Warranty and indemnity insurance

Transcription

1 Warranty and indemnity insurance A global reach Jannan Crozier and David Allen of Baker & McKenzie LLP and Brian Hendry of Willis Limited consider recent trends in global W&I insurance. Warranty and indemnity (W&I) insurance originated in the 1980s and was at that stage purely used by sellers as a protection policy where they had given warranties. It was not until the mid to late 1990s that W&I insurance started to get used in situations where sellers were unwilling or unable to provide prospective buyers with the level of warranty comfort that buyers were seeking for potential breaches of warranty in a merger or acquisition (M&A). Illustration: Getty Images Buyers used to complain that W&I insurance was too expensive and cumbersome to arrange compared with more traditional deal security measures such as escrows and deferred consideration arrangements. But in recent years, W&I insurance has undergone a number of material changes which address many of those complaints. W&I insurance pricing has fallen significantly since Brokers and underwriters have recruited experienced M&A professionals, which has enabled W&I insurance to become more adaptable to deal requirements and, as a process, more compatible with overall deal timetables. As a result, many buyers are now more inclined to view W&I insurance as a credible deal protection measure. There have been other interesting developments. As the W&I insurance product has expanded globally, three core markets have established themselves as the centres for the brokerage and underwriting of transaction risk policies: London, Sydney and New York. Policies provided in these markets have subtle differences that, on occasion, merge into other markets and affect market practice there. There has also been an increase in the use of bespoke policies, reflecting the general acceptance by parties of the use of W&I insurance in transactions. 1

2 Geographical spread of policies (by percentage) Europe (including CEE) UK US and South America Elsewhere (Australia/New Zealand, Asia & Africa) This article looks at: The main types of W&I insurance available and the growing trend for use of W&I insurance in transactions. The key insurance markets for W&I insurance. The practicalities of obtaining W&I insurance. The rise of bespoke policies for different transaction risks. The anecdotal evidence of claims. POLICIES AND M&A There are two main types of W&I insurance policy used in M&A transactions: Buy-side policy. The buyer is insured for any losses it suffers as a result of a breach of a warranty (subject to the agreed limitations and policy limit) given in the transaction documents, plus any associated defence costs. Sell-side policy. The party providing the warranties is insured for any losses it suffers as a result of the buyer bringing a valid claim against it for a breach of warranty (subject to the agreed limitations and policy limit) under the transaction documents, plus any associated defence costs. (For more information, see feature article Covering the risks: warranty and indemnity insurance, Traditionally, the W&I market was built on sell-side policies. However, sell-side policies have become less popular as the party giving the warranties remains contractually liable in the first instance to a claim by the buyer for breach of warranty and effectively remains on risk if, for some reason, the policy does not provide coverage for the relevant breach. This article therefore mainly focuses on points concerning a buy-side policy. Increased use in transactions Over the past three years, the use of transaction insurance has increased on average by about 20% year on year globally. We estimate that in 2012 there have been approximately 650 W&I insurance policies placed globally, with the key markets remaining as the UK, US and Australia. However, there has been a steady increase in the numbers of policies bought in continental Europe and Asia and the interest levels continue to grow (see box Geographical spread of policies ). While W&I insurance has been embraced by the private equity community, it is increasingly being taken up by companies: recent Willis statistics show that over 50% of insured parties are now companies. The average level of warranty protection coverage secured over the last two years has ranged between 10-30% of the total deal value of the target purchased (that is, the enterprise value) (see boxes W&I placements and Average premium ). KEY MARKETS The number of insurance companies that offer W&I insurance globally is limited and the major players have underwriting teams in two or more of the three key markets. Status of key markets The status of W&I insurance in the key markets is as follows: There are currently two W&I insurers based in Australia; further capacity from other insurers is accessed from the London or New York markets. The market focus is on Australian and New Zealand domestic transactions but also extends to certain Asia-Pacific transactions. For Australian/New Zealand transactions, policy terms 2

