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Looking at some of the effects we have observed over the last year and consider whether this will mark a permanent change in the market.

With the last 12 months having been dominated by the impact of the COVID-19 pandemic, as we start to see the next phase in our adaptation to living with the virus take shape, it is worth noting some of the effects we have observed over the last year and consider whether this will mark a permanent change in the market.

Whilst warranty and indemnity (W&I) insurance has been available for use in corporate transactions for decades, the events of the last year have helped to concentrate the mind of both buyers and sellers around the value of taking out such cover. Additionally, insurers have had to consider the extent to which the cover available needs to adapt to the current environment.

What is W&I insurance?

Commonly the balance of risk in the sale and purchase of the shares in or business and assets of an unlisted company will be managed by the giving of warranties and indemnities by the seller to the buyer. Buyers will be keen to agree to broad warranties about the business which provide comfort that gives recourse if all is not as it was represented to them; sellers will typically want to limit those warranties as much as possible and avoid giving indemnities to provide them with a clean break.

While W&I insurance can be considered on most transactions, particular difficulties can arise where the seller is primarily a financial or ‘arms-length’ investor like private equity or a family trust. Management is best placed to provide detailed warranties but they may only have a relatively small stake in the company and may not have the financial collateral to back them up. A financial investor may well have the financial collateral but will not provide the warranty cover for the business which is in the day to day control of management.

Where there is a gap between the expectations of the parties around warranties and indemnities, W&I insurance can provide a bridge. It is designed to provide cover for financial losses arising from a breach of warranty.

The market provides two alternative types of policy:

  • one is a product for sellers providing cover in respect of the recourse buyers may have against them under the warranties and indemnities given in the transaction; and
  • the other aimed at buyers to provide cover where there is little or no financial recourse against the seller under the sale agreement.

With the former, the interests of seller and insurer are aligned and the policy will only be called on if a claim is made against the seller. The seller remains active as the party with liability and the insurance provides a means of recovery for the seller if it has to pay out.

In the case of the latter, the insurer will effectively step into the shoes of the seller with the intention of providing, as far as possible, back-to-back cover with the position agreed in the sale agreement and other transaction documents. This has an advantage to the seller enabling the negotiation of a cap on seller liability at a more desirable level. Such a policy can also be used to extend the length and breadth of cover that may otherwise have been negotiated with the seller. Such policies are subject to specific negotiation with the insurers and usually attract a one-off premium.

A further variation on the two types of policy referred to above is where the seller requires the buyer to take out a buyer policy as part of the deal. This is more common with private equity auction sales.

It should be stressed that such policies do not abdicate the responsibility of the buyer and the seller in conducting appropriate due diligence and disclosure exercises in transactions and policies will mirror the exclusions routinely seen in sale agreements as well as being subject to transaction-specific exclusions. The cost of W&I insurance is often linked to the enterprise value (EV) of the target and expressed as a percentage of policy limit purchased, referred to as a “rate on line”. It is a matter of negotiation between the buyer and seller as to who pays the cost of the insurance. It should be recognised that the cost of the insurance may be wider than the cost of the insurance premium as often insurers will require their own external due diligence exercise to the carried out which may be in addition to the buyer’s due diligence investigations. Understandably, to minimise its own risk of a claim under the policy, a W&I insurer will want its own advisers to review the due diligence/disclosure undertaken and test the buyer or seller (as appropriate) and its advisers about the depth and quality of the process undertaken. This happens towards the end of negotiations between buyer and seller when most of the detailed parameters of the deal have been hammered out and the due diligence/disclosure exercises concluded so as to give the W&I insurer the clearest picture of the risk it is assuming. Of course, this has an impact on timing and can add a further 10 days to 2 weeks to most transaction timetables.

Impact of COVID-19

In a report published by Thomson Reuters in June last year, it was observed that the likely impact of the pandemic on the application of W & I insurance would be seen in the due diligence and exclusions.

The key observation centred around the anticipated likely effect of the virus and the measures taken in restricting its spread and the impact on employees and supply chain. As we now approach the start of coming out of a third lockdown there is greater evidence as to the short-term effect on companies, particularly around the use of the furlough and tax deferrals, as well as the opportunity to consider more long-term effects on the successful shift to remote working and digital communication. More specifically, the following areas were highlighted in the report as being likely to be subject to greater scrutiny:

  • Financial information and the extension of sign off of year-end accounts which has a knock-on effect to the availability and reliability of financial information. This is coupled with the uncertainty around the exceptional nature of the last 12 months and to what extent historic trading can be relied on as a realistic barometer of future performance;
  • Treatment of employees and operational matters. The need to assess risk around employees and how they interact and work safely over the last year has been a major concern for many employers. This has also enhanced the duty of care afforded by employers around the mental and physical well-being of employees which is a responsibility that is likely to increase as we learn to live with the threat of COVID-19 as we come out of lockdown.
  • Contract due diligence and supply chain management.
  • Compliance with banking covenants and the repayment of CBILs and other temporary funding measures.
  • Government support measures more generally and how these have been used and any implications around misuse.
  • Implications for cyber security risks.

The report also suggested that the W&I policies would likely move to include broadly-drawn COVID-19 exclusions based on the fact that there would be little meaningful due diligence to enable a fair assessment of risk. However, that argument has diminished with the adoption of a more sophisticated approach as the market develops a better understanding of the quantifiable risks which have evolved over the last year and will continue to evolve as we move further into 2021.