W&I insurance: the standard solution for M&A transactions in CEE?

At CEEnter stage

Published on 26 April 2023

This episode delves into the topic of insuring M&A deals, exploring the significance of warranty and indemnity (W&I) insurance in the current challenging political and economic climate.

We are joined by three guests. Marcin Stoń, from Marsh McLennan, is the Head of Transactional Risk Insurance, Private Equity and M&A for CEE & the Eastern Mediterranean. Alexander Rakosi is a partner at the CMS Austria office, but has a CEE focus; he is also the head of private equity. Finally, we welcome Saša Sodja, a partner who cooperates with the CMS Slovenia office. Our guests will discuss the key benefits and disadvantages of W&I insurance, and address common objections and fears from clients. Marcin, Alexander and Saša will also share their insights on the future of W&I insurance, discussing the potential for increased interest and use in the CEE region.

Despite a recent slowdown in M&A activity in Europe and the CEE due to rising interest rates, inflation, the conflict in Ukraine, and so on, the significance of warranty and indemnity insurance is increasingly relevant in today's challenging political and economic climate, as its core purpose is to help protect transactional parties from merger and acquisition (M&A) deal risks.

Below you can watch the video, listen to the podcast or read the transcript of the lively debate on the topics currently rousing the country’s business, legal and political community.

Video

the basics of warranties and indemnities in the context of M&A transactions
the main advantages of W&I insurance
why the CEE region lags behind in the use of W&I insurance in transactions

Sašo Papp:
Welcome to the video podcast series At Centre Stage. I'm your host Sašo Papp. In this podcast series, we explore the latest trends, regulatory updates and pressing issues in the dynamic economy, focusing on booming industries and sectors. In this episode of At Centre Stage, we delve into the topic of ensuring M&A deals go through, exploring the significance of warranty and indemnity, W&I insurance in the current challenging political and economic climate. Our guests are Marcin Ston, the head of Transactional Risk Insurance, Private Equity and M&A, CEE and Eastern Mediterranean from Marsh McClennan, Alexander Rakosi, a partner at the CMS Vienna office but with the CEE focus and the head of private equity, and Saša Sodja, a partner in cooperation with CMS Ljubljana office. Together they discuss the key benefits and disadvantages of W&I insurance and address common objections and fears from clients. The guests also share their insights on the future of W&I insurance, discussing the potential for increased interest and use in the CEE region. Despite the recent slowdown in M&A activity in Europe and the CEE due to factors such as rising interest rates, inflation and the conflict in Ukraine, the significance of warranty and indemnity insurance is increasingly relevant in today's challenging political and economic climate, as its core purpose is to help protect transaction parties from merger and acquisition, or M&A, deal risks. To kick off the discussion, can you explain to our listeners the basics of warranties and indemnities in the context of M&A transactions and their importance? Marcin, what are the key benefits of W&I insurance?

Marcin Ston:
Sure. And thank you for having me at this podcast. So, in the vast majority of contracts that regulate the sale of the company—and, whether they are called share purchase agreements, acquisition agreements or investment agreements—there typically is a chapter or even a separate document where the sellers would give warranties to the buyer. The warranties given by the seller can relate to various aspects of the target company operation, such as assets, tax, accounts or compliance with those. Now, if any of those warranties proves to be incorrect, the warrantors, mainly the sellers, would remain liable to the buyer for the resulting loss. And that's where a warranty and indemnity policy becomes relevant. Under a W&I policy, a third party, an insurer, would assume liability for breaches of seller’s warranties given in the acquisition agreement.
At Marsh, we work with a wide variety of clients, and deal makers on both sides of the transaction, depending on their role, in the transaction, their motivation to obtain a W&I policy might be different. In general, an insurance policy can bring benefits both to the sell and the buy side of the transaction. For the sellers, it means a clean exit. In other words, the seller can shift all the liability resulting from a warranty breach to an insurer. This is especially important for private equity sellers that very often liquidate a fund following a transaction. Another benefit for the sale side would be the fact that they can receive all the proceeds from the transaction immediately at closing, rather than, for example, holding them at escrow for several uh months or even more than a year. For the buyer, a W&I insurance policy can provide a better and wider protection than the underlying contract, so the insurer can be liable, for example, for a higher amount than the seller would be. Another benefit of a W&I policy for the buyer would be the fact that it increases their comfort when it comes to an investment in an unfamiliar jurisdiction. For example, we have recently had cases where we advised clients coming from distant jurisdictions, such as Asia, that were investing for the first time in our region, and in that scenario, a policy significantly contributed to the overall comfort with the transaction.
Also, our clients appreciate the fact that, we work with very solvent and financially strong insurers, which gives them additional peace of mind when it comes to a potential claim, because very often the buyers would have some doubts around the solvency of the other side in case of a claim. And finally, the policy can serve as a tool that facilitates the negotiation process. In other words, the presence of an insurer and the fact that a transaction is insured, positively impacts the dynamics of the negotiations and allows the parties to agree on some on some important, clauses in the agreement much faster than would be the case without a policy.

