An introduction to warranty and indemnity insurance

An introduction to warranty and indemnity insurance

When a business is sold a seller is usually required to give various warranties to the buyer. Warranties are statements of fact about the target business which protect a buyer in two primary ways: (i) they help to flush out information which is inconsistent with the warranties that the seller is asked to give, and (ii) they give the buyer a contractual right to bring a claim against the seller in the event that they suffer losses in circumstances covered by a warranty.

A seller will therefore remain at risk for the duration of the warranty period – which is typically up to 2 years from the date on which the business is sold for non-tax warranties, and up to 7 years for tax warranties. In the worst-case scenario, a successful warranty claim could result in a seller being obliged to pay back some or all of his sale proceeds. Indemnities can be even more severe; they provide the buyer with a pound-for-pound remedy in the event that losses arise from a pre-identified set of circumstances.

Warranty and indemnity claims are quite rare for a seller who has been well advised and done a thorough job of due diligence and making disclosures, but the opportunity to insure against this worst-case scenario can be attractive. Warranty and indemnity (W&I) insurance is an increasingly popular, affordable and flexible solution – in 2017 it is estimated that over 3,000 deals used W&I insurance. In larger deals it has become market practice to explore at the outset whether W&I cover is appropriate, rather than bringing it in later on when a deal roadblock arises.

In this article we will look at some of the key features of W&I insurance and address some frequently asked questions.

What are the benefits of Warranty and Indemnity Insurance?

The benefits of W&I insurance to a seller include:

  • Allowing individual sellers to make a clean exit and use his or her sale proceeds immediately – for example to retire, buy a home or invest in another business – without the risk that they will later become liable for a warranty claim. In these circumstances the additional costs of a W&I policy can be outweighed by the peace of mind that it delivers.
  • Allowing institutional investors to immediately distribute sale proceeds to investors.
  • Reducing the need for a retention or escrow account (whereby some of the sale price is set aside until the warranty period has expired).
  • Where a seller is selling the business for a nominal amount (e.g. £1) but the buyer still expects warranties to be given as part of the transaction.
  • Enhancing the value of the transaction (i.e. the price) by allowing full warranty provision to be made in circumstances where the sellers would otherwise be unwilling or unable to give warranties.

Equally important, however, are the benefits that W&I insurance can give to a buyer where:

  • They may be reluctant to bring a warranty claim against sellers who continue to be employed by the business after completion – a W&I policy allows claims to be made without damaging the buyer’s relationship with (and potentially losing) some of its most valuable staff.
  • They are concerned about the sellers’ covenant strength – claiming under a W&I policy removes the risk that a seller will not be able to pay out should a warranty claim arise.
  • The acquisition is to be debt-financed, as negotiations with lenders may be helped by the knowledge that a W&I policy will be taken out.
  • The business is being sold at auction and the buyer needs to distinguish itself from other bidders – a W&I policy can be used to provide the full warranty coverage that the buyer requires without leaving the sellers on the hook, benefitting both parties. A seller might also be willing to entertain a lower offer if they know that the sale proceeds will be immediately available to them, rather than having the uncertainty of waiting out a warranty period or having money held back in an escrow account.

There are also various scenarios in which a W&I policy can be used to reach agreement on a commercial point where negotiations have broken down.

Who takes out the policy?

It is possible for either the buyer or the seller to be insured, but the significant majority of W&I policies are taken out by the buyer, for the following reasons:

  • With a seller-side policy the seller is insured, but the buyer will still need to bring a warranty claim against the seller in the usual way. The seller can then claim against the policy if necessary (and covered). This negates many of the advantages of a W&I policy such as preserving the relationship between buyer and seller.
  • With a buy-side policy the buyer is insured, meaning that it can make a claim against the policy as soon as a breach of warranty occurs.
  • Buy-side policies generally protect the buyer against the fraud of the seller, whereas a seller-side policy will not.

The question of who pays for the policy will normally be subject to negotiation and depend upon the commercial strength of each party to the transaction.

