Understanding Warranty and Indemnity insurance
What is W&I insurance?
Warranty and Indemnity (W&I) insurance is an insurance product commonly used in M&A transactions, which is designed to protect the insured against financial losses resulting from breach of warranties and certain indemnities granted by the seller in the transaction documents of an M&A deal.
Why is W&I insurance taken out?
In an M&A deal, the buyer typically asks the seller to provide various representations and warranties in the sale and purchase agreement covering the target's legal status, financial statements, assets and other relevant aspects of its business. Usually, the buyer also seeks to obtain indemnities from the seller for specific losses arising from concrete risks that are identified during the due diligence process.
When negotiating the terms of the sale and purchase agreement, the representations and warranties, and the indemnities are often the clauses that are the most heavily negotiated between the parties. Occasionally, a transaction can break down when the parties are unable to agree on the fundamental principles applicable to these provisions.
Hence, when the buyer's interests conflict with those of the seller, W&I insurance can make it possible for both parties to be satisfied by ensuring that the buyer is adequately covered for the risks associated with the transaction, while releasing the seller from liability in the event that the buyer suffers damage.
Is there a minimum deal size for using W&I insurance?
W&I insurance is more common in medium to large transactions (typically transactions above EUR/CHF 25 million). According to the CMS M&A Study 2024, W&I insurance was purchased in 38% of the deals with a purchase price between EUR 25 million and EUR 100 million, compared to just 4% of the deals with a purchase price below EUR 25 million. While some insurers may consider smaller deals, the minimum deal size for W&I insurance is often around EUR/CHF 10 million since deals below this threshold might not attract insurers due to the lower premium potential.
How much does a W&I insurance policy cost?
The costs can vary significantly depending on various factors, such as the scope of coverage, the size and complexity of the transaction, the risk level and the financial stability of the parties involved. Additionally, the specific terms of the policy (e.g. deductible, policy limit and possible coverage extensions) can have an important impact on the premium. Premiums typically range from 1.1% to 2% of the policy limit, but they can be significantly higher.
In practice, it is essential that the buyer (through a broker) seek quotes from different insurers and carefully evaluate with its advisors the terms and the coverage options offered before granting exclusivity to an insurer.
Who bears the premium of a W&I insurance?
The buyer pays the premium of the W&I insurance policy. However, the allocation of the costs related to the W&I insurance is often subject to negotiation between the buyer and the seller. In competitive bidding scenarios, the seller may agree to share or even fully bear the premium (directly, by paying the buyer, or indirectly, by accepting a reduction in the purchase price).
What is the process of underwriting W&I insurance?
In theory, the policyholder can be either the buyer (buy-side policy) or the seller (sell-side policy). In almost all cases, however, W&I insurance is taken out by the buyer.
The process of negotiating and concluding a W&I insurance policy is carried out between the buyer and the insurer and usually begins during the negotiation phase of the transaction between the buyer and the seller. The time from initial contact with W&I insurers to the issuance of the insurance policy is usually two to five weeks.
In addition to the advisors already assisting the buyer in connection with the transaction itself (e.g. M&A advisors and lawyers), the buyer generally chooses to be assisted by an insurance broker specialised in the field of transactional risks, with a view to selecting the most suitable offer and negotiating the best terms of the policy with an insurer.
The process of taking out W&I insurance can be broken down into the following three phases:
- Initial assessment: The process begins with the broker submitting the transaction documents to insurers, likely to be interested in insuring the proposed transaction, to obtain quotes. The insurers carefully review the documentation and send the broker non-binding indications, specifying the extent of cover that can be offered and the amount of the proposed premium, depending on the limit of liability and the retention desired by the buyer. The offers generally include a fixed amount to cover the insurer's advisor fees for analysing the documentation and negotiating the terms of the policy. The various offers received are then compiled by the broker in a report (i.e. non-binding indications report) designed to enable the buyer to compare them effectively.
- Underwriting process: On the basis of the report prepared by the broker, the buyer chooses the insurer with whom it wishes to continue the process and enters into an agreement with the selected insurer covering the insurer's underwriting fee. At the same time, the buyer sends the due diligence reports drawn up by its advisors to the insurer and grants the insurer access to the data room. On this basis, the insurer carries out its own analysis of the risks associated with the proposed transaction and submits a list of questions to the buyer (i.e. an underwriting questionnaire). The answers to the questions contained in the questionnaire are usually communicated orally to the insurer during an underwriting call.
- Negotiation: Following the underwriting call, the insurer provides the buyer with the first draft of the policy, which is then negotiated between the buyer and the insurer (and their respective advisors). The policy is issued on the date of signing of the sale and purchase agreement and the insurance premium is paid in a lump sum at the closing of the transaction.
How are claims handled?
The claim process is governed by the terms and conditions of the insurance policy. Generally, the process is as follows:
- Notification of claim: The buyer must notify the insurer promptly after damage becomes known to the buyer. The notification must contain a comprehensive description of the facts related to the damage, including an explanation of the representations and/or warranties in the transaction documents that are allegedly breached, documentary evidence of the breach and quantification of the loss.
