How can deal teams capitalise on the latest trend in the deal insurance market to improve bid success?
By Tom Evans, Paul Davies, David Walker, Michael Green, Aoife McCabe, Harry Redford, Catherine Campbell, and Amy Watkins
The emergence of contingent risk insurance policies, which address known risks that would otherwise be excluded from coverage under traditional W&I insurance, is an exciting recent trend in the deal insurance market. PE funds that identify previously uninsurable risks through due diligence now have the possibility of transferring such risks to insurers, rather than seeking either a price reduction or escrow retention from the purchase price. Therefore, the use of contingent risk insurance can make a PE fund’s bid more competitive and, as a result, more likely to succeed.
As the W&I insurance market has matured and the number of underwriters providing cover has increased, downward pressure on premiums and excess levels has rendered W&I insurance a more cost-effective and attractive option. The latest edition of the Latham & Watkins Private Equity Market study reveals that use of W&I insurance is at an all-time high. Of the 240 deals surveyed between July 2017 and June 2019, 35% featured W&I insurance (up from 13% three years ago) and usage on PE seller deals reached 48%. We expect the use of contingent risk insurance policies to follow a similar trend, as deal teams recognise the utility of such policies for “getting the deal done”.
W&I Insurance Has Limitations — Creative Contingent Risk Insurance Can Offer Solutions
As competition in the W&I insurance market has grown, we have seen increased flexibility on terms and reduced areas excluded from cover. However, W&I insurance is not a panacea for all potential liabilities. Known risks, including in relation to the environment and pollution, and certain tax liabilities, are regularly excluded from cover. Transaction-specific exclusions can also appear during the underwriting process. Exclusions in some areas, particularly relating to tax matters, are broader under a W&I policy compared to an uninsured deal, meaning that having a W&I policy can weaken a buyer’s tax protection. Synthetic tax covenants, which are negotiated directly between the buyer and the insurer, with no involvement from the seller, have become more common, but generally contain the same broad exclusions.
Some exclusions can be negotiated in exchange for the provision of additional details and a higher premium. However, if flexibility on W&I terms is not possible, creative solutions in the form of ancillary lines of insurance can provide useful protection, helping PE firms remain flexible in competitive processes by re-risking a range of issues. Specialist lawyers and accountants have joined brokers, and more recently insurance underwriters, bringing a greater understanding of deal dynamics and the risks in question, allowing for more extensive cover. In our view, previously uninsurable risks are now viewed as increasingly insurable, particularly in the areas of tax and environmental risk.
Navigating Opportunities in Tax Risk and Environmental Risk Insurance
Contingent risk insurance for tax and environmental issues is developing rapidly. Specific policies have emerged for tax risks that fall outside the scope of W&I, such as liabilities arising from known potential tax assessments, or the loss of tax reliefs relevant to deal value. Similarly, there is now a move towards considering specific environmental policies to address pollution risks, given the limited cover available under W&I insurance.
However, implementing these policies needs careful management, as they can be expensive, require significant due diligence, and can disrupt a transaction’s timeline if not properly planned. In the case of current bespoke environmental policies, cover can take months to complete, making them unsuitable for pre-closing implementation on most deals. Typically, tax insurance can be implemented in parallel with any pre-existing W&I insurance process, but deal teams should note that insurers may only be willing to offer cover if additional tax diligence is conducted. This can include calls between the broker, insurers, and CFO, or the preparation of a tax memorandum by a firm of chartered accountants, which can impact the transaction timeline. Unlike standard W&I insurance, insurers typically will not provide their terms until a comprehensive profile of the risk is presented, which can present challenges in competitive deal processes. For this reason, engaging with the transaction lawyers and broker early on to ascertain what information will be required is important.
In our view, deal teams should watch the contingent risk insurance market carefully. Both straightforward and more innovative policies may develop, particularly for pollution and other environmental risks, mirroring the coverage that would have historically been available through traditional warranties.
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