Warranty and Indemnity insurance in M&A transactions
Published on 25th Nov 2020
Warranty and Indemnity insurance in sale and purchase agreements has become an alternative to the warranties traditionally given to the buyer by the seller to ensure fulfillment of the potential indemnification obligations contained in the sale and purchase agreement.
What is a Warranty and Indemnity insurance?
The Warranty and Indemnity ("W&I") insurance covers seller's liability in the event of a breach of its representations and warranties with regard to the situation of the company at the moment the sale and purchase agreement ("SPA") is signed.
This type of insurance policy is increasingly used in M&A transactions and can be subscribed by either the seller or the buyer (it is typically subscribed by the buyer and the premium is often deducted from the purchase price). The premium usually ranges from 1% to 1.7% of the maximum liability covered by the insurance policy.
W&I insurance is an alternative to the warranties traditionally given to the buyer by the seller to ensure fulfilment of the potential indemnification obligations under the SPA, such as a first demand bank guarantee or the holdback or escrow of part of the purchase price.
Common coverage and exclusions
As a matter of principle, W&I insurance covers seller's liability arising from a breach of its representations and warranties under the SPA.
Although the W&I insurance could fully cover the liability of the seller under the terms and conditions agreed in the SPA, W&I policies often exclude the insurer's obligation to pay the indemnification in the following cases:
- known or disclosed facts (for example, contingencies identified in the due diligence or disclosed in the SPA such as specific indemnity obligations or exceptions to the representations and warranties);
- losses and damages arising from fraud or misrepresentation on the part of the insured party;
- any obligations of the seller other than the representations and warranties (for example, the non-compete obligation); or
- certain specific liabilities of the seller (for example, environmental, civil liability for defective products, money laundering or international taxation).
Pros and cons
W&I insurance allows the seller to fully exclude its liability vis-à-vis the buyer after the closing of the transaction (if and to the extent agreed in the SPA) and receive the purchase price in full (once deducted the amount of the W&I insurance premium) without associated financial costs (such as a first demand bank guarantee or an escrow).
The main advantage for the buyer is that it is able to claim directly against the insurer, without having to rely on the seller's solvency after the closing of the transaction.
Thus, this kind of insurance can be especially useful for:
- sellers that may be unwilling to provide warranties (typically in venture capital companies) or that shall remain in the business (such as founders or managers);
- buyers that have concerns about the seller's solvency (for example, in the case of multiple individual selling shareholders); and
- sellers and buyers that will maintain a commercial relationship in the future (avoiding claims for breach of the representations and warranties against each other).
As regards the main disadvantages associated to the W&I insurance, the following could be highlighted:
- the need to involve a third party (the insurer) in the due diligence process carried out by the buyer to assess the risk of the transaction and in the negotiation of the SPA, and the need to coordinate the provisions of the W&I insurance with those of the SPA, which may imply additional costs; and
- in some cases, the insufficient warranty coverage for the buyer, due to the exclusions of coverage in the W&I insurance policy.
The Covid-19 pandemic has still added more complexity to the negotiation and subscription of W&I insurances. The parties should now consider the scope of the coverage or of the exclusions of the risks associated to the loss of value of the companies or the impact of Covid-19 in their businesses, the need to carry out a thorough due diligence exercise in order to confirm the extent of said risks or the increase in the premiums/franchises to face a potential worsening of the claims rate.