Having been sold in Australia for a number of years, warranty and indemnity (W&I) insurance now plays an important role in the M&A market in Australia. There has been an increased demand for the product and a rise in competition among insurers. This has driven down premiums and helped develop policy terms and conditions to the benefit of insureds. Finally, there is increased market confidence in the product as many purchasers and their advisers become more familiar with this form of insurance.
More than 10 US and European insurers currently offer W&I insurance in the Australian market. The average premium is currently around 1–1.5% of the insured amount, down from 3–5% pre-2007. According to Ben Crabtree, an M&A insurance expert at a leading international insurance broker Jardine Lloyd Thompson (JLT), the available insurance capital for any individual transaction in the Australian market is at an all-time high. Policy limits beyond $350 million are achievable today and recent movements in the insurers’ underwriting personnel will result in new insurers opening their doors for Australian transactions. The upshot of this is that, not only are meaningful limits of cover available for the larger transactions, but competition is continuing to grow, which can only benefit those seeking a W&I insurance option in their transaction.
The product has also evolved in recent times to adapt to the demands of the market. We discuss below how warranty and indemnity insurance is currently being used and how it is changing.
Who is taking out the insurance?
Sellers can take out W&I insurance to manage the risk of warranty claims made against them by buyers. However, more often than not, the buyer takes out the policy and is the insured party. This insurance allows buyers to claim losses arising from a breach of contractual warranties by the seller. It enables the buyer to claim directly from the insurer, without having to pursue the seller. There are many commercial reasons for buying W&I. They include concerns about the financial strength of the seller to meet future warranty claims, an inability or unwillingness of the seller to materially stand behind warranties, a reluctance to hold back a portion of the purchase price in escrow, transacting parties in different jurisdictions who have a reduced risk appetite in relation to warranties and a desire to use the insurance to break negotiating deadlocks.
Although most policies are taken out in the name of the buyer, sellers regularly introduce the concept of W&I to transactions. In this scenario, a seller may agree to pay part or all of a buyer’s W&I policy premium in exchange for a much lower cap on their liability in the sale agreement. Strategically, this enables the seller to exit the deal more cleanly.
How much is covered and for how long?
W&I insurance, as with other types of insurance, is typically structured to suit the needs of the parties to a deal. The risks covered and the amount and period of insurance vary and are deal-specific.
The amount of loss (or size of warranty claim) at which the insurance begins to respond (known as the “deductible” or “excess”) is usually fixed at a minimum of 1% of the transaction value. However, it may be possible to reduce the deductible to as low as the first dollar of loss or it can be as high as the parties wish.
For a buyer’s policy, the deductible could be set at the maximum liability of the seller. For example, if the purchase price was $100 million and the maximum liability of the seller was 20% of the purchase price, the deductible could be set at $20 million. In other words, below $20 million is recoverable from the seller and remains the seller’s risk (and uninsured) and above $20 million is recoverable from the W&I policy.
Similarly, the period of cover can vary from deal to deal. For example, the seller may be particularly resistant to giving warranties for a period beyond 12 months after completion. Insurers on the other hand are equipped to insure risks for an extended period. Crabtree's assessment is that, in the Australian market, they will generally be prepared to offer cover for tax warranties up to seven years and general warranties for up to three years, regardless of the limitation period in the sale agreement. The insurance can therefore be structured to cover losses of the buyer arising after the seller’s liability period has expired.
What is the process of negotiating W&I insurance?
A W&I insurer will perform a thorough review of a transaction. This will entail granting them access to the data room and provision of all deal documentation available to the insured party. On the part of the buyer, this will include the due diligence reports. Importantly, insurers are not looking to repeat the due diligence work carried out by the buyer. An insurer’s analysis comes from the perspective of the insurance cover, not from a desire to analyse the target business. Finally, it is typical for there to be a short question and answer session between the insurer and the party seeking the insurance.
Insurers may appoint legal advisers to assist their underwriting. If this is necessary, they will agree with the party who seeks the insurance that a fee will be paid to cover these costs if the policy is not purchased.
After underwriting has been completed, the insurer will offer policy terms which will be tailored for the transaction.
The time period for the underwriting process and negotiation of policy terms may vary. If a large limit of insurance is needed, this may also be impacted by the need to use multiple insurers in the program. The primary policy (being the first layer of insurance) will be provided by the insurer that offers the most competitive terms, conditions and pricing in the early stages of the process. Higher amounts of insurance require further layers of cover, which would be provided by one or more insurers. There are limited insurers domiciled in Australia and overseas insurers (generally European or US based). For these reasons, settling final terms with every insurer on a large program can be quite time consuming.
Another complicating factor is that some insurers may have “standard” exclusions that are inconsistent with the buyer's expected operation of the warranty and indemnity insurance or the position of the primary insurer. For example, the seller may give a warranty that the assets being sold are free from any environmental contamination. If an insurer of one of the higher layers has a “standard” exclusion of liability for environmental contamination, the buyer may need to negotiate with that insurer or find a different insurer. This type of potential delay needs to be factored in by buyers but can also be managed by an experienced broker.