Sašo Papp:
OK, thank you. Let's hear a different perspective on this topic. Alexander, based on your experience, what do your clients see as the main advantage of W&I insurance? Can you share an example of a transaction where W&I insurance delivered a positive effect to all parties involved?

Alexander Rakosi:
Sure. And thanks for having me. I think, as already said, the focus is on risk profile optimization. And that goes both ways for sellers and for buyers. For example, if you're on the sell side, a W&I product provides an opportunity for you to, as it's called, “dressing up the bride” meaning serving up in an auction process. for example, an optimized risk package where you can deliver to the prospective bidders a solution that basically allows the buyer to take over an existing W&I prepared product in order to optimize the risk potential. For example, if you have multiple sellers involved, even more so if it consists of individuals, you oftentimes without the W&I product, have the negotiations on joint life, several liability, are you able to recoup the respective, let's say, risk profile from individual sellers, which on many occasions constitutes a big roadblock in the negotiations. If you're able to provide the counter party with a liability regime by as much a more creditworthy seller, then that usually provides a pretty big advantage in terms of getting to a deal very smoothly. On the buy side, as it's called, “sweetening the bid”: if a buyer already has prepared a W&I cover, it is able to offer to the seller a much more favorable liability regime in many cases, now what we call a “zero recourse”. So, ideally, you would have as a buyer sole recourse against the insurance company and leaving as little liability as possible to the sellers, which obviously makes it much more efficient and much easier to come to terms with the sellers. So that is a dynamic that is quite relevant and is quite favorable in getting deals across the line. With respect to recent examples, those are some of the core constellations that you typically see. For example, we had a private equity fund acquiring a business from existing owners of a company who did not fully sort of divest of all their shares, but who stayed in the whole buying entity in the form of a reinvestment. So obviously there was strong interest to not just only align risk allocation profiles, but also make sure that the parties who were going to continue to work together in the future, that they were able to focus on the business as such and not have to deal with any potential claims stemming from reps and warranties in the future. So, it did allow the parties to really dive into the substantive side of things and focus on growing the business, and allowed the PE buyer to still get sufficient coverage in terms of financial capability standing behind potential claims.
Another situation that we had, for example, was on the corporate side with this multibillion-dollar group which sold one of its divisions. They wanted to use the acquired purchase price as soon as possible after closing, so there was a strong incentive not to have any type of escrow structures, hold back structures or any of that stuff. And the buyer, which in this case was a private equity group, felt comfortable that it had a good enough counter party on the other side without any hold backs, without any escrow, simply by being able to rely on the financial capability of a big insurance group that stands behind this. So, I think these are just some of the scenarios where we do see that the W&I product provides added value and where it facilitates the transaction to make them speedier, more optimized., and I think in this case, in the interest of both parties,

Sašo Papp:
Thank you Alexander, Saša, any additional thoughts about it?

Saša Sodja:
I agree with everything that Alex said. I mean, the advantages are pretty clear. I don't want to sound like a commercial, but, you know, clean exit is always what the sellers are looking for, and having a W&I insurance in place can reduce any hold backs of the purchase price. I mean, reduce, not like completely to remove. Also, it makes the negotiations with individual sales sellers much easier, especially if there is more than one seller on the other side. And from the buy side, you get to avoid any lengthy court procedures and pre transactional restructuring.

Sašo Papp:
OK, according to the CMS Emerging Europe M&A report 2022/2023 the CEE region is trailing behind other Western jurisdictions in the use of W&I Insurance and transactions. Saša, in your opinion, what are the key reasons behind this disparity?

