Use of Warranty & Indemnity insurance in M&A transactions

In corporate mergers and acquisitions, risk management is a crucial aspect. The use of Warranty & Indemnity insurance (“S&I insurance”) can mitigate such risks. This insurance protects both the seller and the buyer against certain liabilities arising from the warranties and indemnities included in the transaction agreement. In this article, I explain what S&I insurance is, why it is used, what the concerns are, and what the advantages and disadvantages are. In addition, I elaborate on the impact of S&I insurance on negotiation strategies.

What is Warranty & Indemnity insurance?

In acquisition practice, warranties and indemnities are one of the most important things that are settled. Of course, the buyer always wants more and more extensive warranties and indemnities from the seller. For the seller, the opposite is true: the seller wants to provide as few warranties and indemnities as possible.

S&I insurance is an insurance policy that provides coverage for damages resulting from a breach of warranties or indemnities in an acquisition. The insurance can be taken out by either the buyer or the seller. In the first case, the buyer receives compensation from the insurer in case of breach of warranty, while in the second case, the seller limits its liability by taking out the insurance. This provides security for both parties and prevents financial claims from causing problems long after the transaction. In practice, insurers will conduct a detailed assessment of the transaction and the due diligence involved. After all, the insurer will have to make its own assessment of the risks.

A distinction must also be made between an S&I insurance policy taken out by the buyer, called a buyer’s policy, and an S&I insurance policy taken out by the seller, called a seller’s policy. With a seller’s policy, the buyer will still have to appeal to the seller; he cannot appeal directly to the insurer. Even if the seller does not pay the claim, the buyer will in principle not be able to go to the insurer. Indeed, the buyer is in principle completely outside the relationship of the seller and the insurer. With a buyer’s policy, however, the buyer will have to approach his insurer immediately, because the seller is then outside the relationship of the buyer and insurer.

Why are W&I insurances used?

Negotiating warranties and indemnities is basically only useful if the seller can provide recourse for breach of the warranties or indemnities. The buyer will often require collateral from the seller for this purpose. In recent years, S&I insurance policies have been increasingly used, because they protect the seller from future claims and give the buyer certainty that any damages will actually be compensated. This is particularly important in situations where the seller wants to secure its proceeds immediately without having to hold a portion in escrow. S&I assurances can facilitate negotiations because parties need to spend less time discussing the forms of security for any breaches of warranties or indemnities. It allows strategic buyers to complete transactions with a higher degree of certainty.

What should you look out for when using H&I insurance?

Although S&I insurance offers many benefits, there are some concerns. Not all risks are covered; for example, insurers routinely exclude tax liabilities and certain environmental claims. It is also common that only general tax indemnities can be insured, provided there is uncertainty on the part of the policyholder.

Of course, there are costs involved, with premiums typically ranging between 1% and 3% of the insured amount.

Also, proper due diligence is very important as insurers in principle do not pay out if certain facts were already known or could have been discovered with proper due diligence.

It is also important to consider the insurer’s role in the claims process. Insurers typically have strict requirements for proving loss, and claims processing can be time-consuming. Also, the definition of “loss” and how it is determined varies from policy to policy and should be carefully assessed in advance.

Finally, the term of coverage is limited, typically to a period of 12 to 36 months after the transaction, depending on the policy terms.

The impact of S&I insurance on negotiations.

The use of S&I insurance also impacts the dynamics of M&A negotiations. Because the insurance takes over risks from the seller and buyer, parties can agree on warranties and indemnities more quickly. This is precisely because a certain amount does not have to be kept aside by the seller, for example, for any compensation for damages. This can be especially helpful in competitive bidding, where buyers can differentiate themselves by purchasing insurance rather than making a heavy warranty claim against the seller.

Advantages and disadvantages of S&I insurance.

The main advantage of S&I insurance is that it limits the seller’s liability and provides the buyer with additional security for warranty claims. This reduces the need to hold amounts in escrow and makes the negotiation process smoother and faster. In addition, it can provide a competitive advantage for strategic buyers in bidding processes. On the other hand, it involves additional costs and does not cover all risks. Moreover, S&I insurance can falsely provide a sense of security if due diligence is not performed carefully enough.

Conclusion

S&I insurance is a good tool in acquisition practice, especially for parties who want to limit their risks and ensure smooth negotiations. They offer protection to both buyers and sellers, but also come with costs and restrictions. The impact on negotiations and transaction dynamics is certainly present, especially in competitive processes. While S&I insurance is no substitute for thorough due diligence and careful contract negotiations, it can be an essential tool to avoid conflict and post-transaction financial uncertainty. For companies considering S&I insurance, I recommend carefully analyzing the policy terms and seeking legal advice.

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