Does W&I insurance impact on the approach to due diligence?
Generally, due diligence is a balance between the costs of undertaking further inquiry (i.e. time, money and resources) and the benefits (i.e. reduced reliance on warranty claims and more accurate up-front pricing of the deal). To put it another way, a buyer may decide to save itself the costs of further due diligence and instead “rely on the warranties”.
However, if the buyer is relying on warranty insurance (and the seller bears little or no liability under the warranties), the position of the buyer is quite different. A W&I insurer will expect that due diligence has been carried out thoroughly, without regard for the insurance.
If a buyer plans to rely on warranty insurance, rather than recourse against the seller:
- it must be able to establish to the insurer that it has undertaken a comprehensive due diligence process; and
- it must understand that matters which are left “unresolved” in due diligence are likely to become buyer risks (and not seller risks, as would be the case under a traditional warranty regime).
What are some of the features of deals in the current market
There has been some development of policy forms for W&I insurance. Certain matters that previously were not covered or shortcomings with standard policy forms, have now been addressed (to the benefit of insureds) as the market in Australia matures.
Increased interest in “no recourse” deals
First, there has been a growing interest on the part of sellers to do “no recourse” deals. These are structured so that the buyer's only rights are against the insurer in the event of a breach of warranty by the seller that does not involve dishonesty or fraud. This structure may be advantageous to, for example, a private equity seller who wishes to exit from an investment without being encumbered by possible breach of warranty claims in the future. The W&I market in Australia appears to be increasingly more comfortable with this structure, despite the fact that it may remove some incentives on sellers to do thorough vendor due diligence or negotiate vigorously the terms of their warranties.
Cover between signing and completion
Second, there is gradually more cover on commercially acceptable terms for a breach of warranty that occurs and is made known to the buyer after signing but before completion.In the past, a buyer holding W&I insurance would typically be exposed in the event of such a breach. This was because it was faced with a difficult choice — either:
- it could elect to complete the transaction and the W&I insurance would not respond to a claim for the pre-completion breach of warranty (by virtue of an exclusion which, essentially, precluded insurance for a loss which the buyer can be said to have chosen to incur); or
- it could terminate the transaction, with the attendant risk of being sued for loss of contract damages.
The choice is particularly difficult because the amount claimable under the warranty may be difficult to quantify with any certainty. In short, a buyer with buyer-side warranty insurance could find itself “between a rock and a hard place”. This is particularly so if it has not negotiated with the seller to include a condition precedent that no material adverse change has occurred prior to completion or, alternatively, a right to terminate in the event of a material adverse change.
However, it seems that some insurers are now becoming more willing to accept terms which see them taking on some of this risk for the buyer. The cover that is available is generally for third party claims against the target company of which the buyer was not aware at signing, but which are made between signing and completion. In circumstances in which there is a short period between signing and completion, it may be possible to obtain full cover for this risk.
Tipping policy deductibles
Third, it may be possible to obtain a warranty insurance policy which includes a “tipping deductible”. Where this is so, the insurer agrees to cover some part (or all) of the policy deductible only if losses exceed a certain amount. For example, if there is a deductible of $2 million and a tipping mechanism of 50%, the insurer will not pay for any losses until the total of all losses exceeds $2 million. Once this threshold is exceeded, the warranty insurance policy will “tip” so as to cover 50% of the $2 million deductible (or $1 million).
The ability to achieve a W&I policy with a tipping deductible is better in Australia than in many other jurisdictions. However, there is a cost to this type of structure which can make the decision to use this arrangement less economically attractive, especially in smaller transactions. Additional premiums charged by insurers are often a factor of the amount by which the deductible tips (for example, a percentage of the $1 million in the example above). An insurer is more likely to be willing to offer a tipping deductible when they can gain comfort that a buyer’s diligence has been thorough and the seller’s disclosure and cooperation in the buyer’s investigation process has been absolute.
Warranty and indemnity insurance is continuing to make life easier for buyers (and sellers) to address risk in M&A transactions.
Like any major commercial insurance, however, it is not a one-size-fits-all product. The party that faces the risk of an inaccurate warranty needs to take steps to ensure that the policy’s coverage is, as much as possible, co-extensive with that contractual risk. However, this can or cannot be achieved to different degrees for a number of reasons. A person buying W&I insurance is well advised to think about purchasing a bespoke product and planning for it as an integral part of the sale process itself.
This article was first published in Inhouse Counsel, Vol 18 No 4, July 2014. The author gratefully acknowledges the contributions to this article of Ben Crabtree, Divisional Manager — Mergers & Acquisitions, Jardine Lloyd Thompson; Geoff Hoffman, Partner, Clayton Utz and Craig Hine, Senior Associate, Clayton Utz.
 Note — premiums can vary materially depending on the nature of the transaction and the structure of the cover.Back to article