How prevalent is the use of W&I insurance in your transactions?
Private Equity (2nd edition)
W&Ι Insurance, although not a standard item in M&A transactions in Greece, is getting more popular, especially in high value transactions. On many occasions M&A parties have found that the benefits of W&1 Insurance outweigh the costs, since this is a way to resolve the lengthy negotiations on representations, warranties, indemnities, as well as, liability limitation (i.e. the seller’s maximum aggregate liability is set in many occasions to the W&1 Insurance retention amount). Obviously, use of W&I Insurance depends with the willingness of the insurer which this is linked to both macroeconomic and transaction sector factors.
W&I insurance has become very popular in recent years and is commonly seen.
When used, it can simplify the negotiation of the warranties between seller and buyer but, equally, putting such insurance in place can lengthen and complicate the due diligence process as the insurers also require access to the due diligence documentation.
Warranty and indemnity (W&I) insurance is increasingly used in Dutch transactions, especially when a (private equity) seller is looking for a clean exit. There seems to be a correlation between the use of W&I insurance and the deal size, meaning that the larger the deal size the more probably it is that a W&I insurance will be used. Based on available sample studies, approximately 20% of the transactions in the Netherlands contained a W&I insurance.
W&I insurance may provide for an elegant solution to the security issue. In general, one of the reasons to enter into a W&I insurance is that it can smooth the negotiation process by avoiding intensive discussions regarding representations and warranties between the seller and the buyer. It may contribute to maintaining a friendly commercial relationship between the seller and the buyer. Moreover, from a seller's point of view a W&I insurance is also considered a powerful tool to achieve a cleaner exit through the reduction of residual seller liability. In addition, the return on investment could be higher compared to leaving part of the proceeds on an escrow account or to provide any other form of security. From a buyer's point of view, the buyer will likely obtain a more extensive list of seller's warranties. A downside for a buyer is that not all warranties will be covered by W&I (general exclusions are pension underfunding, transfer pricing, environmental matters and civil, criminal or administrative fines or penalties).
There are two main types of W&I insurance: a “buy-side” insurance, where the buyer is the insured party, and a “sell-side” insurance, where the seller is the insured party. A buyers policy covers the buyer for damages resulting from a breach of the warranties or a claim under the (tax) indemnity. Instead of claiming its damages from the seller, the buyer has direct recourse against the insurer. A sellers policy is less common than a buyers policy and allows the seller to recover amounts it is required to pay the buyer for a breach of a seller warranty or a claim under the (tax) indemnity from the insurance provider. The most common structure in this context is a seller pre-wiring the W&I insurance in the context of an auction process and the buyer ultimately taking out the insurance policy. The terms of the insurance policy are generally in line with European W&I standards (it is usually non-Dutch insurers that are engaged for the provision of the W&I insurance).
Historically, we saw that W&I insurers prefer the seller to be liable for an amount equal to the retention amount under the policy (which was mostly set at an amount equal to the basked, e.g. 1% of the purchase price), thereby increasing the seller’s incentive to negotiate favorable warranties. The market seems to have shifted to a maximum liability of the seller set at EUR 1, basically meaning that the Seller no longer has “skin in the game”. Insurers also offer policies including a knowledge scrape (i.e. some or all of the knowledge qualifiers in the acquisition agreement do not apply to the insurance coverage).
According to estimates from M&A insurance brokers active in the Norwegian market, W&I insurance is used in 20 – 30% of the transactions in the mid- and large cap space in the Norwegian market. W&I insurance is frequently used by financial sponsors, and increasingly used also by industrial players.
This is becoming increasingly popular in Poland based M&A transactions.
The use of W&I Insurance has not become a common practice yet, however, there has been a significant growth in use of W&I insurance in M&A transactions in Korea for the last few years.
Korea saw the use of W&I insurance starting from around 2013, with approximately one or two deals using W&I insurance per year until 2015. Use of W&I insurance started becoming more popular from 2016 through 2019. Nowadays, most private equity sellers and also strategic sellers in high profile auction deals at least consider the option of demanding bidders/buyers to use W&I insurance.
The activity level has been quite steady over the last few years and in particular in large cap transactions where the deal value exceeds SEK 500 million, and in transactions where the seller is a financial sponsor, W&I insurance is very frequently used. As brokers and underwriters active on the Swedish market have recruited M&A specialists and developed the product and the underwriting process, W&I insurance has become a more flexible and thus viable part of transactions.
Over the past years W&I insurance has increasingly been used in M&A deals in Switzerland. In the current sellers' market we mainly see buyer polices which can be a solution to bridge the "liability gap" where a seller is prepared to give representations and warranties but wants to cap its liability at a level that the buyer is not comfortable with and the W&I insurance can increase the overall cover available for the buyer.
In case the liability cannot be capped or excluded due to the lack of negotiation power of seller, seller policies are used (especially by financial sponsors) to shift the risk of potential outstanding claims to an insurer in order to be able to distribute the exit proceeds to the greatest extent possible to investors immediately following closing.
