Introduction

Warranty and indemnity (W&I) insurance is a product that provides cover for the seller’s liability, in the event of a breach of its representations and warranties in a corporate merger or acquisition (M&A) transaction. While initially, W&I insurance was prevalent only in the US, UK, Europe and Australia, its use has been steadily growing in the Asia-Pacific regions in recent years. Dentons Rodyk co-hosted a webinar with Howden M&A for clients of Dentons Rodyk to discuss recent trends and developments in the W&I insurance scene, and provided some insights on what it would mean for buyers and sellers across APAC. This article reviews what these trends and developments are and highlights key pointers for buyers and sellers in APAC.

What is W&I insurance

W&I insurance can be purchased by the buyer or the seller. Traditionally, W&I insurance was a product that was favoured by sellers, typically, large private equity or real estate funds. As it could aid them in keeping cash on completion of a transaction instead of having it linger in escrow accounts or trapped in other post-completion mechanisms, W&I insurance presented an opportunity to sellers for a clean exit. In a buy-side policy, the purchaser will be the party bringing claims against the insurer rather than against the seller (which would be the case for a sell-side policy), therefore simplifying the claims process.

Depending on commercial agreement and the relative bargaining positions of the parties, sellers may be asked to share the premium with the purchaser.¹

Naturally, W&I insurance carries benefits that accrue to buyers as well. For example, for minority investors who only acquire part of a business and who are co-managers and owners with the sellers, W&I insurance lends a helping hand in maintaining working relationships, as in the event of a claim, the investor will claim directly against the insurer rather than its co-investor.

Recent Developments and Trends

1. Shift in Insurer Focus to APAC Region

For the past 10 to 20 years, W&I insurance has been a staple component in M&A transactions taking place in Australia, Europe, the UK, and the US.² Today, it is estimated that only about 15% of deals in the Asia-Pacific region use W&I insurance, though industry insiders have noted that there is a trend that this is increasing.

Currently, there are perhaps six insurers offering W&I insurance for M&A transactions in the Asia-Pacific region, as compared to around twenty-five in the US. However, more insurers are interested in enlarging their footprint in Asia Pacific to capture the growing market for W&I insurance here, as demand for W&I insurance is expected to increase for deals in APAC.³

2. Shift to Buyers’ Market

Across 2020 to the end of 2021, the Asia-Pacific market was unable to meet the sudden increase in demand as large funds and capital re-entered the market following low transaction volume in 2020, which contributed to a sudden rush of M&A activity in 2021, and also resulted in increasing premiums in or towards the end of 2021.⁴ However, since then, the market has started to stabilise, moving from a seller’s market to a more even buyer’s market. At the same time, the increase of new entrants in the insurance APAC market bumped up the supply of insurers. Together with the decrease in M&A volume and value from 2021 to 2022⁵, premiums in the Asia Pacific market are also starting to decrease.

3. More Larger Corporates Using W&I

W&I insurance was traditionally used by large private equity funds and real estate funds which preferred the certainty of having cash in pocket at or immediately after completion of a transaction, for the purposes of distributing it quickly up the channel which can be immediately utilised for other investments or acquisitions of other assets. In recent times, W&I insurance has also been growing in popularity amongst large corporate firms who are looking to acquire and dispose of assets and who intend to hold those acquired assets for a longer time frame.

4. Multiple Policies Per Transaction

W&I insurance usually only covers unknown risks, hence leaving a gap in coverage in respect of known issues uncovered over the course of due diligence. Traditionally, this has been addressed by way of a specific indemnity provided by the seller in the sale and purchase agreement (SPA) in favour of the buyer. To address these gaps, W&I insurers have been developing products to address targeted risk policies to address these risks. Examples of such specific risk policies include policies covering title, tax, and environmental risks.

This development has resulted in traditional and new users of W&I insurance considering both traditional W&I insurance, with these specific risk policies used as add-ons to the same.