3 have tended to be more favourable towards the insured party (referred to in this article as the insured ). The London market is now the biggest and most established market for W&I insurance with the ability to provide over 300 million of coverage per policy. Most insurers have a global authority (subject to local insurance regulation) and will look at risks anywhere in the world regardless of location with the exception of the US where New York is the main market centre. The New York market has focused on North American transactions and has been slower to expand due to a combination of factors. Premium rates have been much higher in the US than other markets due in part to the US s reputation for being highly litigious. In addition, US transactions have tended to include very broad representations and warranties on an indemnity basis, with no general disclosure provisions and less extensive limitation provisions for claims than other jurisdictions. So the perceived risk profile is higher. The New York market is now starting to grow as the popularity of the product increases and competition among insurers drives down premiums. The terms of W&I insurance vary depending on numerous factors including the insurance market which is underwriting the deal. That market may not necessarily be in the same jurisdiction as the target s jurisdiction, although typically it is the same. Pricing terms There are a number of elements to the pricing of W&I insurance: Premium. The amount payable to the insurer for the policy, generally calculated as a percentage of the amount insured. Retention. Sometimes called the excess or deductible, the retention is the amount for which the insured W&I placements Willis Limited is on risk before the policy will respond to cover a liability. Broker income Total Buyer side Seller side Tax Other Insurer due diligence costs. The insurer may waive these fees if the policy is successfully purchased and placed. Insurance premium tax. In some instances, for a UK insured, this is 6% of the premium; for a Dutch insured, this is 21%; for other jurisdictions, tax may apply to the premium but it may be known by another name (for example, in Australia it is referred to as GST and Stamp Duty and in many US states, it is referred to as surplus lines tax and, potentially, a stamping fee). The scope of the insurance cover and the policy exclusions will invariably affect the premium for a policy. London market premiums. The London market is currently seeing premiums within a range of % of the policy limit insured for retentions of 1% of the deal enterprise value. In some deals, it has been possible to bring the retention level below 1%, even to zero, but this inevitably raises the premium, reflecting the increased risk profile for the insurers. On a buy-side policy, the retention is really an issue for the insured (that is, the buyer). It can choose whether to selfinsure that amount or to push for the seller s liability under the warranties to cover the retention as well. Underwriters have typically insisted that the warrantors must have some liability under the warranties to ensure that there is an incentive to run a proper disclosure exercise (different underwriters have different views on what constitutes sufficient liability ). For example, in many transactions, the seller retains liability under the warranties for 1% of the deal enterprise value. Australian market premiums. Australian market premiums are around 1-1.4% of the policy limit insured for retentions of 1% of the deal enterprise value. The process in Australia has evolved to allow a seller to have zero liability 3

4 Average premium (% of amount insured) Willis Limited Buyer side Seller side Tax under the transaction documents. The seller will therefore have no liability on a breach of warranty claim (save in the event of fraud), and the buyer will effectively self-insure the risk of the retention amount under the policy. Buyers and their advisers have been able to get underwriters comfortable with this position on the basis that it will not affect the depth or quality of the sell-side disclosure exercise, and, indeed, this can only be achieved where the sell-side disclosure exercise appears to have been professionally and thoroughly done. Buyers have been willing to accommodate this also on the basis that their sole recourse, absent fraud, is under the policy. New York market premiums. US market premiums are usually not less than 2-3% of the policy limit insured for retentions of between % of deal enterprise value. Premium rates are generally higher for the reasons mentioned above. Scope of coverage The precise terms of a policy are a matter for negotiation between the insured and the insurer and will be tailored for each transaction. However, the starting point is for coverage under the policy to match the scope of the warranties and the tax indemnity in the transaction documents. For example, where the transaction documents provide for loss for breach of the warranties to be on an indemnity basis rather than contractual damages, the policy will match this. The policy will invariably include a schedule that lists each warranty given under the transaction documents and sets out whether, for the purpose of the policy, the warranty is covered, not covered or covered with a modification. A modification means that the insurer will amend the wording of the warranty to reflect a warranty for which it is prepared to provide cover. A standard policy generally covers: Loss incurred by the insured arising from a breach of the warranties. A claim under the general indemnity for tax. Reasonable costs incurred in the investigation or settlement of a third party claim. Coverage differs between the key markets in a number of ways, including, for example, the use of tipping retentions and the coverage that can be achieved between signing and completion. Tipping retention. The tipping retention is a reasonably well-established policy feature in the Australian market. Once the retention has been eroded, the W&I insurance will tip to cover some or all of the retention (see box Australian model for tipping retention ). The concept of a tipping retention has been available