reveal defects in the company or business being sold to a buyer. To address this issue, buyers typically conduct due diligence on the company or business and seek to rely on contractual warranties and indemnities given by the seller under a sale agreement.

However, the interests of buyers and sellers are not aligned when it comes to negotiating the warranties and indemnities. A buyer will seek a comprehensive warranty and indemnity package to protect against losses which may arise following an acquisition. In contrast, a seller will want to limit the scope of the warranty and indemnity package to reduce the risk of the buyer making a warranty or indemnity claim. The divergence in objectives can result in protracted and contentious negotiations, which can impact on whether a transaction proceeds or not. W&I insurance can act as a valuable tool to bridge the gap between these objectives.

What is W&I insurance?

W&I insurance is an insurance product which covers an insured for financial loss arising from a breach of the warranties or indemnities given by the warrantors (usually the seller) under a sale agreement. This insurance is typically structured as either:

• A buyer policy, whereby the insurer agrees to reimburse the buyer for losses from warranty and indemnity claims without first seeking to recover from the seller; or
• A seller policy, whereby the insurer agrees to reimburse the seller for losses from warranty and indemnity claims made by the buyer.

W&I insurance policies are usually buyer policies because:

• Often under the sale agreement, the seller will remain contractually liable for a breach of warranty if the policy does not respond in respect of the breach;
• As with any insurance policy, the insured has a duty under the Insurance Contracts Act 1984 (Cth) to disclose to the insurer every matter that the insured knows, or could reasonably be expected to know, is relevant to the insurer’s decision to accept the risk of insurance. As a seller will have a more intimate knowledge of the target business, the standard of the seller’s duty of disclosure is likely to be higher than a buyer’s duty of disclosure. On buyer policies, this issue is typically mitigated by the insurer agreeing to limit the meaning of knowledge to the knowledge of the deal team involved in the transaction; and
• Seller policies generally do not cover breaches arising from the seller’s fraud, whereas buyer policies will cover such breach provided the insurer retains subrogation rights against the seller so it can recover its loss against the fraudulent seller.

Reasons for using W&I insurance

The reasons for using W&I insurance may include the following:

Practical issues and tips

While there are many advantages to using W&I insurance, it is important for both buyers and sellers to understand its scope and limitations to ensure the risks covered by their policy are aligned with their expectations. The following is a summary of some practical issues and tips.

1. A thorough due diligence and disclosure exercise is key

Before an insurer will underwrite any M&A transaction, it will require a thorough due diligence to be conducted on the target by reputable legal and financial advisers. The purpose of this exercise is to identify known risks which will not be covered by the policy and give the insurer a good understanding of the risk it is prepared to cover. Insurers will also expect that sellers have carried out a full and proper disclosure exercise and the parties have negotiated an arm’s length transaction. If an insurer is not able to get comfortable with the due diligence undertaken this could increase the premium and the scope of the coverage could be narrower.

2. Basic features and typical cost of a W&I insurance policy

The key features of a W&I insurance policy include the following:

• De minimis – As with a customary share purchase agreement, the W&I insurance policy will be subject to a de minimis per claim and minimum aggregate claim amount. This is usually set at 0.1% of the enterprise value of the target for individual claims and 1% for the aggregate claim amount;
• Retention – Insurers usually require that the minimum aggregate claim limit be borne by the insured before the policy responds. This aggregate is known as the self-insured retention and is typically equal to 1% of the enterprise value of the target. In the Australian market, insurers sometimes offer ‘full tipping retention’ policies where the insurer will cover the insured from the first dollar of loss, as well as, ‘partial tipping retention’ policies where the insurer covers the insured from the first dollar of loss after 25% or 50% of the retention amount has been eroded by claims. The main exception to this is that claims under title and capacity warranties will typically have a retention of nil;
• Policy limit – Insurers usually offer coverage of up to 3 years from the date of completion for general business warranties and 7 years from the date of completion for claims under the title warranties, tax warranties and tax indemnity. These claim periods are longer than the typical time periods negotiated without W&I insurance; and
• Cost – In the Australian market, premiums are usually between 1% to 1.5% of the amount insured with the relevant percentage reducing for larger policies. The premium is a once-only charge for the term of the policy. The insurer’s perception of risk, size of the retention and whether the insured is seeking a tipping retention structure, typically have the most influence on the premium. Who pays the premium is often the subject of robust negotiations. If a seller is conducting an auction sale process, the seller may insist that it is the buyer’s responsibility to obtain and cover the cost of the policy.

3. Standard exclusions from coverage

Insurers customarily exclude coverage for losses arising from:

• Matters which were within the actual knowledge of the insured prior to inception of the policy. However, it is possible to restrict this knowledge qualifier to the actual knowledge of specific members of the insured’s deal team who were involved in the transaction;
• Fraud by the insured under a seller policy. Under a buyer policy, claims arising from a seller’s fraud will still be covered by the policy but the insurer will have a right to subrogate and claim its loss from the fraudulent seller;
• Criminal or civil fines or penalties. This exclusion stems from public policy grounds, although it is sometimes possible to restrict this exclusion to fines or penalties that are not able to be insured as a matter of law;
• Financial estimates, projections or forward looking statements. A common example where this exclusion would apply is for warranties around the collectability of debts or receivables;
• Consequential loss. This exclusion should be carefully examined to ensure it is not overly broad;
• Tax avoidance or the application of transfer pricing legislation;
• Product liability or the condition, existence and/or saleability of trading stock; and
• Breach of warranty between signing and completion of the transaction. In recent times, insurers have started offering ‘new known breach cover’ to cover breaches of warranty during the gap between signing and completion of the sale agreement.

Conclusion

W&I insurance is not a panacea and there will remain certain risks which are not insurable. Care needs to be taken in selecting the appropriate policy structure and ensuring the policy taken out is consistent with the regime in the sale agreement. However, with the right advice and an appropriate policy structure, W&I insurance can take the heat out of warranty negotiation, allow sellers to sleep easy at night and give buyers comfort that valid claims will be met.

This article was written by Matthew Nelson, Partner.