Corporate Law Update: Mind the Gap – Warranty and Indemnity Insurance
25 May 2015
Are you a seller wanting a clean break after completion of your deal? Do you want to avoid worrying that a warranty claim might come down the tracks and take away all or some of those hard earned proceeds of sale?
Are you a buyer involved in a competitive auction process and worried that your change to that incredibly low cap on claims might eliminate you from the race?
If you answered yes to any of these questions, then the simple solution to your problem might lie in a warranty and indemnity insurance policy.
One of the most difficult aspects of any M&A transaction is closing the inevitable allocation of risk gap between seller and buyer. The seller will try to limit its exposure for breach of warranty while the buyer will always try to reduce its exposure in the event of a breach of warranty causing loss to the buyer. Issues relating to this gap between seller and buyer can be one of the main causes of deals stalling or collapsing.
Aside from hard fought negotiation on the extent of warranties, parties have traditionally tried to deal with these issues by allowing:
(i) retention by the buyer of some of the consideration;
(ii) some of the consideration to be held in escrow for a period of time post completion; and/or
(iii) part of the consideration to be deferred and set off against any warranty claims.
Now we are seeing renewed interest in the market in utilising an alternative method, the use of a warranty and indemnity insurance policy.
Warranty and indemnity insurance has changed dramatically since its introduction in the 1980s where it was used only by sellers as a protection policy. It was viewed as being cumbersome and expensive. Today, most notably, the pricing has fallen significantly and brokers and underwriters have also now honed the process so that it dovetails with the specific transaction timetable.
Types of Policy
The most common type of policy is the buyer side policy under which a buyer is insured for any losses it suffers as a result of a breach of warranty. It is also possible to purchase a seller side policy where the warrantor is insured for any losses it suffers as a result of a buyer bringing a successful claim against it for breach of warranty.
What’s the Catch?
You get nothing for nothing, so there is a cost in the form of a premium. Both buyer side and seller side policies will also be subject to a policy limit and other agreed limitations, such as excluding loss that arises from matters disclosed in due diligence reports, the transaction documents and the data room.
Premiums, where there is an excess on the policy of 1% of the deal value, are typically within a range of 1-1.5% of the policy limit. Premiums in the US market are generally much higher and range between 2-3%. In the Irish and UK market, underwriters typically insist on an excess on the policy to ensure there is an incentive to run a proper disclosure exercise.
Given the upturn in M&A activity, warranty and indemnity insurance provides an alternative means by which the thorny issue of risk allocation for breach of warranty can be dealt with. This is especially so in difficult deals where the gap is just too wide to bridge with the traditional methods, or where aggressive auction processes are being run by the sellers. As more and more underwriters enter the Irish market, competition in the market should follow, therefore allowing such insurance to become a very attractive option to close the gap.
For more information, please contact a member of our Corporate team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.