in the London market but normally attaching above a policy excess of 2%+ of enterprise value or greater. Given that it has been possible on some deals to bring the retention claim to zero, it seems a natural development for this trend to migrate into the London market. The concept does not yet seem to have been taken up by the New York market, but given that it is available in the other major insurance markets, the New York market may need to adapt in order to remain competitive. Coverage between signing and closing W&I insurance has traditionally approached the issue of repetition of warranties on the basis that: If a breach of the signing warranties comes to light after signing which was not known on signing, then it will be covered. If a breach of the repeated warranties comes to light after signing but before completion, the insured will not be covered. Subject to the length of time between signing and closing, insurers may wish to see a new disclosure letter applicable to the closing warranties and, at the very least, will want a no claims declaration against the closing warranties (that is, the buyer s deal team confirms that they are not aware of any matter that could give rise to a claim under the warranties at the date of declaration). In such situations, the buyer s only protection is to negoti- 4

5 ate with the seller up front in the acquisition agreement an ability to terminate the transaction or (less likely given that W&I insurance is being used) for the seller to underwrite or share in those risks. This has tended not to be a big issue in deals where W&I insurance is used and there is a private equity seller using a locked-box structure as the business warranties typically will not be repeated on closing. (This is because the buyer will bear the risk and reward of the target business from the effective date.) Australian approach. The Australian market has departed from this position, and coverage has been provided for new breaches that have occurred in a designated period between signing and closing. The key factors relevant to the provision of such coverage are: The time period during which the new breach occurs must be limited. Typically, the time period has been in the range of 30 to 45 days, but in some cases that has extended to 45 business days or even 90 days. One structure that has been used is for the coverage period to be for 90 days, but if a claim is made during that period then claims coverage for additional new claims ends on the 45th business day after signing. The existence of buyer termination rights for a material adverse event, and a requirement in the policy for the buyer to exercise that right. A lower policy sub-limit or a higher retention for any such breach. An additional amount of premium to cover these types of breaches. Australian model for tipping retention In Australia, the level of tipping has been 50%-100% of the retention. This means that, for example, where a policy includes a 50% tipping retention and a retention amount of AUS$1 million, if losses exceed this retention, the policy will pay out AUS$500,000. A tipping retention of 100% works on the same basis, but would cover the whole AUS$1 million. The cost of a tipping retention clearly affects the premium, and the overall materiality will depend on the transaction. As with all pricing issues, it is a matter for negotiation and the broker will play an instrumental role in steering the pricing discussions by reference to what has been achieved in the market on past transactions. Typically, the underwriter will charge an additional premium for the incremental amount of the retention on risk (but see below regarding impact also on follow-on insurers). For example, on the above example, the additional premium would be charged on AUS$500,000 (with a 50% tip) or AUS$1 million (on a 100% tip). In considering the economics, the following key factors should be borne in mind: Size matters. In some deals, an additional premium of 10-20% on the incremental amount of coverage has been charged. On smaller deals, that additional sum can make the overall cost of the policy uneconomical: if only AUS$10 million of coverage was being arranged at a 1% premium, the tipping retention could push the blended premium to 1.5-2% (for a 50% tip) or 2-3% (for a 100% tip). But on larger deals, where, say, AUS$100 million of coverage is being arranged at a 1% premium, the blended impact of the incremental cost may only push the overall blended premium to % (for a 50% tip) or % (for a 100% tip). Impact on excess underwriters. Where the insurance has been arranged in layers with a primary underwriter and one or more follow-on underwriters providing excess-only coverage, the insured will argue that only the primary underwriter should be able to charge an additional premium because only it is at risk if the retention tips. However, the follow-on markets may also try to push for an additional premium on the basis that their insurance is at risk sooner. If the primary insurer provides AUS$30 million of coverage and there was an AUS$5 million deductible then that primary layer would ordinarily extend to provide claims coverage for loss from AUS$5 million to AUS$35 million, and above that the follow-on insurance applies thereafter. If the primary insurers agree to a full-tipping retention then the insured s coverage would extend from AUS$0 million to AUS$30 million, meaning that the follow-on insurer s insurance starts at AUS$30 million rather than AUS$35 million, which places the follow-on insurers at greater risk of a claim. The broker plays a key role in those pricing discussions. However, in the last 12 months, the Australian market has waivered on this issue, and there have been mixed reactions from underwriters on providing coverage for new breaches. Third party claims. The London and New York markets have tended to take the more traditional approach (see above). One exception to this is third party claims. It has sometimes been possible to get cover for third party claims that occur between signing and completion (where the period between signing and completion has been a relatively short and fixed period) and for these to be carved out of the completion no claims declaration. As this is something that is outside of the control of either a seller or buyer, the underwriters are more prepared to consider providing cover on a case-by-case basis to cover this risk. 5

