Strong recent merger and acquisition (M&A) activity has coincided with the increased use of warranty and indemnity insurance for mid-to-high value transactions in the New Zealand market. Advisors and insurers expect this trend to accelerate over the coming months and years.

This article discusses the purpose and benefits of warranty and indemnity insurance along with how it works in practice.

What is W&I insurance?

Warranty and indemnity insurance, commonly called W&I insurance, is a form of transactional risk insurance. It is a bespoke insurance product developed by insurers and underwriters to cover losses arising from breaches of warranties and indemnities given in M&A transactions.

In nearly all M&A transactions, the seller will make a number of representations about the business being sold. These representations will be underpinned by warranties and indemnities given in the transaction documents. The warranties and indemnities negotiated between the transacting parties will represent the allocation of risk regarding the business being sold. W&I insurance will stand behind many of those warranties, subject to certain exclusions.

How it works

Under a typical W&I insurance policy, the insured party is covered for any warranty or indemnity claims within the scope and duration of the policy. Both buyers and sellers can access W&I insurance:

• Buyers: For buyers, access to the policy provides financial recourse to the insurer rather than the seller, in the event of a covered claim.
• Sellers: For sellers, access to the policy delivers a greater prospect of a ‘clean exit’ from the transaction. It often enables the seller to take most, if not all, of the proceeds of the transaction without having to worry about future exposure to a warranty or indemnity claim after settlement.

While both buy and sell side policies are available, W&I insurance is customarily used by buyers in New Zealand.

The insurance premiums for W&I policies typically range between 1-3% of the transaction value, however, premiums have been trending down in our recent experience, generally into the mid – low 2% range and even between 0.9 – 1.5% in global transactions (where New Zealand is a minor participant). Premiums will vary based on the extent of cover, jurisdictions involved, governing law of the sale and purchase agreement, industry sector risk, financial stability of the target company, the period of cover, and of course, the applicable limits and exclusions.

In some cases, a seller may obtain a quote for W&I insurance for an upcoming transaction, particularly in the context of a competitive bidding process. Upon selecting the successful buyer, that policy would be ‘flipped’ in favour of the buyer under the terms of the transaction.

Other reasons a W&I insurance policy may be sought include:

• Preserving relationships: Where a seller will remain in the business post-sale, W&I insurance can relieve tension and protect the ongoing relationship between the buyer and seller by providing financial recourse to the insurer rather than the seller in the event of a warranty or indemnity claim.
• Risk allocation: W&I insurance can mitigate or remove deal-breaking risks from a transaction by offloading the bulk of that risk from the parties to the W&I insurer.
• Extra scrutiny: Further due diligence may be conducted by the W&I insurer, which can uncover additional risks or issues to be addressed in the transaction documents by way of further negotiations around specific indemnities, and/or coverage by the policy. While transaction specific carve-outs for matters identified in due diligence and typical exclusions by insurers (as discussed below) are to be expected, any gaps or targeted exclusions of cover identified by the W&I insurer will be sought to be bridged by the terms of the deal.
• Extending the warranty period: From the buyer’s perspective, it may be possible to obtain insurance coverage for a longer time-frame than the seller is willing to stand behind the warranties and indemnities for. By effectively extending the warranty period, this de-risks the transaction for the buyer.
• Competitive bidding process: Where a prospective buyer has W&I insurance, their offer can appear more attractive to a seller due to reduced exposure to a warranty or indemnity claim for the seller.

Exclusions

While W&I insurance can offer benefits to both buyers and sellers, there are some typical exclusions from cover. These include any known risks, criminal penalties and uninsurable losses or fines, certain environmental issues, misclassification of employees or employee leave entitlements, professional indemnity and product liability exclusions, consequential losses, forward looking projections or statements, post-closing adjustments and completion accounts mechanisms, fraud or dishonesty by the seller, incomplete disclosure, transfer pricing, and cyber related risk. To note, we have seen an emerging trend of tax indemnity coverage becoming more commonplace for New Zealand-based businesses, although cross-border tax issues in the target company are still likely to be subject to exclusions.

Importantly, a W&I insurance policy is not a substitute for undertaking comprehensive due diligence investigations on a business, or proper negotiation of the transaction documents. Insurers usually create an exclusion from cover where due diligence has not been conducted effectively, so the policy will not shield a buyer from cursory due diligence.

Impact on transaction documents

W&I insurance policies generally come into effect at one of two key times:

• On signing: If the policy covers signing and completion warranties and indemnities, then it will come into effect upon the signing of the sale and purchase agreement. Insurers may agree to cover breaches that occur in this interim period prior to completion, with premiums and limits adjusted accordingly.
• On completion: If the policy only covers completion warranties and indemnities, then it will come into effect on completion of the transaction. In this case, a buyer should avoid sole recourse provisions which expressly state that all claims may only be made against the W&I policy (unless the seller specifically agrees to guarantee the interim period between signing the sale and purchase agreement and completion). This is because a breach may occur after signing the sale and purchase agreement but before completion. For additional protection, a prudent buyer may also wish to negotiate the right to terminate the agreement for a breach prior to completion and/or a short term retention or escrow arrangement.

The various quantum and time limitations for warranty and indemnity claims that are included in the W&I insurance policy are usually mirrored in the sale and purchase agreement (or vice versa).

Where the quantum and/or period of cover under the transaction documents are more than the provisions for claims in the W&I insurance policy, the buyer will likely seek the removal of any sole recourse provisions, which rely on the W&I insurance being in place, to respond to the ‘claims gap’. In such case, the buyer will often also require a retention or escrow arrangement be agreed with the seller to bridge the gap.

Where the amount and period of cover under a W&I insurance policy are more than the time limit for claims in the sale and purchase agreement (and similarly where the insured is the seller), there will be little to no impact on the sale and purchase agreement.

W&I insurance developments

Recent commentary in the warranty and indemnity insurance policy market has indicated that cyber risks and data breaches are becoming key areas of concern for insurers. In the last couple of years, there have been numerous ransomware attacks, including the highly publicised incidents involving the NZX and MetService. Accordingly, cyber security is a live issue for companies and insurers alike. Environmental issues and employee leave entitlements also remain key areas of risk and can be a point of differentiation between policies.

Key takeaways

Ultimately, W&I insurance is an effective tool which serves to protect all parties in merger and acquisition transactions. W&I insurance can be an attractive and cost-effective option in certain transactions as well as a means to break a deadlock where negotiations have reached an impasse.

Our New Zealand Corporate and Commercial Team regularly advises on transactions involving W&I insurance as a key deal-making component. For assistance with a transaction or any other corporate and commercial advice, please get in touch with the Dentons in New Zealand contacts listed here or your usual Dentons in New Zealand contact.