Warranty and indemnity insurance

What Is Warranty and Indemnity Insurance?

Warranty and indemnity (W&I) insurance is a specialized insurance policy used in mergers and acquisitions (M&A) to cover financial losses arising from breaches of warranties or indemnities given by a seller in a purchase agreement. As a form of transactional risk insurance, W&I insurance facilitates dealmaking by reallocating risk between the parties involved. It protects either the acquirer or the seller from unexpected liabilities that may emerge post-transaction related to the accuracy of information provided during due diligence.

History and Origin

The concept of warranty and indemnity insurance emerged in the M&A landscape primarily to bridge the gap between a buyer's desire for protection against unknown risks and a seller's wish for a clean exit with limited post-deal contingent liability. While its roots can be traced back earlier, W&I insurance saw significant growth and became a more standard feature in M&A transactions, especially from the mid-2010s onwards. This rise was driven by increased deal complexity, the globalization of M&A, and the evolving demands of private equity firms seeking to limit their exposure and provide clean exits for their investors. By 2019, W&I insurance had become a "new normal" for M&A, transforming how risks were managed in deal negotiations.¹¹ Its adoption has continued to expand, becoming a staple in both private equity and strategic acquisitions.¹⁰

Key Takeaways

Warranty and indemnity insurance protects parties in M&A deals against financial losses from breaches of contractual warranties or indemnities.
It serves to allocate or transfer unforeseen risks, facilitating smoother negotiations and enabling cleaner exits for sellers.
The policy can be either buyer-side (most common) or seller-side, dictating who makes a claim under the policy.
W&I insurance typically covers unknown risks, meaning issues identified during due diligence are generally excluded from coverage.
It has become a mainstream tool in M&A, particularly for transactions involving private equity and in competitive auction processes.

Interpreting the Warranty and Indemnity Insurance

Warranty and indemnity insurance is interpreted in the context of the underlying sale and purchase agreement and the due diligence conducted. The policy spells out the scope of coverage, exclusions, policy limits, and the deductible or retention amount. A key aspect of interpretation involves understanding what constitutes a "breach" of a representation and warranty as defined in the policy, and whether the loss suffered falls within the covered scope. Insurers meticulously review the due diligence reports to ensure that the buyer has conducted a thorough investigation, as the policy is not intended to cover risks that should have been uncovered during this process.⁹ The effectiveness of the insurance is often measured by the insurer's responsiveness and willingness to pay out valid claims, which have reportedly increased in recent years.⁷, ⁸

Hypothetical Example

Consider "Alpha Corp," an acquirer, looking to purchase "Beta Innovations" from its seller, "Gamma Holdings." During the extensive due diligence process, Alpha Corp uncovers various financial, legal, and operational details about Beta Innovations. To mitigate the risk of unknown liabilities post-acquisition and to allow Gamma Holdings a clean exit without a large escrow account, they agree to take out a buyer-side warranty and indemnity insurance policy.

The policy has a limit of $20 million, covering breaches of the warranties provided by Gamma Holdings in the sale agreement. Two years after the acquisition closes, Alpha Corp discovers that Beta Innovations' financial statements, warranted by Gamma Holdings to be accurate at the time of sale, contained a significant undisclosed contingent liability related to a historical product defect lawsuit. This liability was not uncovered during due diligence and leads to a $5 million loss for Alpha Corp. Alpha Corp then makes a claim under the W&I policy, and after investigation, the insurer pays out the $5 million, protecting Alpha Corp from the unexpected financial hit and ensuring Gamma Holdings' post-sale obligations are met through the insurance.

