W&I insurance: a practical guide to the Australian M&A market
What is W&I insurance?
Warranty and indemnity insurance is a cornerstone risk management tool for vendors and purchasers in Australian M&A transactions.
While not appropriate or available in all cases, the question of whether to obtain warranty and indemnity (W&I) insurance should be considered at term sheet stage. This is primarily because W&I insurance is a tool by which vendors can seek a clean exit (or at least mitigate warranty claim risks) and the purchaser can provide a measure of comfort to its financiers.
W&I insurance only covers the financial loss that may arise from a breach of representation or warranty.
Two types of W&I insurance are currently on offer in the Australian market:
- Sell-side policy – here the vendor is the insured and the purchaser claims directly against the vendor for any loss. The vendor may recover from the insurer, and depending on the W&I policy, the insurer may control the defence and settlement of any claims.
- Buy-side policy – here the purchaser is the insured and the purchaser may recover directly against the insurer for any loss.
Buy-side policies are by far the most common form of W&I cover taken out.
The W&I paradox
There is a tendency to ask why, if the deal is going to be insured, should the warranties and indemnities in the sale contract be so heavily negotiated. There are two reasons for this:
- to include a regime which the parties are bound to follow in the event that certain warranties or indemnities are not covered under the W&I policy; and
- the moral hazard argument, being that the availability of insurance will relax the energy of a company that should be directed towards reducing the likelihood that an insured event will occur.
An insurer is focused on addressing the latter of these and will reduce or decline cover if it is not satisfied.
Below we offer a number of practical tips for both vendors and purchasers looking to obtain W&I insurance cover.
Obtaining W&I cover – comprehensive due diligence is fundamental
The better the due diligence, the greater (and better) the warranty and indemnity insurance coverage. Insurers are very focused on the extent of the due diligence which is undertaken. They do not want to be the fall guy unwittingly underwriting risk which has not been properly investigated.
Due diligence which is undertaken internally is likely to be questioned by underwriters and may result in a request for the due diligence exercise to be undertaken again or lead to gaps in cover. Underwriters want to know that external advisers, with the requisite level of knowledge, expertise and professional objectivity from the commercial proponents of the deal, have been engaged.
Insurers like to make an informed assessment of the sale process, including negotiations of the warranties, indemnities, limitations and knowledge qualifiers, the quality of due diligence, the Q&A process and the vendor’s disclosures. Insurers are very interested in matters that were within (or outside) the scope of due diligence investigations. They prosecute this interest through underwriting calls with the purchaser’s advisers and a detailed review of the process.
If an insurer is not satisfied with the level of due diligence, the W&I policy may contain exclusions or the insurer may decline cover.
The cost of W&I insurance
The market for W&I insurance in Australia is presently highly competitive. Premiums tend to range from 1-2% of the insured amount for transactions ranging from A$10 million dollars to in excess of A$1 billion.
Typically, a purchaser will pay the costs associated with obtaining W&I cover. This includes the costs of the underwriter’s lawyers and the W&I premium.
The process of obtaining W&I insurance runs concurrently with the M&A process. Early in the life of a deal, a vendor should consider commencing W&I discussions with a broker (whether the policy will be on the sell-side or buy-side).
Some deals come with pre-packaged cover and others simply with a broker warmed up and ready to go.
Front-ending the W&I insurance process will:
- provide a vendor with an early indication of areas of risk that the insurer is unwilling to insure;
- give an indication of likely premiums and excesses;
- reveal what further due diligence must be done for those uninsurable risks to become insurable; and
- give an indication of what purchaser/bidder due diligence should focus on.
A vendor may also commission special vendor due diligence reports (eg legal, engineering, patent attorney etc) to give additional comfort around complex or critical issues. These are in addition to reports which are typically prepared in any event (eg financial).
As part of the sale process, an insurer or purchaser may request that any vendor due diligence report is given on a reliance basis. It will be necessary to liaise with the relevant advisers early on to confirm that this will be acceptable.
Ensuring the W&I policy is as watertight as it can be
Cover tends to be capped at an amount which is less than the purchase price. Depending on the policy, a vendor may be liable for loss suffered by a purchaser that is in excess of the cap. Alternatively, the W&I policy may be standalone, and a purchaser’s only recourse for any loss suffered will be to claim under the W&I policy. That is, any loss suffered over the cap cannot be recouped.
Sometimes cover is “excess of loss,” meaning that a vendor is liable for the loss suffered by a purchaser up to a certain amount and the W&I insurer is liable beyond that level.
In circumstances where there is fraud, willful concealment or dishonesty on the part of the vendor, liability will not be capped. Here, the W&I insurer is likely to have a right to claim for contribution against a vendor or even rescind the W&I policy. The same typically applies to misleading or deceptive conduct under the Competition and Consumer Act 2010 (Cth) and allied legislation.
How can we help
Hall & Wilcox has substantial experience advising buyers and sellers alike on W&I insurance cover and how best to build the product into suitable deals.
Due to deal innovation and reducing costs, we are seeing increased use of W&I cover in the middle market / SME sector where the product had traditionally been seen as a larger deal risk mitigation tool.
This trend is likely to continue in our view.
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