DealMakers - Q3 2022 (released November 2022)
W&I insurance – A key consideration for M&A transactions (Part 3)
by Andrew Giliam and Anita Moolman
Catering for W&I insurance in the sale agreement
A sale agreement should contain provisions dealing with the W&I insurance arrangements between the contracting parties. These include provisions allocating the responsibility for paying the insurance premiums and the costs of obtaining insurance, negotiating and concluding the policy and delivering documents to the insurer under the policy. It is advisable that the conclusion of the W&I policy be catered for in the sale agreement, as a condition precedent to a transaction closing. This will promote certainty between the parties as to where the liability for breaches of warranty will lie from the closing date of the transaction.
In the case of buy-side policies, it is important to ensure that the relevant concepts under the sale agreement relating to losses, liabilities, claims periods, adverse consequences and the like are replicated in the W&I policy to ensure that there is no residual recourse to a seller under the sale agreement. For this reason, where a deal is covered by a buy-side policy, the sale agreement will usually contain general provisions that limit or exclude the buyer's recourse against the seller for warranty or indemnity claims.
The sale agreement should also record which party bears the risk for claims that are not covered by the W&I insurance policy. For buy-side policies, this risk will usually be borne by the buyer, given that the primary purpose of the insurance in such circumstances is to allow a seller to achieve a clean exit. However, it is open to the parties to agree a different position. For example, a seller may remain residually liable to the buyer for damages that arise the buyer as a result of a claim that is expressly excluded from the insurance cover. In each case, it will come down to what is agreed between the parties in the sale agreement.
The insurer will need to approve and sign off on the sale agreement. There is also usually a general restriction on material amendments to the sale agreement and other material transaction agreements without the prior written consent of the insurer.
Overview of the process
There is no one-size-fits-all approach to procuring W&I insurance. The process will usually be deal-specific. In addition, as the market evolves and W&I insurance products develop to meet the needs of transacting parties, so too does the underwriting process evolve. This overview of the W&I insurance process is based on our experience of historical transactions as at the date of this article.
A broker should be appointed to manage the W&I process, to interface with the underwriters, and to advise the transacting parties on the process. The broker will usually use the term sheet, transaction memorandum or initial drafts of the main transaction agreements to obtain a range of non-binding offers from underwriters. These non-binding offers will generally contain indicative key commercial terms of the insurance policy, including the expected breadth of coverage, the duration of the coverage, the price, any retention amount required by the insurer and the de minimis claim threshold. The broker will often assist the parties in comparing the relevant offers and selecting an appropriate underwriter.
Once an underwriter has been selected by the parties, the underwriter (and its counsel) will be given access to the due diligence data room and the final due diligence reports. They will also be given the transaction agreements containing the warranties and indemnities to be underwritten. The underwriter will interrogate the data room, the due diligence reports prepared by the transaction parties' counsel and the warranty/indemnity lists.
Following this review, the underwriter will generally submit written questions to the transacting parties' advisors and request written responses from the insured party. After these exchanges, there will usually be an "underwriting call" where the insurers and their counsel investigate how the insured party and its counsel obtained comfort on the issues discovered during the due diligence process. It is advisable to maintain a paper trail of questions and answers between the due diligence service providers and the target, to be able to illustrate to the insurer how the parties obtained comfort on risks identified during the course of the due diligence.
Throughout this process, the underwriter is seeking to obtain comfort that each of the warranties and indemnities in the transaction agreements have been properly investigated for accuracy and/or whether there are mitigating factors that the parties have considered, which reduce the risk of a warranty or indemnity claim materialising.
Following the underwriting call, the insurance policy will be drafted and negotiated. The insurance policy is typically negotiated between the insured and the insurer. Depending on the level of activity in the market, the complexity of the deal, and the amount of material that insurers and their counsel are required to review, obtaining W&I insurance, that is, signing the insurance policy, will generally take between two and five weeks.
Typical terms of the W&I policy
Each underwriter has their own W&I policy template which is amended to cater for deal specific issues. A W&I policy usually comprises of:
(i) a policy schedule which contains the commercial terms of the policy, and
(ii) the general terms and conditions relating to the cover provided.
