Warranty and Indemnity Insurance: a risk mitigation tool in Private Equity

Warranty and Indemnity (W&I) insurance has emerged as a crucial tool for risk management in private equity transactions, enabling the transfer of responsibilities from the seller to the insurer. This article analyzes the advantages of W&I policies compared to traditional mechanisms such as escrow and bank guarantees, exploring their impact on liquidity, fund certainty, and opportunity cost. It also examines the underwriting process, typical exclusions, and potential future innovations in the M&A insurance market.

Translated article written for ilQG - Altalex

How W&I is revolutionizing risk management in M&A Transactions

Private equity transactions are characterized by high complexity, especially regarding the management of risksassociated with representations and warranties provided by the selling party. In this context, Warranty & Indemnity (W&I) insurance has established itself as one of the most effective tools for mitigating such risks, often becoming the only available remedy. This article aims to explore the complexities of W&I insurance, its multiple benefits, and its transformative impact on the private equity landscape.

W&I insurance represents a highly specialized insurance product. Its primary purpose is to cover liabilities that may arise from breaches of warranties and indemnities in M&A transactions. Its diffusion has been favoured by the increase in the size and complexity of transactions, as well as the need, both for sellers and buyers, to minimize post-closing risks.

To fully understand the value and importance of W&I insurance, it is essential to contextualize it within the broader scenario of breaches of representations and warranties in M&A transactions. Traditionally, when such a breach occurs, a series of established remedies are available. These include contractual guarantees, which offer direct legal protection; price adjustments, which allow modifying the transaction value based on discrepancies discovered later; earn-out mechanisms, which tie part of the payment to future performance; bank guarantees, which provide external financial security; and escrow deposits, which involve depositing part of the purchase price with a third party. Each of these mechanisms, while offering specific advantages, also has limitations.

For example, escrow accounts, although providing almost absolute certainty of funds, have the disadvantage of tying up a substantial portion of capital, making it inaccessible for an extended period. This can be particularly onerous for sellers, who may have immediate liquidity needs or reinvestment opportunities. On the other hand, bank guarantees, while offering a high degree of financial security, often involve significant costs and can be administratively complex to manage, requiring separate negotiations with financial institutions and potentially affecting the seller's existing credit lines. It is in this context that W&I insurance emerges as a particularly attractive and innovative alternative. Comparing W&I insurance with more traditional approaches such as escrow and bank guarantees, substantial differences emerge that highlight its advantages.

In terms of fund certainty, while escrow offers almost absolute security (subject to potential claims from other creditors), both bank guarantees and W&I insurance depend on the financial status of the bank and insurer, respectively. However, considering the financial solidity and rigorous regulation to which insurance institutions offering W&I policies are subject, the level of security offered is generally considered high.

A fundamental aspect where W&I insurance clearly stands out is risk transfer. While neither escrow nor bank guarantees offer true risk transfer, W&I insurance allows effectively transferring the risk to the insurer. This represents a significant advantage, as it frees both the buyer and the seller from potential future liabilities related to the transaction.

Regarding costs and administrative burdens, W&I insurance offers considerable advantages. While escrow involves average but prolonged costs over time and bank guarantees present high and also prolonged costs, W&I insurance is characterized by medium-low and, most importantly, one-time costs. This means that once the policy is stipulated, there are no further costs or administrative burdens to manage, greatly simplifying the post-transaction process.

The operationality of coverage is another aspect where W&I insurance differs. While for escrow and bank guarantees, operationality depends solely on the sale contract, for W&I insurance, it is determined by both the sale contract and the insurance policy. This double level of definition can offer greater flexibility and customization of coverage based on the specific needs of the transaction.

Finally, the opportunity cost for the seller is a crucial factor to consider. With escrow, funds are tied up and unusable, representing a high opportunity cost. Bank guarantees, while not directly immobilizing funds, can significantly reduce the seller's credit capacity. W&I insurance, on the contrary, presents a very low opportunity cost, allowing the seller to have full access to the proceeds of the sale immediately after the closing of the transaction.

