W&I insurance is increasingly being used as a mechanism to re-allocate the risk of breach of warranty claims in private market real estate transactions. Janine Fenwick and Ben Brindle of Risk Capital Advisors explain its merits
Warranty and indemnity (W&I) insurance is a tool for a buyer or seller to transfer the risk of liability created by the warranties and indemnities that form part of a share or asset sale agreement in private market mergers and acquisitions (M&A).
W&I insurance is a cost-effective alternative to the “traditional” means of addressing transaction risks such as purchase price adjustments, escrows, hold-backs or parent company/bank guarantees.
The product provides cover for the insured party in respect of financial loss arising from a claim for breach of an insured warranty or indemnity and can be procured by or on behalf of either a buyer or a seller.
The warranties and indemnities that can be insured cover a wide variety of commercial and operational areas, such as:
- title and capacity to shares and the property being sold;
- accounts and financial statements;
- key contracts and assets;
- employees’ litigation and disputes;
- replies to enquiries;
- intellectual property; and
- accuracy of information provided by the seller.
Where the seller is the insured party, the seller and the insurer work together to defend any claims brought by the buyer and where liability is established or a settlement is reached, the insurer will pay any loss directly to the buyer.
Where the buyer is the insured party, there is no need for the buyer to pursue a claim against the seller for a breach of warranty or indemnity. Instead, the buyer has direct recourse to recover financial loss from the W&I insurer. With a buy-side policy, the buyer also has protection against the fraud of the seller.
Why use it?
There can be many reasons why parties involved in corporate real estate transactions are, in increasing numbers, purchasing a W&I insurance policy.
Some of those reasons are:
Provision of debt: Prospective financiers and lenders will typically insist on the buyer obtaining warranties so that it has some element of protection if issues are discovered post-completion. If the seller is a fund, they are unlikely to want to stand behind their warranties. The proceeds of a policy claim can be assigned to the lender.
Credit risk: Buyers can rely on any claims being met by a financially secure insurer rather than taking credit risk from a seller.
Achieving a “clean exit”: Real estate, infrastructure and private equity sellers can close their funds post-disposal without the need to provision for future breach of warranty and indemnity claims.
What types of deals can it be used on?
W&I insurance can be used on a variety of real estate transactions, including the sale of shares, single or multiple asset sales as well as entire portfolios. Users of the product include real estate, infrastructure and private equity funds, corporates and private individuals.
W&I insurance can be utilised in competitive auction processes or proprietary deals. It is possible to insure a wide variety of corporate real estate transactions including retail, office, residential (e.g. student accommodation) and industrial.
Although some tend to focus primarily on transactions in the UK and across Europe, the geographic appetite of many W&I insurers for corporate real estate transactions is wide-ranging. It would not be unusual, for example, for a London-based W&I insurer to insure a transaction that involved a US buyer of a Swedish retail real estate portfolio, where the ultimate shareholder of that portfolio was headquartered in Jersey.
What does it cost?
The cost of a W&I policy is calculated as a percentage of the insurance limit of the insured purchases.
Premium for real estate transactions is around 1 percent of the limit, for a multi-year policy (typically out to seven years for any tax exposure) and can sometimes be even lower for the right deal. For example, one could purchase a policy limit of $30 million for between $275,000 and $300,000.
The premium is a one-time expense and for certain insurance brokers which have the requisite expertise, this includes claims handling services provided by the insurance broker for the life of the policy (typically up to seven years).
The cost associated with the insurance is often shared between the seller and the buyer or subtracted from the final purchase price.
What are the limitations?
W&I policies generally provide cover for breach of general warranty claims – for example accounts or property-related warranties – for a period of between 18 months and three years. For tax warranties and a market-standard tax indemnity or tax covenant, cover can extend for as long as seven years from completion.
The retention or excess under a W&I policy is the uninsured amount that one or both of the parties must bear before the insurer will pay a claim.
Real estate transactions enjoy very low retention levels for W&I policies when compared with other sectors. At present, a typical retention is 0.1 percent of the purchase price, or no retention at all. That means that the W&I policy will respond to all claims over and above the small claims threshold.
Are there limits to what is insurable?
Certain elements of risk are not insurable under a W&I policy, but these categories are limited. Examples of uninsurable risks include:
- Known matters: Matters that are “known” to the buyer, such as issues identified through disclosure or due diligence, provided they have been “fairly disclosed”.
- Forward looking statements: Warranties that cover subject matters like the collectability of book debts or the occurrence of future events.
- Performance obligations: Opinion-based statements about the financial performance of the target or asset going forward.
- Structural defects: Warranties regarding the structural integrity of a building or condition of property, unless there has been comprehensive diligence undertaken by a structural engineer and a written report has been prepared.
- Environmental risks: Certain insurers will not cover pollution or contamination risks, although that does not mean all categories of environmental warranties are uninsurable.
Process and timing
W&I insurance can be introduced at any stage of a real estate transaction, but the earlier a specialist W&I advisor is engaged the more likely it is that the parties will secure the broadest possible cover under the W&I policy.
A seller can incorporate W&I insurance into a transaction at the same time as it prepares a target or asset for sale. W&I insurance can be built into the first-seller draft of a share or asset purchase agreement so that prospective purchasers are aware from the outset that the sole or primary recourse for breach of warranty and indemnity claims will be to an insurance policy rather than the seller.
Buyers can propose that W&I insurance be included in a bid, at the point that they receive preferred bidder status or exclusivity or even after they have completed an acquisition.
The W&I insurance process is designed to run in tandem with the transaction timeline agreed between the parties. A W&I insurer will generally require approximately 10 business days from the date that it is engaged to underwrite the transaction and negotiate an agreed policy with the insured. However, there is flexibility to complete the process in a shorter timeframe where required. The W&I insurer will require access to the data room and disclosure materials prepared by the seller, including any vendor due diligence reports or disclosure letter.
Where the buyer is to be the insured party, copies of all internal and external due diligence reports prepared in connection with the transaction will also need to be provided. At a minimum, W&I insurers expect to see written legal, tax and financial due diligence reports for real estate transactions.
A raft of new W&I insurers have entered the market in the past year and there are now 14 Lloyd’s and company markets which specialise in this product.
In addition to the increase in the choice of insurance providers, those insurers which have been writing business in this market for a number of years have recently increased their insurance capital.Whilst all W&I insurers can offer clients a policy with a limit as low as $10 million, some insurers can now provide a policy limit as high as $175 million for a single transaction. Global capacity for any one transaction has also increased markedly to approximately $500 million.
Janine Fenwick is a director at Risk Capital Advisors. Email: janine.fenwick@ riskcapitaladvisors.com
Ben Brindle is also a director at Risk Capital Advisors. Email: ben.brindle@ riskacpitaladvisors.com