Practical Applications

Warranty and indemnity insurance has become a versatile tool with several practical applications in the M&A landscape:

Facilitating Deal Closings: By transferring the risk of warranty breaches from the seller to an insurer, W&I insurance can bridge valuation gaps and expedite negotiations, especially in competitive auction processes where sellers seek to limit their post-deal liability.⁶ This enables sellers to achieve a cleaner exit and reduces the need for large indemnity escrow arrangements.
Enhancing Acquirer Protection: For buyers, W&I insurance often provides a higher limit and longer coverage period for warranty claims than sellers would typically agree to directly. This offers robust protection against unforeseen issues that could arise after the deal closes, without having to pursue the seller directly, which can be particularly advantageous if the seller is a private equity fund looking to distribute proceeds to its limited partners.
Supporting Distressed Transactions: In situations involving distressed assets or sellers facing insolvency, W&I insurance can provide buyers with meaningful recourse against top-rated insurance capital, as traditional seller indemnities may be insufficient.⁵ This adaptability makes W&I a critical component in complex M&A scenarios.
Promoting Risk Management in Cross-Border Deals: The use of W&I insurance has been instrumental in standardizing risk allocation in international M&A, providing a consistent framework across different jurisdictions and legal systems.⁴ The product has become an increasing market trend in transactions involving European companies.³

Limitations and Criticisms

Despite its widespread adoption, warranty and indemnity insurance is not without limitations or criticisms. One common concern is that the availability of W&I insurance might inadvertently reduce the rigor of a buyer's due diligence process, as the buyer might rely too heavily on the insurance to cover potential oversights rather than conducting a comprehensive investigation. However, insurers typically require a robust due diligence process to be undertaken by the buyer before providing coverage.²

Another limitation is that W&I policies generally exclude known risks or issues specifically identified during due diligence. This means the insurance is designed for unknown breaches, not for deliberate gaps in disclosure or identified problems. Policy exclusions also often cover forward-looking statements, specific environmental liabilities, or certain highly sensitive tax matters, requiring parties to sometimes seek bespoke insurance for such risks.

Critics also point out the potential for moral hazard, where sellers might be less diligent in their disclosures if they know their liability is largely covered by insurance. Furthermore, the premiums and deductible associated with W&I insurance can be substantial, adding to transaction costs. While generally effective, the claims process can sometimes be challenging, and not all claims are paid in full. For instance, in one public case, an insurance payout did not fully compensate the buyer for its losses, leading to further legal action against the seller.¹ This underscores that while W&I insurance significantly mitigates risk, it may not cover every single loss or eliminate all potential post-closing disputes.

Warranty and Indemnity Insurance vs. Representations and Warranties

Warranty and indemnity insurance is frequently confused with the broader concept of representations and warranties themselves. The key distinction lies in their nature and function within a transaction.

Representations and Warranties: These are statements of fact made by the seller about the target company or asset in the purchase agreement. They cover various aspects such as financial condition, legal compliance, assets, and liabilities. The buyer relies on these statements, and if any are found to be untrue, they constitute a breach, entitling the buyer to seek indemnity or damages from the seller as stipulated in the agreement. They are fundamental contractual protections.
Warranty and Indemnity Insurance: This is an insurance product designed to provide financial coverage for losses arising from breaches of the aforementioned representations and warranties. It acts as a financial backstop, transferring the risk of such breaches from the seller (or directly protecting the buyer) to a third-party insurer. Instead of the buyer making a claim directly against the seller (beyond a small retention), they claim against the insurer, allowing the seller a cleaner exit and often providing the buyer with higher coverage limits.

In essence, representations and warranties are the contractual promises and protections, while warranty and indemnity insurance is the financial mechanism that underwrites the risk associated with those promises.

FAQs

What does a warranty and indemnity insurance policy cover?

A warranty and indemnity insurance policy primarily covers losses that an insured party (typically the acquirer) incurs due to unforeseen breaches of the contractual representations and warranties made by the seller in an M&A deal. It generally applies to unknown issues that were not discovered during the due diligence process.

Who typically pays for warranty and indemnity insurance?

While the policy can be structured as either buyer-side or seller-side, the buyer typically incurs the cost of warranty and indemnity insurance. This is because a buyer-side policy directly protects the buyer and is often preferred by private equity sellers seeking a complete exit from liability. However, the cost may be factored into the overall valuation and purchase price negotiation.

Is warranty and indemnity insurance always used in M&A deals?

No, warranty and indemnity insurance is not always used, but its prevalence has grown significantly. It is most common in medium to large mergers and acquisitions, particularly in competitive auction processes and private equity transactions, where it helps facilitate a clean exit for sellers and enhanced protection for buyers. For smaller deals, the cost of the premiums might outweigh the benefits.