Saša Sodja:
The statistics are improving. They are improving slowly, but they are improving. I think this is due to the lack of familiarity with the whole product, but also due to other reasons such as exclusions in coverage and the level of cost and the complexity of the whole underwriting process. I mean, in relation to lack of familiarity usually, businesses and legal matters are used to doing things the way that they have done them before and even though objectively insurance provides simplification, it's still not perceived as such due to the additional steps that they need to take before signing the deal and to purchase the insurance policy. It's a great alternative to escrow accounts, you know. So, in the higher value transactions, like Alex already said, the parties are more inclined to explore the possibility. But in lower value deals, the cost of the premium mostly makes sense only if you know you're buying a distressed company or if you have an individual on the other side that cannot really vouch for any damages and indemnities. In relation to coverage, most of the risks that do cause a divide between parties in the negotiation stage are known risks. And generally, W&I insurance does not cover known risks and, of course, there are some blanket exclusions such as data protection matters, tax and environmental risks. These are generally excluded. So, this is something that, usually, the parties fight about how they want to allocate the risk. And if the insurance doesn't cover that, then it doesn't make sense in their heads to purchase the policy and have an additional cost. And I also think there's like this subjective element of why the W&I insurance is not used as much as it could be. I mean, if it's planned for the start, it's easier to kind of blend it in the whole timeline of the transaction. But if it's not, and somebody wants to introduce it, it subjectively seems to clients as if it was forced by the other party, and you bring in a third person into the transaction, which is supposed to be already negotiated and confidential. So, you know, once the SPA is more or less negotiated, none of the parties wants to hold back the signing and have someone else meddling with the SPA. I think these are the most apparent reasons in the CEE region.

Sašo Papp:
Is a lack of knowledge the only factor behind the underutilization of W&I insurance in M&A transactions, or are there also challenges and risks associated with warranties and indemnities that discourage companies from using it? Alexander, in your opinion, what are the key drawbacks that still discourage companies?

Alexander Rakosi:
Yeah, I think it builds on what some of what Sasha already said. I think, it used to be just pure unfamiliarity with a product that no longer I think is the case in a widespread manner. But I think what is still lacking, oftentimes, or there's a less of an awareness how specifically a product can be tailored to fit the particular situation. So, I think there's more, let's say, parts in the toolbox to tailor it for this particular situation. We're talking about enhancements. So, there isn't just the basic product. You're able to supplement the basic product with certain things such as more damage categories being covered, different types of disclosure concepts being covered. You have different situations, whether you have a split signing and closing. So, whether you have reps at signing and the clothing that you need to have covered, which entails bring down mechanisms and other stuff. So, these are some of the let's say specifics that if you're not using the product very often, you may find it a bit cumbersome. I think if you have used it, and if you're sort of involving experts then oftentimes some of the perceived drawbacks, you can find a way around or even use it to your benefit. And then also, there's still the perception that how does the claims handling process work? Do we even get to put in any claims? Aren't the insurance companies resisting that from the beginning? So those are some of the conceptual drawbacks that still exist. And, then again, as Sasha said, I think knowing when to start using the product is key. I think if you, on the cell site, for example, fold it in at the very beginning, it can really, impact the transaction in a positive way. You can do away with several headaches that you would otherwise face. Whereas if you throw this in at the last minute like anything else in the transaction, not just W&I, it causes some more time delays, it causes maybe some discussions at a time where people are already losing their nerve. So, I think it's just, the awareness as to when to place it properly. And then another drawback of a substantive side is that, and it's still a requirement, due diligence is the basis for sufficient coverage, and there are certain areas which parties tend to, typically, I don't want to say ignore, but not focus on in their due diligence. And it just, generally speaking, isn't possible to not have to have a good cover if you haven't the proper due diligence. So, there are some specific areas such as IT, maybe cybersecurity, even data protection these days. So, areas that previously used to be almost not insurable, these days are at least within the realistic expectation of getting insurance. But you have to have done, you know, the diligence. So due diligence, scoping is key for what you're able to do with the W&I product.

Sašo Papp:
Now let's move the ball into your court Marcin. How are insurance companies responding to client’s objections, doubts and fears?

