We are seeing an increase in the use of warranty and indemnity insurance (W&I) on transactions, which is a theme we expect to continue as buyers target companies that are in financial distress in the wake of Covid-19.
W&I has become commonplace in the UK M&A market as a way to ‘bridge the gap’ between buyer and seller when allocating risk. Traditional W&I policies insure against a breach of the warranties contained in the underlying sale and purchase agreement (SPA). The insurer relies on the parties to the SPA to negotiate the warranties as if no insurance is in place.
Whilst the uncertainty and risk posed to companies by Covid-19 could be seen as a risk to W&I cover, insurers have taken a more pragmatic and pro-active approach. No doubt mindful of the likely increase in deals coming to market where the seller cannot or will not give meaningful warranties, either because the target or seller is in financial distress (including being subject to a formal insolvency process) or with sellers of uncertain credit worthiness, insurers have responded by offering more policies insuring against breach of entirely ‘synthetic’ warranties.
Synthetic warranties, which are negotiated by the buyer directly with the insurer (and, although not contained in the SPA, are deemed given by the seller to the buyer) are not a new concept. Their value lies in giving downside protection to a buyer when seller protection is limited, particularly in the case of accelerated distressed deals.
Before buyers rush to put synthetic W&I policies in place as a means of enabling a distressed deal to complete, they should understand that a number of factors determine the availability (and scope) of the cover.
- Insurers expect a buyer to carry out due diligence before offering a synthetic policy. As a consequence of Covid-19, we expect underwriters may require increased diligence on business continuity matters and the impact of Covid-19 on the target. This could impact on a transaction timetable
- An insurer will want to know that the buyer has priced the Covid-19 (or other) risk into the deal. A failure to do so by the buyer will likely have an impact on the coverage offered. W&I cover is not designed to enable a buyer ‘to do a bad deal’
- Higher premiums are charged for synthetic W&I policies, and we anticipate that the impact of Covid-19 and the likelihood of increased claims could see premiums rise still further.
- Undoubtedly insurers will prefer to insure a deal where there is a management warranty deed, even where management’s liability is capped at £1,000, as they get the comfort that a disclosure exercise has been completed.
As the Covid-19 pandemic evolves, so does the market for W&I and, notwithstanding any increase in premium or the level of diligence required, W&I policies may prove the right solution to enable post-Covid-19 deals to be done. To ensure that the insurer understands the transaction and the risk, it is more important than ever to take the right advice and for the deal team to work closely with W&I providers early in the transaction to structure the right deal.