W&I insurance offers advantages for both sellers and buyers, contributing to making private equity transactions smoother and more efficient. For sellers, one of the main advantages is the possibility of a "clean exit." This means they can exit the transaction with minimal or no future liabilities, an aspect particularly appreciated in scenarios such as the sale of stakes by private equity funds that are closing or the sale of non-core assets by large companies. Moreover, W&I insurance effectively replaces the need for escrow or bank guarantees, immediately freeing up capital that would otherwise be tied up. This allows sellers to have full freedom in distributing the proceeds of the transaction, a significant advantage in terms of financial flexibility and reinvestment opportunities.From the buyers' perspective, W&I insurance offers a series of strategic advantages. First, it allows obtaining guarantees even in situations where the seller might be reluctant or unable to provide them directly. This is particularly relevant in scenarios such as bankruptcy sales or transactions involving multiple sellers. Additionally, W&I insurancemight offer a higher limit or duration of coverage than the seller would be willing to grant, thus providing broader protection to the buyer.

Another significant advantage for buyers is the coverage of the seller's creditworthiness. In transactions where the seller's financial solidity might be uncertain or variable over time, W&I insurance provides an independent and reliable guarantee. This can be particularly useful in cross-border transactions or in sectors characterized by high volatility.

W&I insurance can also represent a differentiating element in competitive auction processes. An offer that includes a W&I policy can appear more attractive to the seller, as it reduces potential post-closing complications and offers greater certainty of closing the transaction. Moreover, in investment or co-investment scenarios where the buyer anticipates maintaining business relationships with the seller, W&I insurance can facilitate maintaining positive relationships by reducing the risk of future disputes related to warranties.

The coverage offered by W&I insurance is generally very broad, including a wide range of warranties typically present in M&A transactions. These include fundamental warranties, which concern essential aspects such as the ownership of shares or assets subject to the transaction; account warranties, which cover the correctness and accuracy of financial statements and information provided; and a series of business warranties that can range from financing to material contracts, from employees to regulatory compliance, from intellectual property to insurance, from litigation to insolvency, from activities from the date of the last balance sheet to real estate.

Particular attention is often dedicated to environmental warranties, which cover aspects of compliance and permits related to environmental regulations, an area of growing importance and scrutiny in modern transactions. Finally, tax warranties represent a critical area of coverage, given the complexity and potential scope of tax liabilities in many jurisdictions.

However, it is fundamental to note that some areas are generally excluded from W&I insurance coverage. These exclusions typically include fraud and known facts (actual knowledge), as insurance is not intended to cover fraud or intentional omissions. Forward-looking warranties are also generally excluded, as insurance focuses on facts and circumstances existing at the time of the transaction rather than future projections.

Other common exclusions concern civil and criminal sanctions, post-closing consideration adjustments, reorganizations and losses, specific tax issues (such as transfer pricing), specific environmental liabilities (such as pollution or hazardous materials), anti-corruption, asbestos and construction defects on real estate, defective products or services, medical malpractice, and some employment-related issues such as the reclassification of employees and consultants.

The underwriting process for W&I insurance generally consists of two main phases. The first is the scouting phase, which typically lasts 5 to 7 working days. During this phase, the insurer conducts a preliminary assessment of the transaction, examining key documents and evaluating the feasibility and general terms of coverage.

The second phase is the actual underwriting process, which usually requires 10 to 15 working days. In this phase, the insurer conducts thorough due diligence, examining in detail all transaction documents, including due diligence reports, the sale and purchase agreement, and disclosure letters. The objective is to accurately assess the risk profile of the transaction and define the specific terms of the policy.

W&I policies have key characteristics that are important to understand to evaluate their suitability in a specific transaction. The liability limit, or the maximum amount the insurer will pay in case of indemnity claims, is typically between 15% and 25% of the enterprise value. This limit can be negotiated and adapted to the specific needs of the transaction.

The retention, or deductible, is usually set between 0.5% and 1% of the enterprise value. This represents the amount that must be exceeded before the insurance begins to cover liabilities. It is important to note that the retention is a fixed amount for the entire duration of the policy, thus offering a clear delimitation of responsibilities.

The duration of coverage varies depending on the type of warranty. Typically, fundamental and tax warranties are covered for 7 years, employment and environmental warranties for 5 years, and business warranties for 3 years. This structure reflects the different nature and potential duration of liabilities associated with each type of warranty.

The insurance premium for W&I policies generally ranges around 1-2% of the liability limit. An important feature is that the premium is paid one-time at the closing date, thus eliminating the need for recurring payments. The premium tax varies depending on the jurisdiction of the insured; for example, for an Italian entity, the tax is 21-25%.