Marcin Ston:
Sure. Currently, we are witnessing a very competitive, W&I insurance market. We have seen new insurance entering this sector, this line of business and the existing ones expanding their geographical appetite. This is, of course, very good news for our clients, especially in the sea region, where historically, the insurer's appetite was much lower than let's say in in Western Europe. And now this gap is narrowing and in in some countries, such as, for example, in Poland, the gap has actually already closed, and we can work with, more than 25 insurers. The increased competition means that we are able to obtain much better insurance terms for our clients in the sea region. It's true, what Saša said that the product is not as widely used, especially on the smaller transactions, but when it comes to the medium or large deals, the product is not used, it's at least seriously considered by the parties. And I have to say that, the deal makers, in the region, such as the lawyers or other advisors, their knowledge about the product is already much, much larger than it was, for example, two or three years ago. W&I insurance policy, indeed, as Alexander mentioned, is a bespoke product, which means that each and every policy is unique and tailor made to a particular transaction. And nowadays, more than ever, the insurers are open to out of the box insurance solutions and offer those, deal specific enhancements. that can remove important obstacles from the negotiation table and facilitate the closing of a deal. Just to give you an example, right now we are working on a on a very small transaction in Bulgaria, where the one of the sellers, the majority seller, is not able to give any warranties at all. And insurers can actually agree on a warranty catalogue and insure that, even though this is not given by the sellers. Furthermore, there has been recently a very substantial investment in claims departments, both on the side of insurers and the brokers. For example, at Marsh, we have also a dedicated claims team who regularly assist our clients in claim scenarios. We offer both our technical expertise and our leverage, against the insurers. And when we recommend a particular insurer, to our client, we actually always consider our claims experience with this particular, market, whether their claims representatives are responsive, pragmatic and above all, whether they actually honour their commitments and pay claims. Regarding timing, of course, the underwriters from the insurance companies are used to work under pressure, and against tight deadlines.
However, in order to obtain an optimal insurance solution, we always recommend to our clients to start the W&I insurance stream well in advance and ideally, not later than four weeks before the planned signing date. This will allow us to have the best possible policy that can be ready to be issued on the signing date and actually involving insurer at the very beginning, can help negotiate, help the parties understand what is actually insurable and negotiate the SPA so, the acquisition agreement accordingly. Alexander mentioned also due diligence and insurance companies do expect to see a customary due diligence in order to be able to ensure the warranties that would typically encompass legal, financial and tax due diligence. And in principle, any material limitation in the due diligence scope might result in certain area being excluded from insurance. However, it is worth stressing that, also in this aspect, the insurance companies can nowadays show flexibility. And, for example, they can work on the basis of an internal due diligence, if the buyer has sufficient in-house expertise to do that, or they can also work on the basis of vendor due diligence.

Sašo Papp:
Thank you, Marcin, Alexander, for your expert opinion. What trends do you foresee in the future? Do you think the growing interest in the region will lead to an increase in the use of this type of insurance policy?

Alexander Rakosi:
Yes, I absolutely think so. I think the growing influence of regional international buyers, as they are flocking into or more flocking into the sea region inevitably also leads to a higher sophistication of the deal terms that applies to how sales and purchase agreements are handled. That applies to how structuring is done, and I think the same applies to how risk allocation situations are being optimized and W&I being at the forefront of doing this. We do strongly believe that this trend will lead to the W&I solution being used more often by various buyers across the board and across sectors. And I think this will also lead to a growing familiarity with selling entities and shareholders, even selling individuals, [on the idea] that this is an option that they can pursue. So we do think this is not just a temporary item that is keeping us busy in in deal making. We think this this will turn into a pretty regular staple in transactions. And I think just looking at it over the past 10 to 15 years, I mean, obviously, if there is something 10 years ago where we'd only very seldomly see the W&I product even mentioned. Nowadays, we're not close to what the usage in Germany or the UK is. But I think in the vast majority of cases of transactions, there's at least a discussion as to whether or not W&I may be a good solution in that case, and we see in absolute terms a pretty growing number of deals being shared. So, I think that is definitely something to monitor. And then I think just another trend that we do expect to continue is to transaction parties using W&I in a more tailor made manner and, trying to also discuss with brokers such as Marcin and his team, how a particular situation can be optimized to fit the situation and to align the party's interest even more.

Sašo Papp:
Sasha, what is your crystal ball saying?

