We are seeing an increase in the use of warranty and indemnity insurance (w&ii) on corporate transactions and the signs are that this trend is going to continue. So, what’s the attraction?
What is warranty and indemnity insurance?
When a company or business is sold, the buyer will usually require warranties form the seller. In the event that these statements of fact about the business are found to have been untrue (and the seller has not formally notified the buyer of these facts), the buyer will have a contractual claim against the seller for loss suffered.
The parties will usually agree certain limitations on the seller’s liability; however, the buyer’s ability to bring a warranty claim usually last between 2 and 7 years and so the seller has the possibility of a claim lingering for what could be a fairly lengthy period after the sale.
W&ii is a way of mitigating this risk as the policy would (subject to qualification criteria being met) pay out to cover the cost of such claim. The policy can either be taken out by the seller or buyer (although buyer side policies tend to be more common).
Buyer side v seller side policies
Buyer side policies often result in a drop in the purchase price to take into account that the buyer has to cover the cost of the policy premiums (usually around 1-2% of the amount insured). However, this usually results in the seller receiving a larger sum upfront since the buyer is less likely to insist on a retention of part of the purchase price for the duration of the warranty claim period. In this way the seller has the benefit of a “clean break”.
The seller may be asked to bear liability for claims up to the policy excess or a certain percentage of the purchase price. Equally, it is possible for seller liability to be capped at a nominal amount (e.g. £1); however, policy premiums are normally more competitive where the seller accepts some liability as it serves as an incentive to engage properly in the disclosure process.
Sellers may want to limit their exposure to warranty claims by taking out a w&ii policy themselves. It is usually prudent to keep the existence of the policy confidential from the buyer (and it may even be a requirement of the policy to do so) since the availability of the policy could increase the likelihood of a buyer claim.
Seller side policies can be put in place in advance of or after the ale, but a broker should be consulted at an early stage to discuss terms.
A seller side policy will not affect the amount of any retained purchase price – the buyer may still demand this pending expiry of the claim period.
What are the advantages of warranty and indemnity insurance?
- Useful in private equity backed deals and transactions where the seller remains involved with the business, as the investor/buyer is unlikely to want to claim against the continuing management team. A claim against an insurance policy is more neutral.
- Buyer may view the insurance provider as a better covenant than the seller – especially where there are multiple individual sellers.
- Buyer may be able to secure better terms with a lender financing the transaction if the lender is aware that there is a policy in place.
- Immediate release of funds to the seller as retentions not necessary (or where they are required, they are likely to be for much smaller amounts – perhaps to cover just the excess on the policy).
- Seller has benefit of a “clean break” and is not looking over their shoulder for the duration of the warranty claim period.
- Very useful where you have a number of sellers who are silent investors and who really don’t want to give warranty cover since they know little about the business. This saves them the risk and also means they don’t all have to become too engaged in the burdensome sale process.
- It is actually possible to get insurance for a known specific warranty breach or indemnity – ie a known breach of IP rights – which is useful if private equity doubt the financial strength of the sellers or are reluctant to sue their now management team following an investment.
Is warranty and indemnity insurance a replacement for disclosure?
No, quite the contrary. The insurer will expect to see that a thorough due diligence and disclosure process has taken place. Any shortcomings in this exercise are likely to result in the insurer demanding increased premiums.
With warranty and indemnity insurance being more readily available and premiums becoming more competitive, it can be a useful mechanism for giving the parties increased financial security whilst enabling a clean break with funds being released to the seller immediately on completion. We are therefore expecting to see its use continue to grow.
If you would like to discuss any of the content of this blog please do email Jennifer Packer.