6 Policy exclusions A standard policy will sit behind the warranties on a back-to-back basis but will also customarily exclude the insurer s liability for losses arising out of the following: Matters of which the insured had actual knowledge before the effective date of the policy. In order to limit its scope, this exclusion is often restricted to the actual knowledge of specified members of the insured s transaction team (this is limited to the internal deal team of the insured and does not include advisers). Fraud and deliberate non-disclosure on the part of the insured. Amendment of the transaction documents without the prior written approval of the insurer. Fines and penalties, in respect of which the insurer is not permitted by law to underwrite. Any pension arrangement underfunding. Tax avoidance. Purchase price adjustments and locked-box leakage covenants. Forward-looking warranties (for example, a warranty relating to the target s ability to collect debts after completion of the transaction or financial projections). One of the more creative aspects of W&I insurance is the ability to include enhanced protections in the policy to improve the position that otherwise would have been achieved in the transaction documents. For example, where warranties have been provided subject to seller s awareness, it is possible (in the right circumstances) to remove the knowledge qualifiers for certain of the warranties so that the warranties are treated as being given absolutely in the policy. The insurer will typically only remove the knowledge qualifier for warranties which are not usually qualified by awareness (for example, an audited accounts warranty would ordinarily not be qualified by awareness in an M&A deal between two companies), but it will not, for example, remove the knowledge qualifier for speculative warranties, such as whether litigation is expected to be threatened. ARRANGING A POLICY The process for arranging W&I insurance has significantly improved in recent years and dovetails well with the transaction timetable. Before an insurer is prepared to offer cover on a binding basis, it will need to have a good appreciation of the transaction and to feel confident that adequate disclosure and due diligence have been undertaken by the parties. Key steps To arrange the placement of a standard buy-side policy, the following steps will typically need to take place: Review the feasibility study. The buyer will engage a broker and provide the broker with a basic overview of the transaction, including details of the target, jurisdiction of the target business, likely deal value and potential policy amount. At this stage, the buyer does not need to provide any documents to the broker. The broker, using its market experience and without going out to the insurance market, will provide the buyer with a feasibility study which will include an indication of possible pricing and guidance on the likely reaction of the insurance market to the request for W&I insurance. Approach the insurers. If the buyer remains interested in obtaining a policy following the feasibility study, the broker will approach the applicable insurance market to secure non-binding indicative terms based on a preliminary set of business warranties. The buyer will be required to provide the insurers with an overview of the target business (for example, a copy of an information memorandum), the last set of (audited) accounts, the data room index and a set of warranties. The insurers will sign a customary confidentiality agreement. The seller s preliminary warranties will ideally be marked up by the buyer to show the differences between the seller s and buyer s proposed set of warranties, but, if this is not available, educated assumptions can be made on where the warranty language may move. The idea is to present the insurance market with the best position on the warranties from a buyer s perspective in order to obtain the most realistic pricing and determine whether the insurance market will provide coverage for those warranties. Review indicative report. The nonbinding indicative terms from the insurance market will be provided to the broker and will include an indication of cost and the basic terms of the policy, including the amount the insurer is prepared to go on risk for, the retention and key exclusions from the coverage the insurer is prepared to offer. The broker will then compile the numerous non-binding indications into an indicative report. The indicative report sets out details of each insurer s terms in a format which is easily comparable. If the level of cover required by a buyer is likely to exceed the amount of coverage that any one insurer would be prepared to accept, it will be necessary to arrange a programme of insurance using a syndicate of insurers. If this is the case, the broker will present a number of options for how the buyer might wish to form the programme insurance (that is, which insurers will take the primary layer, first excess, second excess and so on; the excess layers are known as follow-on markets ) based on the best combinations of premium rates offered by the insurers. Insurers due diligence review. Following the review of the indicative report, the buyer will select a preferred insurer who will then conduct a non-intrusive due diligence review. 6

