Warranties and Indemnity Insurance

Warranties and Indemnity Insurance

Warranties & Indemnity Insurance is an insurance policy used in mergers and acquisitions to protect against losses arising due to the seller’s breach of certain of its representations in the acquisition agreement.

Warranty and Indemnity insurance responds to cover financial losses arising from breaches of the warranties, and in certain jurisdictions tax indemnities, provided to facilitate a variety of corporate transactions, especially mergers and acquisitions.

The breaches are exemplified as under –

• Financial statement misrepresentations account for the bulk of the breaches – most commonly alleged breaches were for financial statements, tax information, and compliance with laws.
• There are other kinds of breaches – breaches of intellectual property, trademarks, copyrights, data, etc – mostly in advanced economies
• Whereas, other economies reported more breaches of contracts
• A buyer policy indemnifies buyers for losses caused by breaches of warranties given by the seller in the SPA (Sale & Purchase Agreement). It enables the buyer to claim directly from the insurer without first having to pursue the seller.
• A seller policy indemnifies sellers for losses resulting from claims made by the buyer for breaches of the warranties given in the SPA (Sale & Purchase Agreement).

The key points of such insurance policies are as follows:

• The policy coverage is typically a dollar amount equal to 10% of the M&A purchase price.
• There will be a deductible amount under the policy that is excluded from coverage (the “retention”), typically a minimum of 1% of the M&A purchase price.
• There are “standard” exclusions to coverage; for example, the insurance does not cover covenant breaches by the seller or purchase price adjustments, and there may be specifically tailored exclusions based on the results of the insurance company’s due diligence/underwriting.
• Not all representations and warranties of the seller are covered
• The buyer or the seller can be the insured party, but 90% of the time the insured is the buyer.
• The premium payment is typically a one-time fee paid upfront.
• The policy term is typically for 3 to 6 years, to be negotiated with the insurer.

Typical Process for Obtaining Warranties & Indemnity Insurance:

The process for obtaining a policy usually starts with the buyer or seller approaching an insurance broker to solicit quotes from insurers. An insurance application must be completed.

The following are the key information and documents the insurer will want to review:

• The parties involved
• The coverage amount sought
• The form of the acquisition agreement, especially the nature and scope of the seller’s representations and warranties
• The seller’s online data room
• The buyer’s due diligence reports on the seller
• The seller’s Disclosure Schedule connected with the acquisition agreement

The Benefits of Warranties & Indemnity Insurance:

There are multiple benefits to the parties to an M&A deal.

For sellers, the benefits of such insurance can include:

• It can allow for the reduction or elimination of the traditional seller’s indemnity for breach of representations and warranties.
• It can allow for the reduction or elimination of an escrow or hold back that would otherwise reduce the proceeds received by the seller’s shareholders at the closing of the acquisition.
• It can provide for a cleaner exit to the seller, with fewer contingent liabilities associated with the sale of the company.
• The seller (and seller’s counsel) may feel it can give the more extensive representations and warranties the buyer will want in the acquisition agreement, without as many “materiality” and “knowledge” qualifiers, leading to a quicker resolution of the form of an acquisition agreement.

For buyers, the benefits of such insurance include:

• The buyer’s bid can look much more attractive to a seller if there is no (or limited) escrow or holdback required since the buyer will rely on the insurance for indemnification protection.
• It can extend the time duration of the representations and warranties, giving the buyer additional time to discover problems with the acquired business.
• It can enhance or increase the amount of protection to the buyer, in amounts greater than the seller might otherwise agree to.
• Since the seller will likely be willing to give more extensive representations and warranties in the acquisition agreement, this improves the buyer’s likelihood of prevailing on a claim under the policy.

And, for both parties, the anticipated use of Warranties & Indemnity Insurance usually simplifies and speeds up the negotiation of the acquisition agreement since the seller has less interest in negotiating the scope of its representations, especially if they do not survive closing.

Further, in a deal where there will be some limited post-closing indemnification by the seller’s stockholders, the seller has less interest in resisting materiality caveats where the insurance will cover all losses, and therefore this aspect of the deal negotiation also can be concluded relatively quickly.

Importantly, Warranties & Indemnity Insurance policies typically contain the following exclusions and limits:

• The policy covers up to a certain dollar amount for losses, typically 10% of the M&A deal consideration. Therefore, the buyer can be at risk for extraordinary losses.
• The policy does not cover breaches of the seller’s covenants in the acquisition agreement.
• The policy does not cover purchase price adjustments (such as for working capital adjustments as of the closing date of the deal).
• The policy will exclude losses due to breach of representations and warranties of which the buyer had knowledge, typically defined as “actual knowledge” of certain identified deal team members. Given the extensive due diligence investigation buyers typically undertake (and insurers expect), this exclusion might result in non-coverage of material risks, such as the risk of patent infringement.
• The policy may exclude certain tax-related issues, including taxes accrued on the balance sheet for pre-closing periods, transfer taxes, taxes disclosed on the M&A Disclosure Schedule, and the availability to the buyer of net operating losses and R&D tax credits.
• The policy may include a carve-out for liabilities associated with misclassification of employees/independent contractors and wage and hour laws.
• The policy may exclude liabilities related to asbestos or other environmental issues.
• The policy may exclude forward-looking representations and warranties (such as revenue projections).
• The policy may exclude certain types of losses (such as consequential or multiple damages).

If the buyer has specific concerns about the limits or exclusions (for example, as to intellectual property infringement), some insurers are willing to negotiate coverage under an “excess coverage” rider to the policy or otherwise modify the policy in consideration of the payment of special additional premiums. Nevertheless, for strategic buyers, Warranties & Indemnity Insurance may not be an attractive alternative to traditional post-closing remedies.

To summarise 

Buy-Side Policy :

• Insured: The buyer
• Objective: To provide coverage against financial loss suffered as a result of a breach of the seller’s warranties
• Structure: Warrantors give warranties but these are capped at a lower amount, the insurance policy sits in excess of these warranties
• First party policy: Policy is independent of the seller, therefore the buyer is entitled to make a claim directly against the policy

Sell-Side Policy :

• Insured: The warrantors
• Objective: To provide coverage in the event that the buyer sues the seller for a breach of warranty or indemnity
• Structure: Can insure up to the warranty cap as defined by the sale document
• The policy of indemnity: Seller still retains liability under sale document, therefore is liable for any breach not picked up by the insurance policy