Saša Sodja:
I agree. I agree. I think that the use of transactional insurance in the region will increase. I mean, it's a very practical tool to avoid certain complications in the future. Hopefully, there will be no further disruptions in the region, so the region will not be perceived as carrying more risk as was the case in the past. With competition, the coverage should increase, and I think that these insurance policies will become a standard solution for a cleaner transaction. I think there's only one thing that will not change. I mean, at least in Slovenia, we don't have a lot of large transactions, and with small transactions, cost is also a factor. But I guess that with competition that will decrease as well.

Sašo Papp:
OK, before the end, if we go back a bit. Alexander, can you maybe share a real-life scenario in which a client utilized their W&I insurance policy post transaction, and what the outcome was?

Alexander Rakosi:
Sure. I mean, I think, for example, we had a situation which was a somewhat sizable transaction for the region, close to 100 million of purchase price in the financial services sector, which is not, the most common sector where W&I is applied. But even then, as we're able to see, it may provide a viable element to the transaction. So, what happened there is that, there were a number of portfolios of loans and other financial products, some of which the selling party did not fully disclose and it turns out that some of the underlying litigation proceedings led to a result that was adverse to that would have been disclosed.
So there was a claim being made, or various claims being made, to recoup this from the insurance company. I think what happened was that at the end, that the clients or the policy holder was able to recoup this from the insurance, though the way to get there was maybe an example of where it could be optimized further. So, for example, I think in this case, I mean Marcin has stressed that choosing the right insurer isn't only for its underwriting speed or its ability to get the policy issued quickly. But at the same time, you will also want to consider how nimble or how sophisticated an insurance claims department is, because when you get to actually needing to levy a claim, the deal is over, and maybe there is less pressure involved from parties to get things done. I think in this case, it turned out that, there was a bit of headway to be made to get the claim satisfied. But I think at the end, it resulted in a positive result for the client. I do think what the parties need to be mindful of is also to make sure that they formulate the claims pretty quickly that they put together a sound factual basis for a claim to the insurance. Because obviously, you need to consider that the claims department was not involved in the transaction from the beginning. They need to work themselves into the case from the beginning, and the more concisely and credibly you put together the materials, the factual basis, and also what it is that you're requesting from the insurance, the more streamlined and the more easily, at the end of the day, you're able to recoup your damages, which you believe you paid for by purchasing the insurance. So, I think there is a bit more development to be made and also focusing on the post issuance of the policy and getting also the policyholders processes in line to make sure that they cater to the claim situation appropriately,

Sašo Papp:
Marcin, according to your statistics, how frequently is W&I insurance enforced, and what is the success rate when it is used?

Marcin Ston:
Sure. So, we at Marsh have been in this business for quite some time now, and we have been gathering statistics, which provide some meaningful and interesting conclusions. We regularly issue transactional risk, claims reports, and the most recent issue, was actually released last year, and relates to the year 2017 to 2021. And first, it shows that roughly 15% of W&I policies receive a claim. So, in other words, about 15% of transactions which Marsh helped to ensure resulted in a warranty breach. And in my opinion, it's a quite significant ratio. Secondly, the most commonly reported claims under W&I policies relate to financial statements and tax. And if I remember correctly, together they accounted for more than 40% of all claims notified under policies that were placed by Marsh. Interestingly, these two warranty bridge types were the most common in our previous reports, in our previous report that was released in 2019. and we actually do not, expect changes going forward. When it comes to claims actually paid by insurers, this has improved, and this again reflects also the competition against the insurers and their investment in claims teams and on claims that were notified to the insurers through Marsh. Actually 89% of the claims up until 2021 have been paid, and only 11% have been denied.
And when it comes to quantum, the claim payment under W&I policy can range from tens of thousands of US dollars to actually multimillion payments. Since 2017, W&I insurers have paid more than $500 million to Marsh clients, and this includes also the sea region, where we have already seen first payments under W&I policies.

Sašo Papp:
Well, Marcin Alexander, Saša, it was a pleasure, big, big thanks for your time. To all of you who are listening, watching, thanks for joining us. If you would like to see our previous episodes, you can find them on our website, CMS website. And you can revisit them through your LinkedIn profile if you wish so. Until next time, stay safe and enjoy life.

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Speaker

Marcin Ston

Marsh McLennan

Alexander Rakosi

Partner

Vienna

Saša Sodja

Partner

Ljubljana

Expertise

Corporate/M&A Insurance

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