In addition to the premium, an underwriting fee is provided, typically in the order of 20-30 thousand euros. This fee covers the costs associated with the due diligence and underwriting process conducted by the insurer.

An area of particular concern in M&A transactions, which deserves specific consideration in the context of W&I insurance, are breaches that occur during the interim period. These breaches present unique challenges, as they occur at a time when the buyer has already made a contractual commitment but does not yet have full control of the target company.

Standard W&I policies typically do not cover these interim period breaches, potentially creating a significant coverage gap. To address this issue, some insurance companies have begun to offer specific products or extensions of W&I policies that also cover this critical period. However, these solutions require careful evaluation and often involve additional premiums or specific conditions.

In addition to W&I insurance, the insurance market offers other specialized products that play crucial roles in M&A transactions. Among these, contingent liability insurance and title risk insurance deserve particular mention.

Contingent liability insurance is a versatile tool that covers heterogeneous specific risks identified during the due diligence process. These may include potential litigation, not fully quantifiable environmental liabilities, or specific tax liabilities that could emerge in the future. The duration of these policies is generally limited to 7-8 years, except in cases of previous legal prescription. The maximum limit and deductible are negotiable elements, adaptable to the specific needs of the transaction and the nature of the covered risk.

A distinctive feature of contingent liability insurance is the need for a third-party opinion in the underwriting process. This requirement adds an additional level of due diligence and risk assessment, contributing to a more accurate determination of the policy terms. The cost of this insurance varies significantly depending on the covered case, with premiums typically ranging between 4% and 10% of the indemnity limit. Despite the potentially high cost, this type of insurance can be crucial to unlock transactions otherwise blocked by specific risks that are difficult to quantify or accept for the parties.

Title risk insurance, on the other hand, focuses on a fundamental aspect of many M&A transactions: the certainty of ownership of the asset or shares subject to the transaction. This policy specifically covers ownership issues, such as problems related to reduction actions in succession cases, offering protection for both risks unknown at the time of the transaction and issues that emerged during due diligence but were considered low risk of materialization.

A particularly attractive aspect of title risk insurance is its coverage for full value losses. This means that in case of third-party claims on the ownership of the asset, the insurance can cover the entire value of the asset itself, offering complete protection to the buyer. The policy focuses on named and specific risks, not replicating the general warranties of the Share Purchase Agreement (SPA), but focusing on ownership issues.

The duration of these policies can extend up to 10 years, except in cases of previous prescription, thus offering long-term protection that can significantly exceed the duration of standard warranties in an SPA. The cost of this insurance is generally more contained compared to contingent liability insurance, with premiums typically ranging between 0.2% and 0.4% of the indemnity limit. This makes it an attractive option for many buyers, especially in transactions involving high-value assets or in jurisdictions with less reliable property registration systems.

In conclusion, Warranty and Indemnity insurance, along with other specialized insurance products such as contingent liability insurance and title risk insurance, has revolutionized risk management in private equity transactions. These tools offer flexible, efficient, and economically advantageous alternatives to traditional guarantee methods, facilitating smoother transactions and aligning the interests of buyers and sellers.

The growing adoption of these insurance products reflects their effectiveness in addressing the main concerns in the M&A process. However, it is fundamental to emphasize that W&I insurance and related products are not a panacea for all risks related to transactions. Their effectiveness depends on a series of factors, including the quality of due diligence, the structure of the transaction, and the clear understanding and negotiation of policy terms.

To maximize the benefits of these insurance tools in private equity transactions, an approach that includes careful consideration of the specific context of the transaction, thorough due diligence, and the involvement of legal and insurance experts from the early stages of the process is essential. Furthermore, it is crucial that all parties involved fully understand the terms, conditions, and exclusions of the subscribed policies.

Looking to the future, one can expect that the continuous evolution of the M&A insurance market will lead to even more sophisticated and personalized products. The growing complexity of private equity transactions, combined with increased regulation in many sectors, will likely stimulate further innovations in this field. Parties involved in transactions will need to stay updated on these developments to fully exploit the opportunities offered by these risk management tools.

Ultimately, W&I insurance and related products represent not only risk mitigation tools but also catalysts for more efficient and secure transactions in the private equity landscape. Their intelligent and strategic adoption can significantly contribute to the success of transactions, facilitating value creation and growth in the dynamic world of mergers and acquisitions.

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