knowledge 24 April 2018 |

Insurance for M&A Transactions: Mitigating Risk  

 

Two types of policy

 

(1) Buy side policies

 

A buy-side policy will indemnify a buyer for breach of any warranty / tax indemnity provided by the seller. Most W&I insurance policies are buy-side policies.  Benefits for a buyer include:

 

• direct recourse to an insurer;
• assuages concerns over the financial covenant strength of the sellers;
• if problems emerge, the buyer does not have to sue the seller in an unfamiliar jurisdiction in international transactions; and
• may avoid the embarrassment of claims against managers who gave warranties and who  continue to work in the target business after sale.

 

(2) Sell side policies

 

A sell-side policy can limit the seller’s exposure on warranties / tax indemnities given to the buyer. Sell-side policies are less common. They have two distinct features:

 

• they can be bought after the completion of the transaction or to cover residual liabilities from different historic transactions; and
• they must be kept confidential from the buyer – the insurer’s concern is that if buyers know of the insurance they might be encouraged to sue if the transaction disappoints.

 

How the policy works

 

W&I insurance covers unknown and unforeseen risks only, with some exceptions discussed below. To get this insurance, buyers therefore must carry out the usual full diligence, negotiation of warranties and obtaining of disclosures from the seller. The share purchase agreement should exclude seller’s liability for matters known to the buyer.

 

Where the seller arranges a buy-side policy for the buyer, the seller carries out initial discussions with insurers and will make it clear to the buyer that their liability will be nominal (and that a buyer’s policy will be offered).  The buyer / potential buyers are given a report and once exclusivity is granted, the insurer finalises negotiation for the policy with the buyer.  This in turn can also lead to shorter warranty / tax indemnity negotiations.

 

W&I insurance can sometimes act as additional ‘top-up’ insurance if there are insurance policies already in place in the target company. Supplemental cover for known issues is potentially available where sufficient due diligence has been undertaken and reports are given to insurers.

 

Retention, limits and timing

 

In most W&I insurance policies, there is a “retention” amount (or deductible) which is a fixed amount of insured loss that the insured party must bear themselves before the policy will respond.  The policy will only pay the amount that exceeds the retention.  Ideally, under a buy-side policy, the retention is set to match the aggregate liability cap of the seller, so that as soon as the seller’s liability is exhausted, the policy will respond. 

 

The monetary limitations on liability in the SPA are often higher in insured transactions than in uninsured transactions. The time limits in the W&I insurance policy will typically match those in the SPA, although a buy-side policy can extend the time limits.  For example, if a seller intends to dissolve the selling entity, say, 6 months after completion, it can give warranties for 6 months, but the buy-side policy can continue as required.

 

Excluded claims

 

W&I insurance policies do not cover known liabilities.  Some other liabilities are typically excluded from a W&I insurance policy.  These include:

 

(a)  product liability;

 

(b)  anti-bribery/anti-corruption;

 

(c)   pollution/contamination;

 

(d)   pension underfunding; and

 

(e)   criminal fines and penalties (uninsurable at law).

 

Gap between signing and completion

 

In the past, insurers would not cover issues arising between signing and completion because these were seen as a form of “known” issue. The buyer will usually know about these issues from the supplementary disclosure letter provided prior to completion and will have to make a “no claims declaration” to insurers where warranties are repeated on completion. However, insurers may now be willing to provide “new breach” cover for matters that are discovered during this gap period.

 

Tax liability insurance

Given the increasing complexity of tax law, tax liability insurance has developed as a result of the need for protection from identified tax risks in M&A transactions. Tax liability insurance is predominantly used to provide a buyer comfort and certainty over a known tax issue which has been discovered in the due diligence process.   A tax liability insurance policy will generally cover the tax liability, defence costs, interest, penalties insurable at law and gross-ups (where applicable).  Such a policy is designed to cover interpretation risks rather than implementation risks.