- Review of the notification by the insurer and request for additional information: Upon receipt of the notification, the insurer analyses the merits of the claim and assesses whether a payment must be made under the policy.
- Cover decision and payment of claim: The insurer informs the buyer whether in its estimation the claim is covered by the policy. Once the amount of the loss has been determined, the insurer arranges for the payment of the claimed amount.
In the meantime, if the transaction documents provide for a joint or subsidiary liability of the seller, the buyer needs to ensure that it complies with the notification deadline and requirements set forth in the sale and purchase agreement.
Furthermore, where a potential breach involves a claim from a third party, the policy often provides for the buyer to seek the consent of the insurer before incurring defence costs and/or entering into a settlement with the claimant.
What are the current trends in connection with W&I insurance?
Under the pressure of increased competition, W&I insurers have recently begun offering lower premiums and better coverage. In particular, the following enhancements are increasingly offered by W&I insurers:
- Enhanced cover for contingent risks: Some insurers are willing to cover a wider range of transactional risks. This includes specific covers for identified intellectual property risks, environmental risks and/or tax risks that might otherwise have represented a deal breaker in the negotiations between the seller and the buyer. Coverage of such risks usually requires a thorough risk assessment from the insurer.
- Broader territoriality: Most insurers can now cover entities in every European jurisdiction and accept transaction documents governed by local law and due diligence in different languages. Furthermore, cross-border European transactions can be underwritten with very few obstacles.
- Knowledge and materiality scraps: The knowledge and materiality qualifiers inserted in the warranties made by the seller in the transaction documents can be removed for the purposes of the policy.
- Synthetic covers: All or part of the warranties can be negotiated directly between the buyer and the W&I insurer without being reflected in the transaction documents.
- New breach cover: Some insurers agree to cover breaches of warranties occurring between signing and closing, which were traditionally not covered by W&I insurance.
What are the key considerations for a buyer wanting to take W&I insurance?
A buyer wanting to cover a transaction with a W&I insurance should consider the following:
- Due diligence: The buyer and its advisors need to ensure that a comprehensive due diligence of the target is performed to identify potential risks associated with the transaction. Generally, W&I insurers require that due diligence covers the commercial, financial, legal and tax aspects of the target's business. In addition, the insurers expect the buyer to conduct due diligence with the scope corresponding to the market standards for deals of similar size and nature. Insurers will not allow the buyer to rely on the policy to cover blindly the risks associated with the transaction and, therefore, usually only provide coverage for matters, which have undergone an appropriate due diligence.
- Terms of the policy: The buyer should determine carefully with its advisors the insurance coverage it wants to obtain. The policy limit needs to be sufficient to cover potential losses, but not excessive so that the buyer does not overpay for insurance. The buyer should also consider whether policy enhancements, aiming to bridge the gap between the protections the buyer is seeking and those, which the seller is prepared to give, are desirable.
- Scope of coverage: Upon receipt of the first draft policy, the buyer, assisted by its legal counsel and its broker, needs to carefully review the warranty spreadsheet, listing all the representations, warranties and indemnities provided for in the sale and purchase agreement and specifying, for each of them, the extent of the coverage offered by the W&I insurer. The buyer must also review the exclusions and limitations contained in the policy, as they impact the scope of coverage, and ensure that risks that are material to the transaction are not carved out.
- Legal Advice: The buyer should be aware that insurers expect transaction documents to be in line with market standards and for the parties to enter into a balanced and negotiated sale and purchase agreement. The buyer should ensure that it receives assistance from legal counsels with sufficient expertise in transactional matters and who are able to insert appropriate provisions in the transaction documents.
What are the key considerations for a seller in a transaction involving W&I insurance?
Here are some key considerations for a seller in a transaction involving W&I insurance:
- Sharing of expectations: The seller should inform potential buyers up front if it wishes the involvement of W&I insurance for the transaction. It is also advisable that the seller and the buyer agree early in the process on a possible subsidiary or joint liability of the seller for matters that are either not (or are only partially) covered under the insurance policy or involve a risk of serious damage to the buyer.
- Due diligence: The seller needs to be ready to undertake a proper disclosure of all material documents and information relevant to the divested business as the quality and depth of the due diligence performed by the buyer can significantly impact the availability, cost and terms of the W&I policy.
- Negotiation of warranties and indemnities: The seller should be mindful of the impact that a refusal of insurance cover could have on its subsidiary liability under the contractual documentation and on the overall deal. The seller must therefore ensure that it negotiates actively the contractual documentation.
- Post-closing obligations: The seller must be aware that the W&I policy does not necessarily imply that the seller is entirely free of obligation following closing of the transaction since the transaction documents may provide a subsidiary or joint liability of the seller. Furthermore, W&I insurers benefit from a subrogation right against the seller in case of willful misconduct or fraud by the seller.
