Warranty and indemnity (W&I) insurance products have been marketed as a “silver bullet,” which can bridge the gap between a buyer’s wish to receive proper deal protection and a seller’s aim of a clean exit. However, as the market continues to mature, insurers are becoming cautious and terms are tightening. In our view, recent developments in insurance practice pose new practical issues for buyout firms, particularly on German deals.
According to the Latham & Watkins 2016 European Private M&A Market Study, which examined over 170 deals signed between July 2014 and June 2016, the proportion of transactions employing W&I insurance has increased over 60% since Latham’s 2015 survey. As expected, W&I insurance is most prevalent in sales by private equity sellers. Recent claims data compiled by AIG (R&W Insurance Global Claims Study 2016) indicates that claims are filed against around one in seven W&I policies globally, suggesting real protection for buyers and also benefit for sellers, who would otherwise have been the addressees of such claims.
However, such claims have resulted in significant payouts, particularly against financial and tax warranties. A relatively large proportion of claims come from continental Europe, with insurers reporting further large European losses pending. Consequently insurers, particularly in Germany, are increasingly conservative and are reflecting their claims experience in the terms on offer. There is greater reluctance to cover matters outside the scope of due diligence (even on a knowledge qualified basis) and insurers are less willing to compromise on general exclusions such as property and pension payments. In addition, while W&I insurers have always required sight of transaction documentation, German W&I insurers are now reviewing deal terms in more detail and are imposing their own requirements, such as warranty bring-down at closing. While this is typically for insurer information purposes only, buyers and sellers must carefully review transaction documentation alongside the insurance policy to ensure that any seller disclosure does not inadvertently release the insurer or expose the parties to additional risk or liability.
So how should buyout firms respond to get deals done? Timing is key. Deal teams must consider insurance needs earlier than ever before, including when determining the scope of due diligence. Protection beyond the due diligence scope (e.g., a lower claims threshold) can be obtained for a higher premium, but other scope exclusions (e.g., excluded jurisdictions) can rule out coverage. Sellers should consider arranging for a “stapled insurance” package tailored to the draft share purchase agreement in order to support the overall deal process. When a target is active in regulated ndustries, more “exotic” jurisdictions, or in markets that insurers may be reluctant to enter, parties should prepare for longer insurer education processes or should consider specialist insurers early on. Known issues in areas such as tax, environmental, pensions and litigation are commonly excluded from W&I policies, often in situations where there is a real risk that may prevent the deal from proceeding. The market for known risks insurance is growing and can offer solutions early in the deal process, albeit at a cost. Other alternatives to W&I insurance (e.g., escrow, liability of seller) do exist, but may be unappealing in competitive auction scenarios.
Practical difficulties associated with the product explains why W&I policies are only used on approximately one in three private equity exits. We expect the W&I insurance market to continue to evolve, and anticipate that the number of German deals with W&I insurance will converge closer to current UK levels.