The policy schedule will include the deal-specific commercial terms of the insurance cover. This will include, amongst other things:
the details of the insurer and the insured party;
the inception date and duration of the insurance cover;
the amount of the premium payable to the insurer;
the total limitation of the insurer's liability, being the maximum amount that can be claimed from the insurer under the policy;
a de minimis amount, being the minimum amount that can be claimed from the insurer in respect of any one claim under the policy; and
a retention amount, being an amount that needs to be eroded in its entirety before any claims are paid out by the insurer. This essentially specifies a portion of losses that will need to be borne by the insured party before the insurer becomes liable for claims, and represents a risk-sharing mechanism. Policies without a retention amount included will generally attract higher insurance premiums.
A W&I policy will not necessarily provide cover for all warranties and indemnities in a given sale agreement. A policy will contain a number of exclusions or limitations on cover, including:
certain standard exclusions (which will differ from insurer to insurer) which generally relate to bribery, corruption and money- laundering, price adjustments, forward looking information, post-closing events, asbestos liability, changes in accounting methods, consequential loss, certain environmental risks and tax risks (such as transfer pricing). The standard list of exclusions will differ slightly from insurer to insurer. On sell- side insurance, a seller will also typically not be covered for fraud or fraudulent non-disclosure by the seller. While these general exclusions are always a feature of a policy, an insurer may be willing to negotiate the exclusions, depending on their relevance to the transaction and the target, in-house business policies, and other mitigating factors that the parties can raise; and
specific exclusions or partial carve-outs from cover relating to known issues or issues that have been disclosed or identified during the due diligence process. Usually, the extent of the cover for each warranty is set out in a cover spreadsheet which lists all of the warranties, and the extent to which the insurer will insure the risks, ranging from complete cover to partial cover (and the extent of the partial cover), and complete exclusion.
The cover on warranties and indemnities is also usually limited under the policy to the extent that any matter, fact, or circumstance has been disclosed during the due diligence or is included in a disclosure schedule or other disclosure materials. In other words, if there is a known issue with any of the warranties which has not been otherwise mitigated in a way that is satisfactory to the insurer, the insurer may decline to provide cover for that warranty, either entirely or to the extent of the known issue.
The W&I policy will also oblige the insured party to disclose matters it becomes aware of during the interim period between signing of a sale agreement and the closing date during a bring down or ongoing disclosure process. To the extent that an insured party is not willing to accept and bear the risk of the policy exclusions, it will have to find comfort in some other way. This may include allocating the risk to the seller in the sale agreement (if this can be agreed) or obtaining additional specialised insurance relating to the applicable risk, or by implementing post-closing mitigation measures. As an aside, W&I insurance is not designed or intended to replace other forms of business insurance (such as directors liability insurance, professional indemnity insurance, business interruption insurance etc).
The W&I policy will also specify details around the payment of the premium and the delivery to the insurer of final copies of the transaction agreements, disclosure materials and other prescribed information within a certain number of days from the inception date to avoid the W&I policy being terminated. A buy-side W&I policy will also usually limit the insurer’s rights to subrogate settled claims against a seller, except in situations where the seller has been fraudulent or has acted in wilful default.
While it has its drawbacks, the benefits of W&I insurance make it an attractive prospect in the context of a wide variety of M&A transactions, and offers significant comfort to a buyer and seller. W&I insurance may be unsuitable for smaller deals, given the costs involved and the extent to which insurers require the insured party to share in a level of the risk. W&I insurance may also not be an attractive option to the parties where the insurer requires a high level of risk sharing by way of a large retention amount, although there will generally be underwriters in the market who are willing to negotiate on the retention position.
However, at the very least, obtaining W&I insurance should be a consideration at the start of any arms- length deal where warranties and indemnities are provided. Transacting parties should raise the possibility of obtaining W&I insurance with their advisors at the earliest opportunity.
Giliam is a Senior Associate and Moolman a Director in Corporate & Commercial | Cliffe Dekker Hofmeyr