Warranty and Indemnity insurance is a specialist type of insurance used in mergers and acquisitions transactions to protect both buyers and sellers. We take a closer look.
What is warranty and indemnity insurance?
Warranty and indemnity, or W&I, insurance is a type of transactional risk insurance. This bespoke insurance product comes into play to protect both buyers and sellers in mergers and acquisitions (M&A) transactions.
During an M&A negotiation, the seller makes certain representations about the business being sold. These are underpinned by warranties and indemnities, a source of risk for the buyer if a breach occurs. W&I insurance is taken out to mitigate that risk, transferring the financial cost of potential liabilities arising from a breach of the representations and warranties to the insurer, subject to exclusions.
The use of W&I insurance is on the rise, mirroring the increase in M&A activity in Asia and across the world, and this trend is expected to continue.
Who needs warranty and indemnity insurance?
W&I insurance is a bespoke product used in the specific context of an M&A transaction. Policies are drafted and underwritten on a case-by-case basis. A W&I policy can be taken out either by the buyer or the seller in the transaction although buy-side policies, taken out by the buyer are more common.
With a buy-side policy, in the event of a claim, the buyer is reimbursed by the insurer rather than the seller. There are a number of benefits to the buyer including increased leverage in a negotiation, a smoother negotiation process, protection against the risk of insolvency of the seller, simplification of ongoing relationships with the seller, the removal of commercial tension in the event of a claim if sellers stay on to run the business and a more streamlined indemnification process.
In the case of a sell-side policy, a W&I policy enables a clean exit from the transaction by removing exposure once the transaction has been signed. Any claims on warranties or indemnities after that time will be dealt with by the insurer. Again, exclusions apply. In certain cases, a sell-side policy can be flipped to cover the buyer once the transaction is completed.
A seller also benefits from a smoother negotiation process with a W&I policy in place. Another major advantage is that W&I insurance can remove the need for escrow holdbacks of the purchase price to provide for potential warranty claims.
Warranty and indemnity insurance: a hypothetical case study in an M&A transaction
During the M&A negotiation
BTX, a mid-sized technology firm based in Singapore, was seeking to acquire a smaller software development company in Malaysia to expand its product offerings and strengthen its market presence in the region. The negotiation and due diligence process revealed potential risks associated with the target company’s financial statements, intellectual property, and client contracts.
During the due diligence process, BTX identified several areas of concern, including:
- Inconsistencies in the reported revenue figures of the target company.
- Unclear ownership rights and potential disputes related to key intellectual property assets.
- Lack of clarity in some client contracts, raising doubts about revenue sustainability post-acquisition.
Given the identified risks, BTX agreed to proceed with the deal but wanted protection against potential liabilities arising from the identified issues. To bridge the gap between BTX’s desire for protection and the seller’s reluctance to provide extensive warranties or financial recourse, BTX opted for a Warranty & Indemnity (W&I) insurance policy.
Negotiation of the W&I insurance contract
BTX negotiated terms with the seller, incorporating specific warranties and indemnities into the acquisition agreement. The parties decided that instead of the seller providing direct warranties or holding a portion of the purchase price in escrow, they would rely on a W&I insurance policy to cover potential losses arising from breaches of warranties or unforeseen liabilities. The terms were discussed in detail with the insurer and the policy was drafted to cover specific risks identified during due diligence, such as breaches of financial statements, intellectual property claims, and client contract disputes.
Following the acquisition, within the policy’s coverage period, an issue arose regarding the ownership of a critical software patent that the acquired company had claimed as its own during the due diligence process. A third party raised a patent infringement claim, disputing the target company’s ownership rights.
Instead of resorting to legal action or pursuing the seller for indemnification, BTX made a claim under the W&I insurance policy. The insurer investigated the claim and subsequently covered the legal costs incurred in defending the patent infringement claim. The policy provided indemnity to BTX, protecting it from financial losses associated with the dispute.
Protect your M&A transaction with warranty and indemnity insurance
If you are negotiating an M&A transaction, a W&I insurance policy can smooth the process. You will need to take advice from a specialist broker who can advise on policy terms. Due to the bespoke nature of the cover, this is a complex product requiring an in-depth understanding of the market.
There are several factors to consider when choosing a policy – policy limits on the maximum payout in a single claim, the deductible, and coverage exclusions. It can be difficult to balance all these factors against your risk and the premium. That’s where the help of a professional can be invaluable.
Infinity has an in-depth knowledge of the W&I insurance market in Asia and would be happy to help you create a bespoke policy tailored to your mergers and acquisitions transaction needs. Whether you are looking for a buy-side or sell-side policy, talk to us
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