Demystifying M&A

Demystifying M&A: What is Warranty and Indemnity Insurance?

19th February 2019

By Alastair Church

Warranties and indemnities are an important part of most M&A transactions. They are the medium by which risk is allocated between the buyers and sellers of a business. Increasingly, Warranty and Indemnity (W&I) Insurance, a recent development in the insurance market, is being used to transfer much of this risk to insurance companies.

What are warranties and indemnities?

When buyers are looking to acquire a business, they aim to minimise the risks they face post-deal by conducting significant due diligence to uncover as much as possible about the business. However, there will always be some level of uncertainty from the buyer’s perspective. Warranties and indemnities are used to mitigate this unknown risk and are included in the Sale and Purchase Agreement (SPA).

Warranties and indemnities are in essence an assurance from the seller that the buyer will not be liable for any unforeseen future costs that arise from the pre-ownership period. They can be used to protect against a wide range of scenarios, most commonly for the likes of future tax liabilities but also other potential liabilities that may arise.

A warranty is an assurance from the seller to the buyer to reimburse them if the warranty is broken: a party must prove they have suffered a loss as a result of a breach of warranty. An indemnity is an obligation for the seller to reimburse the buyer in regard to a specific liability, should it arise.

How does warranty and indemnity insurance help?

Insurance removes the risks of future liabilities from the parties involved and moves it into the insurance industry. In our experience, it can allow for a much smoother transaction close for both parties. Using our SMART dealmaking process, we actively work to get the best result for clients, which can often include a W&I policy alongside the SPA.

Typically, W&I insurance is particularly helpful where no individual shareholder would be able (or willing) to cover the risks associated with warranties and indemnities, or where no-one is willing to stand behind them. A W&I policy allows the sellers to effectively cap their liability at a much lower amount than a buyer would normally accept. It can speed up the negotiation of potentially quite emotive aspects of the deal, increasing the likelihood of a successful transaction. W&I insurance also plays a role in reducing tensions on the sell side if there are a number of shareholders with differing willingness or ability to assume future liabilities (e.g. where there are external financial investors alongside executive management).

With a W&I insurance policy in place, escrow and hold-back are no longer required, allowing the seller to access their full deal consideration on the close of the transaction. Transferring the seller’s liability to an insurance company allows the seller to have a clean exit from the deal at close and buyers will not have to involve the sellers in a claim in the event of a breach.

The costs can be quite variable and are deal specific. Typically, the premiums charged are a small percentage of the policy cover, which is typically between 10-30% of the deal value. In our experience, the increasing use of W&I insurance confirms that the pricing of such policies is usually reasonable and delivers good value.

3 key things to be aware of:

Get advisors on board: W&I insurance can become a very technical area and the policies are highly specialised. At FirstCapital, we can help you choose appropriate brokers. It is also very important to have external legal advisers on board given how tightly the policy is linked to the sale documents.

Expect lots of due diligence: Insurance companies will require a large amount of due diligence, both commercial and financial, in order to be able to assess the risks. It is much easier to secure W&I insurance when external due diligence reports already exist, as is typical in private equity deals for example, but that hasn’t prevented W&I policies being used in trade deals, which is increasingly common.

Start early: Although getting a W&I policy in place only takes a few weeks, it is necessary to have it agreed before the deal can close. Therefore, we would recommend early engagement with specialist insurance brokers to ensure that insurance underwriters’ specific requirements don’t cause any delays and that the transaction stays on schedule.

To discuss your transaction requirements, get in touch with the FirstCapital team.