In Belgium, W&I insurance policies have so far been quite exceptional in M&A transactions. However, in the context of transactions organized as competitive auctions and in real estate transactions, selling financial sponsors that are looking for a clean exit have started to introduce W&I insurance. In recent years, W&I insurance policies have sometimes been entered into in the context of large transactions with high deal values, although in small and medium-sized transactions they are still only rarely used.
Duff & Phelps estimate market penetration of representation and warranty insurance at approximately 17% of the addressable market, suggesting there is still room to grow. It should be noted that the addressable market is not exclusive to the financial sponsor context.
Financial sponsors have readily adopted the representations and warranties insurance product in their transactions, although use is not universal. The size of the deal and competitiveness of the process is still a key determinant in the use of the product. While there is a trend towards adoption of a full “clean break” with the advent of this product, in Canada, it is still common to see a combination of indemnification escrows as a first recourse prior to the policy, and specific indemnities for known (and uninsured) risks may still be requested.
W&I insurance has been introduced to China market for more than 10 years, and are increasingly popular among the parties to M&A (and private equity) transactions for the following reasons we observed: (i) a transaction involves auction process which makes it almost impossible for the purchaser to have a thorough due diligence investigation due to its limited access to seller data and the given time pressure; (ii) the W&I insurance can cover the losses of a purchaser above the seller’s liability cap (if any) agreed upon in the transaction documents; (iii) many sellers, especially the financial sponsors, wish to realize a clean exit from the transaction, as they need to be certain about the sales proceeds distributable to their investors, without bearing contingent liability arising from a purchaser claim; and (iv) some purchasers may be reluctant to claim against the seller, aiming to maintain good relationship with the seller or seller’s parent. In contrast with a purely domestic transaction in China where both parties are Chinese entities who are familiar with the legal and policy risks under the Chinese law, W&I insurances are more often used in cross-border transactions, in particular the outbound investments made by Chinese purchasers. A regulation promulgated by the State-owned Assets Supervision and Administration Commission in 2017 even highly recommends that all state-owned or controlled enterprises at the central government level utilize insurance tools for risk avoidance purpose when they make outbound investment.
France remains a jurisdiction with significant M&A volumes that are not using insurance. This situation could be explained by the fact that financial sponsors generally do not provide representations and warranties. This situation is reinforced by the fact that managers of French companies under LBO are generally treated on a pari passu basis with the financial sponsor. However, managers may accept to provide representations and warranties to the extent a W&I insurance entirely covers their risk. Other exceptions may be seen in trade sales.
More generally, W&I insurance is still seen as making the process slower or burdensome. However, more and more clients are considering, at some point in a transaction, the opportunity to purchase a M&A insurance.
Today, the use of W&I insurance is crucial to German private equity transactions and is an established tool for the majority of deals. In previous years, financial sponsor buyers used W&I insurance to increase the appeal of their offer by limiting potential seller exposure. Given the growth in use and competition in the W&I insurance market, W&I insurance policies have evolved from purely insurance to include operating warranties (title warranties, specific tax insurance, zero seller liability structures) without significantly increasing premiums. As such, contractual mechanisms to ensure feasible remedies for the buyer, including partial purchase price retention, escrow models or bank guarantees, are now less relevant as they only apply to breach of fundamental warranties, which in itself is unlikely.
The use of W&I insurance is not common in Mexico. When seen it is usually in the context of cross-border transactions with agreements governed by foreign law.
The use of W&I insurance is becoming the norm in private equity exits. For sellers, W&I insurance can help achieve a clean exit (e.g. with no escrow) and in some cases offer nil exposure for the warrantors for warranty claims. For buyers, W&I insurance can enhance the warranty protection on offer by extending the duration and scope of warranty coverage. It is also possible for buyers to include a tax deed (subject to a £1 cap or synthetic) to cover most unidentified tax risks and/or to obtain separate coverage for identified tax risks.
It is common in auction processes for the seller to arrange a stapled sellside policy which ‘flips’ to a preferred bidder. The stapled policy can help with a quicker underwriting process and, if well managed, the W&I process can be a useful sellside tool to manage auction dynamics.
In highly competitive auctions, a bidder may forego the inception of a W&I policy at signing (to deliver signing earlier than other bidders who see signing contingent on the inception of the policy) and finalise its work on W&I post-signing.
W&I insurance has not been commonly used in private equity transactions in Vietnam.
While the concept of a W&I insurance is evaluated in almost all deals, in our experience, deals where it is procured are few and far between. Such insurance involves a high transaction cost and premium, which sellers are not very comfortable bearing in the context of India-focused deals. Further, due to various factors such as evasive regulatory regimes and grey areas in respect of disclosures made by sellers, many insurers are not comfortable covering a vast variety of matters for India-specific M&A transactions, which also makes such insurance an undesirable and often unpopular for the parties involved. However, we have recently seen trends where W&I insurance is being actively sought in Indian M&A deals, especially where a foreign parent company or group of companies is involved.