How much does it cost?

The overall cost of taking out W&I insurance will include the following elements:

  • The insurance premium, which is a one-off, non-refundable payment that is made when the policy is taken out. The cost of the premium will depend upon the nature of the policy required, the percentage of the purchase price that is to be covered by the policy and the specifics of the transaction (including the identity of the parties), but for UK transactions it is typically around 1% of the amount of coverage required.
  • Most insurers will expect the sellers to share some of the risk with them by paying an excess. This is often held back in an escrow account – and would also typically be around 1% of the policy limit. On a successful warranty claim, the retention will be paid out first to cover the excess before the insurer is required to pay out.
  • Insurers will engage lawyers to review the transaction documents (see below) and advise on the level of risk that they are bearing. These costs will usually be added to the premium.
  • In the UK an insurance premium tax will be applied against the total value of the premium. This is currently set at 12% but has changed several times in recent years.

It should be noted that the figures indicated above will vary on a transaction-by-transaction basis so as to reflect the risk being assumed by the insurer.

As with any product, the cheapest policy will not necessarily be the best option. Buyers and sellers should look for the best, most appropriate coverage, and should consider in detail the flexibility of the provider and the overall cost of the policy (including the amount of retention that is required).

Traditionally the costs of W&I premiums have meant that the transaction value / policy limit at which they start to become economically viable was quite high. However, as W&I policies become more popular, premium costs have started to reduce.

How long does it take to arrange?

The insurer’s lawyers will need time to review key transaction documents such as the sale and purchase agreement and disclosure letter, as well as due diligence reports which have been prepared for the buyer. Most of the work is carried out in the later stages of the transaction, but generally it will take a couple of weeks for the policy to be agreed.

The policy will normally take effect from completion of the business sale, although it may also be possible to enter into a policy after a transaction has completed.

Are there any downsides to W&I insurance?

If the sellers know that the business being sold is very clean and the risk of a warranty claim is therefore very low, the cost of a W&I policy may not seem worth it (although applying the same logic the W&I premium is likely to be much lower to reflect the risk profile). The same principle will apply to lower-value transactions.

A buyer should also be aware that there will be certain costs/losses which are not insured, including:

  • The cost of investigating and bringing a warranty claim.
  • Any claims with a value below the de minimis threshold in the policy.
  • Claims which the insurer disputes, or where loss has been suffered but it cannot be shown to have resulted from a breach of warranty.

Is there anything the policy won’t cover?

It is also important to note that W&I insurance should not be considered a panacea for all risks as there will always be certain matters that cannot be insured against – for example, matters known by the insured party and breaches relating to tax and pensions are typically not covered by the insurance. Insurance will usually not cover claims arising from fraud and dishonesty.

As with most commercial policies, most risks can be insured against, but this is likely to impact upon the cost of the premium. Alternatively, separate policies for known risk areas (such as environmental liability relating to a property) may be available from specialist insurers.

Where there are ‘gaps’ between the warranties given by the seller and the coverage provided by the W&I policy the buyer should carefully review the risks associated with a claim arising which will not be covered by the policies.

We might restructure the target company after completion. Can the policy be assigned to another company?

This should be discussed with potential insurers, but in principle most insurers are happy for the insured party to assign the benefit of the W&I policy to another company within the same group.

This is important because if the underlying business is transferred to a group company then it will be the group company that is at risk of suffering loss for breach of a warranty – and will therefore need to be the beneficiary of the W&I policy.

I’m interested in W&I insurance. What should I do next?

Please do speak to us if you would like more information about W&I insurance. We will be happy to discuss whether W&I insurance might be suitable for you and introduce you to specialist insurance brokers to advise you on the next steps.

If you are in the process of negotiating a deal and think W&I insurance should be used, we would always recommend that you include as much detail as possible in heads of terms, including excesses and total cover, who will be paying for the premium and how this will be reflected in the context of the overall agreement that has been reached.

This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.