Warranty and indemnity (W&I) insurance is increasingly being used to facilitate mergers and acquisitions (M&A). We assess the role of the insurance, how a policy works and how the transaction risks inherent in M&A deals can be identified and managed with the right insurance cover in place.
As 2018 draws to a close, it looks to have been a bumper year for global M&A activity.
According to the Institute of Mergers, Acquisitions and Alliances, as of 20 November 2018, almost 41,000 transactions had been completed globally with a value of more than $3.5 trillion.
Likewise, analysis by the Financial Times predicted that total would hit $4.3 trillion before the year is out, making it only the third time that the value of M&A activity will have exceeded $4 trillion.
And sitting behind a growing number of these deals is warranty and indemnity (W&I) insurance, providing greater security for buyers and facilitating the clean exit that more and more sellers seek.
Covering breaches of representations and warranties made in purchase agreements, it can provide a clean exit for the seller who is unwilling or unable to provide any warranties; bridge the gap between the liabilities that a seller is prepared to accept and what a buyer requires; or help in a range of situations where a buyer would be unwilling to pursue the seller in the event of a warranty breach.
Although a comparatively young market (these policies have only been available since the early noughties), there has been a marked increase in the use of this cover and the number of insurers willing to underwrite the risks.
Research from Munich Re shows that global demand for W&I cover has tripled since 2011 and increasing capacity in the market is matching the pace of that growth.
“Go back to the beginning of the decade and there were approximately seven or eight insurers operating in the London market,” says Ben Crabtree, Partner, Mergers and Acquisitions at JLT Specialty.
“Now there are over 25 and they are all out there fighting for business.”
Although the volume and cost of claims in this sector has been historically low, making it an attractive proposition for insurers, Hayley Tennant, Partner at JLT Specialty, points to broader market dynamics to help explain the rapid growth.
“Sellers now have record levels of capital at their disposal, leading to an increase in auction sale processes where the seller requires the buyer to purchase W&I in lieu of indemnity protection,” she explains.
“There has also been a rise in nil recourse deals where the seller assumes no or minimal liability, particularly within the real estate sector.
“In such scenarios, the seller desires a clean exit enabling return of funds to investors with the buyer relying on the insurer’s security.”
In addition, new entrants and existing players are offering broader coverage and lowering excess levels, sometimes to zero, in order to secure business.
All this, of course, will and does have an impact on the volume and value of claims coming through, with AIG, one of the largest insurers in this space, revealing that one in five of its W&I policies received a notification of claim in 2017.
Most claims arise from breaches of warranty concerning financial reporting, tax or regulatory issues and, as the breadth of cover and knowledge of how the policies work increases, so do the claims.
“The market historically has had very low claims ratios,” says Tennant. “But that has changed in the last three to four years.”
She explains that an increase in sellers insisting on low or nominal levels of liability means that policies are paying out more regularly than they have in the past but cautions that “claims activity is certainly increasing but … is generally proportionate to the use of W&I insurance overall”.
And although this European experience in terms of growth and demand is largely reflected in JLT’s Asian, US and Canada markets, there are some interesting anomalies, particularly around rates and levels of coverage.
Although rates in the US and Canada have decreased by 5 per cent in the past 12 months, that is a positively hard market when compared with rate reductions experienced in Asia (-35 per cent) and the UK (-23 per cent).
However, it appears that policyholders aren’t pocketing the savings – they are taking out higher limits of cover instead which, despite the rapid softening of the market in some territories, points to a growing desire for and faith in the coverage these policies provide.
And it could be that, as the market matures and the incidence of claims increases, the individuals advising and facilitating M&A are seeing the true value of the product.
Crabtree explains: “A lot of people who use this insurance are transactionally focused – they want the deal done and signed. But what we are seeing is more focus on what the broker will do around the claims support.
“These are seven-year policies so it’s not just about placing the risk – it’s important a broker is able to help the client through any claims process.”
He goes on to explain that, although W&I claims are seldom simple, he has found that insurers are “behaving well” and can sometimes go beyond what is required contractually to pay the claim.
All this paints a picture of a healthy, functioning and growing market. But, with new capacity entering and claims increasing, is the future really as rosy as it looks?
“The majority of M&A currently isn’t using this kind of insurance as part of the process but, as awareness of the product continues to grow and coverage broadens further, more and more businesses will factor W&I insurance into their deals,” says Tennant.
For more information please contact Ben Crabtree, Head of M&A on +44 (0)20 7558 3824