The increased use of W&I insurance has been major development in the structuring of M&A transactions in Ireland in recent years. This has been particularly true in the last 12 months as businesses acquired by financial sponsors over recent years are now being disposed of and those sales processes will typically include a W&I policy. The use of W&I is most common on share sale transactions where the the underlying asset is property related (including wind farms).
Hannes Snellman: The use of W&I insurance has become increasingly common in Finland over the last few years and particularly in auctions and other sponsor-led sales processes. Especially in auctions, it is common that the seller initiates the insurance processes, which is then “flipped” over to the buyer in the final round of the auction. Standard W&I insurance provides coverage for breaches of representations and warranties with general exclusions, which include for instance known/identified issues, criminal liability, penalties (e.g. GDPR fines), secondary tax liabilities and forward-looking statements.
The use of W&I insurance still is quite uncommon for most of the transactions in Brazil. However, according to a well- known brokerage insurance firm in Brazil, W&I insurance demand in Brazil over the first half of 2018 grew by 35%, compared to the same period in 2017, indicating a possible turnover on the risk allocation methods that the companies should assume for the next years.
Warranty and indemnity insurance is more frequently discussed in private equity exits, but still not as common as what we see in other jurisdictions, such as the UK and Germany.
Private equity sellers sometimes use warranty and indemnity insurance to “bridge the gap”. Seller policies are usually not discussed in the course of the sales process unless the buyer is expected to bear all or part of the costs. Conversely, if a buyer’s policy is proposed, this is usually addressed early in the process. The typical retention (also known as an excess), which is the uninsured amount of the loss to be borne by the insured, is around 1% of the consideration. Policy limits vary between seller policies (usually they match the agreed maximum liability under the purchase agreement) and buyer policies (usually they start at around 20% of the enterprise value but can also cover the full enterprise value). Typical carve-outs and exclusions include fraud, and matters the insured was aware of at the time of taking insurance, forward looking warranties (e.g. the ability to collect accounts receivables). Indemnities for risks identified in the course of the due diligence can sometimes be insured as part of the policy, if the contingent risk is identifiable and quantum and likelihood assessable.
During the last few years the use of R&W insurance has increased significantly. According to data analyzed by Advisen, from 2008 to 2018, total use of R&W insurance policies per year rose from 40 deals providing $541 million in coverage to over 1,500 transactions providing aggregate coverage of $38.6 billion. For deals with a financial sponsor buyer and/or seller on which we worked over the past 12 months, an overwhelming majority used R&W insurance. The use of R&W insurance is less prevalent in deals with strategic buyers, although strategic buyers have become increasingly comfortable in using R&W insurance and its use by strategic buyers is on the rise.
The premium for the R&W insurance policies has been decreasing over the past few years as its use becomes more prevalent and more underwriters enter the market. The process of obtaining R&W insurance does not have a material impact on the deal timetable, as insurance providers have become very responsive to demanding timelines.
Insurance products have also expanded from a basic insurance solution to cover operating representations and warranties to also cover title representations and warranties, provide specific tax insurance and accommodate zero seller liability structures (i.e., no “skin-in-the-game” by the seller), in each case without incurring substantial additional premiums.
Importantly, although the use of R&W insurance is prevalent and often alters the total composition of risk allocation, R&W insurance is not an exclusive alternative to traditional indemnification or escrow/holdback requirements. The typical R&W insurance policy will include exceptions (e.g., seller covenants, known losses, issues or breaches, certain tax and environmental matters), which can result in bespoke indemnification constructs and separate escrow/holdback requirements as an ancillary feature to an R&W insurance policy.
General interest in W&I insurance among Japanese sellers and buyers are increasing, and we have seen cases where W&I insurance policies are purchased for M&A transactions in which the targets are Japanese companies. Still, the use of W&I insurance in domestic M&A transactions is not as common as in other jurisdictions.
One of the major reasons for such lack of usage of W&I insurance may be because of its impact on the transaction schedule. The underwriting process for the W&I insurance, including the due diligence and review of transaction documents by the insurance companies, is sometimes difficult to complete for transactions with tight timelines because the underwriting process will add additional time and costs and additional burdens on the resources of the transaction team members until the execution of the transaction documents.
Another major reason has been the language issue. For a typical transaction between a Japanese seller and a Japanese buyer, transaction documents are prepared in Japanese language. On the other hand, most of the insurance companies which can provide W&I insurance coverage operate primarily in English. Such insurance companies only accept transaction documents and due diligence reports written in, or translated to, English for their review and they only issue policy documents about the W&I insurance coverage in English. This language issue adds further time and costs to the procurement of W&I insurance coverage. Recently, some insurance companies started to accept Japanese language transaction documents and due diligence reports, and the situation may gradually change.