Warranty and Indemnity Insurance - Part 1

Warranty and indemnity insurance has been used in M&A transactions for a number of years now, with its use having grown exponentially in recent years. W&I insurance policies are particularly attractive to sellers (whether private equity or otherwise) who want to reduce the burden of post-closing warranty and indemnity liabilities, and to buyers in cases where the seller is offering limited indemnification or recourse. In this Part I of our two-part blog post on W&I insurance, we look into what W&I insurance is, what is covered under a W&I policy, certain key concepts and how W&I insurance is obtained.

Warranty and Indemnity Insurance - Part 1

What is it?

W&I insurance is transaction insurance that protects either the buyer or the seller from financial loss resulting from a breach by the seller of the warranties and representations contained in the acquisition agreement. In a typical transaction, the buyer will look to seek broad warranties and representations from the seller to protect against losses which the target company (or the buyer) may suffer as a result of a breach of those warranties and representations. A seller on the other hand, will seek to limit the warranties and representations it gives to the buyer. W&I insurance bridges this gap. It can be obtained by either the buyer (buy-side) or the seller (sell-side) in a transaction. From the buyer's perspective, a buy-side W&I insurance policy will, subject to a retention or deductible, serve as the direct indemnity for breach of the warranties and representations given by the seller. From a seller's perspective, a sell-side policy will serve as a backstop for the seller's damage and indemnification obligations to the buyer.

W&I insurance (which covers unknown and unforeseen loss) falls within a broader category of insurance products referred to as "transactional risk insurance", and may be used in transactions alongside other transactional risk insurance offerings (which cover identified and known risks), for example a tax indemnity insurance (for identified and known tax issues).

What does W&I insurance cover?

What will be of particular importance in this regard will be:

  1. the scope of the warranties and representations;
  2. the time limitation for the warranties and representations – linked to the policy period; and 
  3. any qualifiers which the warranties and representations are subject to – or are made subject to by the insurance.

Regarding scope, W&I insurance will usually cover most of the warranties and representations in the acquisition agreement on a blanket basis, but W&I insurance policies can also be structured to cover only specific warranties and representations. Insurers do, however, often refuse to insure warranties and representations which they are of the view are:

  1. easily capable of breach; 
  2. forward-looking in nature; or
  3. relate to contingent liabilities.

As to duration and time limits, the duration of the W&I Insurance policy will usually mirror the time limitations of the acquisition agreement.

W&I insurance policies will usually exclude coverage in instances where, among other things: 

  1. the insured or its deal team (as agreed with the insurer) had actual knowledge of a breach of warranty or representation (discovered during due diligence or as disclosed in the exhibits to the acquisition agreement);
  2. there is fraud on the part of the insured; 
  3. the acquisition agreement already makes provision for some adjustment mechanism in order to compensate the insured for the breach; and/or 
  4. there is an "interim breach" – i.e. a breach of warranty or representation which arises and is discovered after the W&I insurance policy has been put in place, but prior to closing of the transaction. Accordingly, between signing and closing 'no claims' forms, (i.e., confirmations that there are no breaches that would be known to the deal team) need to be submitted to the insurer by the insured.

Key concepts

Every W&I Insurance policy will be issued subject to a "policy limit" or a "cap", being the maximum amount of money which the insurer will pay to the insured under that policy. For buy-side policies, this will typically be between 10% and 30% of the purchase price, and for sell-side policies, typically be between 5% and 15% of the purchase price. If a party to the transaction requires additional coverage and one insurance company alone is not willing to provide it, it can consider a "tower-model" where more than one policy is obtained from different insurers and stacked together in an "insurance tower" in order to achieve the required aggregate policy limit.

The insured under the W&I insurance policy will be liable to pay a "premium", which typically ranges from 2% to 4% of the policy limit. 

Not all losses suffered by the insured as a result of breaches of the warranties and representations under the acquisition agreement will entitle the insured to claim the full amount of such losses under the policy. The policy will be subject to a "retention" or a "deductible", which is the portion of the loss which the insured, or someone else, has to bear. The deductible will typically be between 1% and 3% of the purchase price. In the case of a buy-side policy, there will likely be a discussion between the buyer and the seller as to whether the seller must bear the amount of the deductible. Any losses suffered by the insured which exceed this amount can, subject to tipping to nil provisions, then be claimed by the insured under the policy. 

A W&I insurance policy will be for a defined period (referred to as the "policy period"), which typically commences at signing of the acquisition agreement (subject always to closing occurring as contemplated in the acquisition agreement). Any claims must be brought by the insured during that policy period.

The Process for obtaining W&I insurance policy

The party seeking to obtain W&I insurance cover will usually engage a broker. The broker, after entering into the relevant non-disclosure agreements, will solicit insurers and obtain non-binding quotes from potential insurers. The insurance broker will thereafter typically prepare a non-binding preliminary indication letter summarizing the various insurance quotes it has received, the key policy terms and the significant coverage items. The party seeking the W&I insurance will then make its selection and the selected insurer will commence the underwriting process. In doing this, the insurer will conduct its own due diligence (requiring access to the data room, due diligence reports, the latest draft of the acquisition agreement (followed by any updates)). It may choose to use its internal legal team or hire external counsel to assist with this process. The insurer will draft and present a policy document for negotiation. Execution of the policy will typically be done prior to or at the time of signing of the acquisition agreement.

Keep an eye out for Part II which will provide an introductory overview of the mechanics of how a W&I Insurance policy works, the costs associated with W&I Insurance and the claims process.

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