For instance, for asset heavy deals, title to assets (including shares) is of utmost importance and usually constitutes part of (or substantially the whole) of the suite of fundamental warranties provided by the seller. However, it may be discovered during the due diligence that there are title defects, for example, errors in the local registry records in relation to the characteristics of these assets, or irregular or incomplete filings that affect validity of title to these assets. For such issues, title risk insurance may be helpful in addressing these known risks. Users of such policies would find it more advantageous to take up a lower limit on W&I insurance, and adding title insurance as a specific top-up to the cover, thereby overall ending up with a cheaper price for a full cover.

What this may mean for the M&A landscape

1. More rigorous due diligence process

W&I insurers primarily rely on external due diligence to determine the extent and manner of their coverage, and thus rely heavily on expert due diligence conducted by a company’s external legal, financial, and tax advisors. In evaluating due diligence reports issued by these external advisors, W&I insurers are concerned with looking at whether the scope of the due diligence encompasses or is aligned with the warranties that the seller is providing. Hence it would be prudent for the scope of due diligence to be closely aligned to the matters underlying the suite of seller’s warranties.

In conjunction with the prevalent use of red flag limited due diligence by buyers and sellers (as opposed to full due diligence), W&I insurers have also increased their acceptance of such reports subject to a more rigorous underwriting process. In this regard, buyers can expect more underwriting calls and more questions, where the insurers’ focus would be on ensuring that any item not reported on has been excluded as it was not a red or yellow flag, rather than being excluded as it is outside the scope of the due diligence altogether.

Further, the materiality threshold of a due diligence report would have a bearing on the underwriting process. In a deal that involves W&I insurance, the insurer would prefer that the materiality threshold that the due diligence is pegged to the actual or proposed de minimis threshold of a transaction. For instance, if the de minimis threshold of a transaction is at US$50,000, the due diligence should be looking at issues at a value in excess of US$50,000. It is worth taking this into consideration when delineating the scope of due diligence at the outset.

2. Streamlined SPA Negotiations

Negotiations usually center around a few core provisions like seller’s disclosure, warranties and indemnities and limitations of liability. However, with the inclusion of W&I insurance (and/or specific risk policies) as a backstop in deals, the seller will no longer be the sole recourse for all potential liability, inadvertent or not, that is tied to the company or asset that is being sold. Parties will be able to focus on key commercial points rather than trying to allocate risk to each other, thereby facilitating quicker resolutions and closing of deals.

With W&I insurance covering sellers’ liability, sellers will also be more comfortable with providing buyers a full set of warranties, thereby raising the bar in terms of the level of protection availed to both parties. Negotiations can become less adversarial, which in turn smoothens out any future working relationships especially for situations where key employees of the seller continue to retain some form of control and/or management powers over the business. In a bid situation, bidders who have incorporated W&I insurance into their bid are also able to differentiate themselves from other bidders to the targets.

Concluding remarks

The growth of W&I insurance activity in the Asia-Pacific region spells exciting change for the M&A landscape as well as for the risk factors of undertaking M&A, with reduced transaction costs from less protracted negotiations. By understanding how W&I insurance and related policies can make a difference to one’s transaction, buyers and sellers in Asia-Pacific region will be well placed to evaluate all the choices in structuring and managing their transactions more efficiently and effectively.

¹ Howden M&A Email Bulletin of 6 February 2022: https://emailcc.com/rv/ff00a37ef95f6376657446ca334682a200ca9e26 

² According to James Kay, Director of Howden M&A, 80% of all Australian M&A transactions include W&I insurance. Around 60 to 70% of M&A transactions in Europe and the US include W&I insurance.

³ Riskpoint recently announced the opening of their Singapore office which is expected to commence business in Q1 of 2023: https://riskpoint.eu/riskpoint-expands-into-asia/

⁴ https://howdenmergers.com/news/ma-insurance-apac-2022-onwards/

⁵ https://www.pwc.com/gx/en/services/deals/trends.html#:~:text=Global%20M%26A%20volumes%20and%20values,2020%20and%20pre%2Dpandemic%20levels