7 W&I insurance process Phase 1 Phase 2 Phase 3 Phase 4 Deal status Indicative offers/ bidding or heads of agreement. Due diligence/ Second round bids. Exclusivity/negotiation of transaction documents. Signing/completion. Information required by broker/insurer Deal size, industry sector, jurisdiction. No documentation required by broker. Information memorandum. (Audited) accounts. Data room index. Draft share purchase agreement (SPA). Updated SPA. Disclosure letter. Due diligence reports: tax, environmental, legal and any specialist reports (non-reliance basis). Access to data room. Final SPA and disclosure letter. Final due diligence reports. Underwriting call (insurer holds this with legal advisers and insured's deal team: approximately one hour). No claims declaration signed. Insurance stage Broker provides feasibility/ conceptual study giving opinionbased pricing and guidance. Broker makes submission to insurer and will obtain indicative report (costs and terms). Insurer will sign confidentiality agreements. Insurers review documents. Commitment to insurer fees. Insurer offers quotation on formal terms. Finalisation of policy. Binding policy. Payment of premium. Time required 1-3 days. 5-8 days days. 3-5 days. Total time required 1-3 days days days days. The insurer s due diligence exercise is not intended to duplicate the main due diligence process or the transaction disclosure exercise, but rather to gain an overview of the deal and, if necessary, review specific issues. The insurer will review the transaction documents containing the warranties, the disclosure letter and any due diligence reports prepared by the buyer s advisers (including legal, financial and environmental), and any vendor due diligence reports; in each case, this will be done on a non-reliance basis. The insurer will also require access to the data room. At this stage, the buyer is likely to need to commit to covering the insurers due diligence costs to enable the prospective insurer to conduct its review of any relevant documents either using internal or external advisers. If the buyer concludes the policy with the insurer, the insurer will typically write off these costs. If a programme of insurance is required, the primary insurer selected by the buyer to proceed to the first part of the formal underwriting stage will produce a report which will then be made available to the other insurers who will piggyback off the work done by the primary insurer rather than conducting their own due diligence. Consider the offer. If, following its diligence, the insurer is satisfied with its findings and the overall due diligence process that has been undertaken by the buyer, it will offer a quotation on formal terms. This will include a formal offer on price and insurance coverage terms. The insurer will also provide the buyer with a draft policy. If a programme of insurance is being put in place, the follow-on markets will provide their formal offers on price, but will typically accept the same coverage and policy terms as set by the primary insurer. Negotiate policy terms. If the buyer is satisfied with the formal offers, the insurer and the buyer (assisted by its broker and lawyers) will proceed to negotiate the policy terms. Any updates to the transaction documents or due diligence reports will need to be made available to the insurer. Participate in underwriters call. Before the signing of the transaction documents, the insurer will require the buyer to provide final versions of the transaction documents, the disclosure letter and due diligence reports. The insurer will also hold an underwriters call with 7

8 the buyer (including its deal team) and its advisers. On the call, the insurer will ask the buyer and its advisers to talk it through the rationale for the deal, the due diligence process undertaken, the deal process, negotiations with the sellers and any specific issues regarding the target business that the insurer was not able to understand in sufficient detail as part of its own due diligence process. The purpose of the call is to help the insurer be satisfied that a due and proper process has been undertaken by the buyer and that the deal is an arm s length transaction with the seller. The call generally lasts one hour. Sign the policy. On the transaction signing date, the policy will be finalised and signed. The buyer will also be required to make a no claims declaration to the insurer. Timing The timing for each of the steps can vary considerably depending on the type of transaction and the transaction timetable, along with the complexity of the policy and the programme of insurance that the buyer is trying to obtain. Generally, for arranging the placement of a standard W&I insurance policy, the feasibility phase will take between one and three days, the compiling of an indicative report can take between five and eight days, the insurers due diligence review and formal offer takes around two weeks, and the finalisation and inception of the policy can take five days (see box W&I insurance process ). In total, the process can take between two and a half and three and a half weeks. The market will react to the needs of the