Until recently, warranty & indemnity insurance (W&I insurance) was only rarely used in Danish M&A transactions but due to faster underwriting processes and lower insurance premiums, we see a tendency towards an increased use of W&I insurance.
W&I insurance covers the economic loss suffered by a company where the warranties and indemnifications given in connection with an M&A transaction turns out to be incorrect. Both the buyer and the seller can take out an insurance policy, but the insurance coverage will differ depending on who takes out the insurance. This is described in more detail below.
Sell-Side and Buy-Side Policies
The sell-side policy is taken out by the seller and covers the potential liability of the seller as a result of breach of a given warranty or indemnity in the share sale and purchase agreement (the SPA). In sell-side policies, the seller often assigns its potential claim on the insurance company to the buyer. In a sell-side policy, breach of a given warranty or indemnity caused by seller’s fraudulent behaviour is not covered by the insurance policy. Hence, the buyer can only claim for damages from the seller in case hereof.
The buy-side policy is taken out by the buyer and covers the buyer’s potential claim against the seller in case of breach of the agreed warranties. The buy-side policy has the advantage that seller’s breach of a warranty caused by seller’s fraudulent behaviour is covered by the W&I insurance and the buyer’s coverage is therefore broader with a buy-side policy than with a sell-side policy. In our experience the predominant part of W&I insurance for Danish transactions are taken out as buy-side policies – presumably due to the broader coverage of the buy-side policy.
In both sell-side and buy-side policies the insurance company usually waives its right of recourse against the seller unless the breach of the warranty in question is a result of seller’s fraudulent behaviour.
Reasons for Choosing W&I Insurance in M&A transactions
First of all, taking out W&I insurance limits the seller’s liability towards the buyer as the insurance company, as above mentioned, in most policies will waive its right of recourse against the seller, thereby providing for a “clean exit” for the seller.
However, W&I insurance is also an alternative to the general holdback mechanisms used in most SPA’s, e.g. to hold in escrow a certain amount of the purchase price for a specific period of time or using claw-back clauses in the SPA. Hence, one of the main reasons for a seller to take out W&I insurance in an M&A transaction is that the purchase price will be at the disposal of the seller immediately after closing. This is particularly relevant in M&A transactions where the seller is a PE fund as the fund can distribute the full purchase price to its limited partners after closing. Another advantage of W&I insurance is that the seller’s investment possibilities will increase compared to the limited investment possibilities in an escrow arrangement. Given the current low interest rates, the premium payable to the insurance company can be financed by the margin between the yield of a low risk investment compared to the interest paid by the relevant bank managing the escrow account.
There are also several reasons for the buyer’s interest in taking out W&I insurance. Firstly, coverage of a W&I insurance may cause the seller to undertake more warranties and indemnities and increase the cap and survival limitations in such warranties, which will eventually increase the purchase price or allow for a smoother negotiation of the deal. Secondly, by taking out W&I insurance the risk of seller’s insolvency is transferred to the insurance company. Thirdly, in an auction process the buyer can make its offer more attractive to the seller by including W&I insurance in the offer, giving the seller the above-mentioned advantages compared to offers comprising holdback mechanisms.
A mutual reason for both the seller and the buyer to take out W&I insurance arises where the seller holds a certain part of the shares in the company post transaction. In this case the W&I insurance eliminates the rather precarious situation where the buyer must initiate proceedings against a co-owner of the acquired company to pursue the buyer’s rightful claim arising out of a seller’s breach of the warranties in the SPA concluded between the parties.
Insurable Warranties and Limitation of Scope of Coverage provided by Insurance companies
Ideally, the W&I insurance policy mirrors the warranties in the SPA between the seller and the buyer as all risks are thereby transferred from the contracting parties to the insurance company (in excess of the retention amount).
For regulatory and commercial reasons, insurance companies do not underwrite all risks represented in the warranty catalogue of an SPA. Certain toxic risks, as e.g. transfer pricing issues and issues related to pension underfunding, are usually not underwritten by insurance companies. For commercial reasons, forward-looking warranties are generally not insurable.
In addition, we have also experienced an examples of unwillingness on the part of insurance companies to cover certain warranties given in relation to directors’ and employees’ potential violations of the U.S. Foreign Corrupt Practices Act of 1977 and the UK Anti Bribery Act 2010.
Despite insurance companies’ above-mentioned unwillingness to underwrite certain risks arising from the warranty catalogue of the SPA, there is a tendency towards improved coverage and insurance companies generally exclude less warranties just as a growing number of policies are taken out on back-to-back terms with the SPA.
Retentions and De Minimis claim thresholds
In order for the parties to have “skin in the game” and to ensure that the parties do not agree on excessive warranties and indemnities, the insurance coverage is usually limited in the insurance policy by way of a retention clause and a de minimis claim threshold. The retention is the amount which a claim, or if agreed in the policy; the cumulated claims, must exceed in order for the insured party to be entitled to insurance cover. The de minimis claim threshold defines the amount a single claim must exceed in order to be included in the loss calculation.
Generally, the retention amount is approx. 1 percent of the enterprise value but moving downwards. In real estate transactions, the retention amount may be significantly lower.
When negotiating the SPA the parties must agree on which party is to bear the risk of the claim or cumulated claims not meeting the retention threshold in the insurance policy. In our experience, depending on the circumstances and the parties’ leverage in the negotiations, both buyers and sellers undertake to bear the risk of the retention threshold not being met.
Ideally, the retention in the W&I insurance policy and the de minimis claim threshold match the deductible and the de minimis claim threshold agreed in the SPA.
Growing Demand for W&I Insurance in the Danish M&A Market
In general, we experience an increased use of W&I insurance in both Danish and Scandinavian M&A transactions.
We believe that the increased use is a result of lower premiums and a faster underwriting process but that it is also driven by the growing awareness of the product. W&I insurance is used both in PE fund transactions but also in other transactions. While a substantial number of the W&I insurances have been driven by PE funds we have also seen a number of other reasons, e.g. succession on seller side, seller retaining part ownership of target, etc.
Decrease in Premium Prices
In general, the premiums charged by insurance companies have decreased significantly as the market is maturing and along with the maturing market, insurance companies are getting more comfortable pricing risks arising from warranties in SPAs. Within a 4-year period, we have experienced a 50 per cent decrease in premium prices. The premium charged by insurance companies is generally within a margin of 1-2.5 per cent of the insured amount.
W&I Claim Handling – the Unanswered Question
Albeit the maturing market, we have yet to see how claims arising out of W&I insurance policies governed by Danish law will be handled. The majority of insurance companies operating within the field of W&I insurance also operate in more mature but still comparable W&I insurance markets as e.g. the Swedish and Norwegian markets. Hence, we foresee that insurance companies’ claim handling will be carried out similarly to such markets in case of claims arising out of W&I insurance policies taken out in Danish M&A transactions.