Why Warranty and Indemnity insurance is increasingly used for M&A transactions in Europe?

Introduction

  1. M&A process is basically a tedious, costly and time consuming process for both the buyer and seller.The buyer and seller invests a lot of resources and time with a hope that the deal would be executed.But still most of the deals do not get executed.This will impact the seller more as they have spent more time and resources in engaging bankers and attorneys in addition to uploading all the information in the data room.
  2. So a huge risk for the seller in the M&A transactions is uncertainty in the deal getting closed.Some of the reasons why the deals are terminated mid way is because the buyers and sellers are not able to allocate the risk identified in mutually agreeable manner.For instance, when the buyer identifies the risk in the due diligence, then it would mitigate the risk by either asking for an indemnification from the seller for protection in the event of a breach or would demand for an adjustment in final purchase price.The seller on the other hand might recognize the risk identified but also sure that the probability of the risk occurring is very low and the cost for the risk incurred would be very high.So the seller would not be ready for high indemnity and also a final reduction in purchase price.In that case, the buyer and seller would be involved in extensive negotiations on how to allocate the risk identified.
  3. In case of the buyer, any risk that is identified would affect the final valuation metrics and also will have an effect on the post merger integration process in the transaction. The buyer would be cautious not to overpay for the deal.
  4. In addition to the risks inherent in the transactions, political and macroeconomic uncertainties along with any key legislation introduced like GDPR would also affect the deal certainty. For instance in UK, majority of the buyers do not want to proceed forward due to the uncertainty over Brexit and how this will impact the deal value.

Why M&A Insurance increases Deal Certainty?

  1. M&A insurance is emerging as a preferred way for the parties involved in the transaction to improve deal certainty.Here a part of the risk is absorbed by the insurance company of any liabilities that is incurred after transaction in exchange for a premium.
  2. This is an effective way of risk management.In a M&A transaction, any risk that is identified by the buyer during due diligence and also quantified would be mitigated by incorporating an indemnity from seller.There can be cases where the risks identified by the buyer cannot be quantified and also allocated between the parties.For instance, a tax liability that is identified would be difficult to allocate due to the probability of the risk happening.In such cases, the buyer and seller are caught in a fix on how to mitigate the risk.In other cases, the buyer may have done adequate due diligence from its side and may not have uncovered any risks which could occur after the transaction.The buyer generally addresses these risks by retaining a part of the purchase price hold in an escrow account so that the buyer is compensated when any such hidden risks occur.With seller not preferring to have its money held in escrow amount for a longer period, W&I insurance offers an alternative option.
  3. Along with the risk identification and allocation, how long the risk would be covered forms a key part of the negotiation process.The buyer would demand for a longer protection for around 3 years where as seller would not be ready for any coverage for more than a year.W&I insurance policy covers a buyer for more than 5 years for those liabilities that are covered by the insurer.

So is M&A insurance a substitute for due diligence process?

  1. Many buyers might be of the opinion that they need not invest a lot in due diligence as they would be indemnified by the insurer for any liability incurred post transaction. This is not correct as the insurer would not be covering any risks that the buyer is unable to identify normally during a due diligence or any risks identified but not reported by the buyer during due diligence.
  2. The insurance will only cover risks that are identified along with any hidden risks that could not be identified inspite of a detailed due diligence process, but have occured after the acquisition.
  3. Hence the buyer still needs to engage third party consultants for the due diligence and come up with a final report of risks identified along with synergies opportunities to justify the valuation of the target firm.

How does M&A Insurance process work?

  1. Generally, the buyer and seller decides to go for an insurance to reduce negotiations on warranties and indemnifications at the beginning of the transaction.In most of the cases, the seller pays the premium amount for the insurance policy.The premium amount will be around 4% of the final purchase price.
  2. Selecting the right insurer that can provide a broader coverage for all the liabilities is extremely important.In most of the cases, in the event of the liability claim, a deductible is needed to be borne by the parties.The deductibles are generally around 15% of the total liability incurred.This deductibles can be negotiated between the buyer and seller on who will bear the amount.
  3. The insurer will involve an underwriter who shall do an independent due diligence on the transaction to uncover any additional risks and also ensure that the premium price for the policy is correct The insurer will not indemnify 100% of all liability breaches that are reported by the buyer post acquisition. The seller would still be required to indemnify a part of risks especially for fundamental reps where the insurer shall not provide any coverage.
  4. Hence the parties need to confirm if most of the warranties and indemnities are covered by the insurer. Hence the right strategy would to select the best insurer with comprehensive coverage against insurer with lowest price.For liabilities not covered by the insurer, the seller would be required to indemnify.Hence the escrow provisions along with baskets and caps will still be valid for deals with M&A insurance.

Claims Processing in M&A Insurance

  1. In addition to selecting the best insurer with comprehensive coverage, the insurer should also help in claims management and quick settlements.
  2. It is necessary that the buyer informs the insurer immediately on the breach of any warranty claim.The insurer shall evaluate the breach to confirm if this is covered in the contract.Post the confirmation, the insurer should be able to quickly address the claims to the buyer satisfaction.

Popularity of M&A insurance in EMEA Deals

  1. More and more of the M&A transactions in Europe are using M&A insurance because of the quick settlement and better support provided by the insurers.
  2. Deals covering Nordic countries use M&A insurance in almost all private transactions due to the certainty that insurance provides for the deal execution.
  3. With more regulations involving data privacy norms and increasing use of Cybersecurity breaches, the buyer due diligence might not be completely fool proof in able to identify all the risks.Hence having a M&A insurance helps in mitigating the risk and transferring it to an insurer in exchange for a premium.

Conclusion

  1. M&A insurance is included in almost all European M&A deals as this helps in deal certainty and transferring a part of the transaction risk to the insurer in exchange for an initial premium.This will help in the deal execution and avoid any delays on issues that the buyer and seller are stuck in during negotiations.
  2. A M&A insurance is not a substitute for inadequate due diligence. The buyer still needs to be invest in due diligence and involve third party consultants to identify the risks in the transaction.
  3. With increasing political uncertainty like Brexit, US China Trade war and new legislation like GDPR, more M&A deals are getting stuck in getting executed due to the above risks.Having a M&A insurance would protect the buyer from both known and unknown risks arising out of the proposed acquisition.


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