M&A transactions are one of the most complex processes undertaken by an organisation, presenting a wide range of potential pitfalls for both buyers and sellers. As organic growth opportunities become more challenging and buyers look to acquisitions to drive growth, the need to mitigate transactional risk is increasing.
The use of M&A insurance products, in particular Warranty & Indemnity (W&I) insurance, has become commonplace in the US and European M&A markets over the last five years, with a number of major law firms reporting that it is used on 20-25% of deals that they have advised on. Whilst the product has been somewhat slower in gaining traction in India, the gap is starting to close.
What is M&A insurance?
W&I insurance policies provide cover for losses suffered in connection with warranty or indemnity claims and may be taken out by either the seller or the buyer.
Under a buyer policy, the buyer typically claims against the seller up to the liability cap agreed in the sale documents, and then claims against the insurance policy for any losses above the cap.
Under a seller policy, the buyer would claim against the seller under the sale documents in the normal way and may not be aware of the insurance policy. The seller would then make a claim under the insurance policy and remain directly liable to the buyer (the insurer would, however, have the ability to control any defence or settlement of the claim).
W&I insurance typically covers unknown risks; however, in certain circumstances, bespoke insurance policies may be available for known but contingent and/or unquantifiable risks, including certain tax risks, that may otherwise be dealt with as an indemnity from the seller.
A recent development is the evolution of seller policies into end-of-fund (also known as fund wrapper) policies, which are designed to facilitate the winding-up of an investment vehicle at the end of its life cycle. Under a fund wrapper, policy residual liabilities in the sale documents for each of the disposals made by the fund are transferred to the insurer, allowing the fund vehicle to return the proceeds to its investors and commence the winding-up process without needing to retain funds to meet contingent liabilities or provide guarantees. Such policies may be used by funds to reduce overheads by terminating the investment structure earlier than it otherwise would be able to.
Strategic benefits of M&A insurance
There are typically four key drivers for a buyer or seller to seek to insure an Indian transaction:
1. Achieve a clean exit: Many sellers, particularly private equity sellers, require certainty of sale proceeds, in order to make a distribution to its investors, but which are commercially required to provide a market-standard warranty package to the buyer.
2. ‘Topping-up’ the seller’s liability: Insurance may be used to increase the level of recourse available to the buyer if it is not comfortable with the cap proposed by the seller, or to extend the time limit for making a claim. Buyers in a competitive auction process may also introduce W&I as a means of enhancing their bid by offering low liability caps to the seller.
3. Recoverability: Even with extensive contractual protection, a buyer will still be exposed to the risk that they will not be able to recover damages against the seller. This will be a particular concern if the seller is an individual, an SPV, in financial difficulty or otherwise where enforcement against the seller may be difficult in the event of a successful claim. Timing is also an important factor, as a claim against a seller in the Indian courts may take several years, whereas a claim against an insurer would be expected to be resolved in a significantly shorter period of time.
4. Relationship with the sellers: Some buyers, particularly private equity sponsors, will be unwilling to make a claim against the warrantor sellers as they are likely to be involved in the continued management of the target business. Although buyers (and insurers) may require the warrantor sellers to have some liability (‘skin in the game’), insurance may be used to reduce this and mitigate the risk, enabling the buyer to make a commercial decision not to recover against the warrantors if that is in its best interests whilst still recovering the balance (usually any loss above the first 1% of enterprise value) from the insurer.
Seller to buyer ‘flips’ are increasingly being used in auction processes, whereby sellers procure indicative pricing and coverage terms from insurers for a policy that will ultimately be taken out by the buyer. The insurance coverage is then used as a tool to resist any attempts by the buyer to seek a liability cap from the seller above the attachment point of the policy, particularly where the seller is paying the cost of the premium. In doing so, the seller puts itself in a position to achieve a better and more certain valuation as there is no need to tie up proceeds in escrow to cover unknown risks.
The importance of diligence
M&A insurers are particularly focussed on ensuring that the transaction has been negotiated as if insurance was not in place and that there has been both a thorough diligence process by the buyer and disclosure process by the seller.
As insurance is intended to cover ‘unknown unknowns’, it is important that buyers intending to insure a transaction agree to a due diligence scope with their advisers that covers the areas that the warranties relate to. This will avoid warranties which would be insurable if a reasonable level of diligence had been carried out from being excluded from cover under the policy.
Pricing
While the cost of W&I insurance is still generally higher in India than in Europe, it has fallen significantly in recent years and the market for Indian policies has increased in response. Although market data remains somewhat distorted due to the volume of smaller limits placed at a fixed minimum premium rather than a percentage of the limit purchased, the insurance market is typically pricing Indian risks at a rate of between 2% to 3.5% of the limit with an attachment point of 1% of the enterprise value of the transaction. Parties often obtain insurance for between 10% and 40% of the enterprise value, with rates reducing as larger proportions of the enterprise value are insured.
Claims
Any purchaser of insurance will want to know that the policy will respond in the event of a valid claim, and M&A insurers are increasingly being asked to provide information regarding their specific M&A claims handling experience and capabilities.
In 2016, AIG released a global claims study of over 1,000 transactions with a value of more than $200 billion, which revealed that nearly 14% of the M&A insurance policies written by AIG globally between 2011 and 2014 resulted in a claim. Data for an extended period to 2015 will be released later this year and is expected to show that the proportion of policies resulting in a claim has increased further.
As confidence builds that M&A insurance policies will respond to claims and the use of insurance as a strategic tool rather than a means of allocating risk becomes better understood, it is expected that the recent growth in the use of M&A insurance will continue in the years to come.
Mark Storrie is senior underwriter for M&A and transactional liability at insurance firm American International Group (AIG) based in London. Sushant Sarin is senior vice president for commercial lines at Tata AIG General Insurance Co.
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