deal, however, and can move much faster if required. New approach by sellers Some sellers have been arranging W&I insurance in a similar way to stapled financing over the last two years, particularly in auction deals where the seller wants to sign a transaction quickly once Related information Links from This article is at Topics Acquisition Finance Asset Acquisitions Insurance Legal Risk and Compliance Owner-managed Businesses Private equity and venture capital Share Acquisitions: Private Practice notes Disclosure: acquisitions Warranties and indemnities: acquisitions Previous articles Warranties, indemnities and disclosure: comparing US and UK law and practice (2012) Covering the risks: warranty and indemnity insurance (2008) the winning bidder has been selected. (Stapled finance is essentially pre-arranged finance arranged by the seller s advisers and made available to potential buyers of a target company to enable the purchase to be made by the eventual buyer.) In this process, the sellers engage a broker who will approach the insurance market to obtain terms for a buy-side insurance policy. At this initial stage, the insurers will usually see the sellers draft of the acquisition agreement, an information memorandum, the latest audited accounts plus an overview of the sale process that is being undertaken and the likely timetable. Following a review of the documents and making educated assumptions as to how the acquisition agreement may be negotiated, the insurance market will provide indicative terms to the sellers. As the sale process develops, further information is shared with all or selected underwriters (such as access given to the For subscription enquiries to PLC web materials please call data room), their terms are refined and, in many instances, the policy is substantially negotiated by the seller. At a point that makes sense within the context of the specific transaction, the policy terms are shared with the bidder(s) and the bidder(s) are put in touch with the selected insurer(s). At the appropriate time, the bidder/buyer is put in control of the insurance process (including the assignment of the broker s engagement letter to the buyer), further information that is in the control of the bidder is provided to the insurer and the policy is negotiated towards a final agreed form. If the buyer requires additional cover beyond the scope that the seller had established, this can be built into the policy and, when the acquisition agreement is in an agreed form and due to be signed, the policy will also be executed. The key question which the market has not settled is precisely when control of the process should be handed over to the 8

9 buyer by the seller. Some firms are of the view that control should only be ceded at the 11th hour before signing. Clearly, this in part is dictated by the competitiveness of the sales process and the parties bargaining powers. BESPOKE POLICIES W&I insurance is designed to address unknown risks. Bespoke policies are designed to cover known risks that have been excluded in standard W&I insurance. If there are specific known issues highlighted in the due diligence exercise, these would not typically be included within the cover offered as it is expected that the parties would deal with these risks at the negotiation table. If issues have a high cost if they occur, but a low probability of coming to fruition, and good analysis is available for insurers to assess the extent of the exposure, then cover may be available. If cover is made available, the parties to the transaction will have their own preferences as to whether cover is incorporated within the scope of a W&I insurance policy or separately via a contingent liability cover. Cover would normally be taken outside the scope of a W&I policy if the policy wording (such as conduct provisions and representations) needed for the bespoke risk had features that would not be dealt with appropriately in a W&I policy form. The most common example of a bespoke policy is a tax liability policy designed to underwrite a specific identified tax issue. As the risk has been specifically identified, the level of due diligence required by the insurance market to offer cover for the exposure is significantly more intrusive; sometimes counsel s opinion as to the extent of the liability may be required. Premiums for bespoke tax liability policies will be higher than for W&I insurance: 3.5% to 5% is the average range although 10% is not uncommon. Subject to the nature of the tax risk, a retention will usually only apply to the defence costs aspect of the cover. Tax matters continue to be the most common known risks that are insured in the market, but in theory any known matter that has a legal risk profile can be insured. For example, actual and potential litigation matters and environmental issues have been insured by the markets. EVIDENCE ON CLAIMS In general, warranty claims are reasonably uncommon. The experience of the insurance market bears this out but, due to confidentiality, hard statistics on the number of claims and payments made is not available. However, based on recent analysis of the London market, it is considered that of the projects insured, one in six policies has a claim notification made against them. Not all notifications turned into claims: some were below the policy excess and others ultimately were not valid breaches. It is known that there have been numerous settlements agreed, some into eight figures. Jannan Crozier is a senior associate and David Allen is a partner at Baker & McKenzie LLP; Brian Hendry is Executive Director, Transaction Solutions at Willis Limited. 9