Warranty & indemnity (W&I) insurance protects buyers and sellers against the liability risks that can arise from M&A transactions. Although W&I insurance is not new, global economic uncertainties caused by the COVID-19 pandemic or the war in Ukraine have increased the demand for it. In recent times, a special case of W&I has come into focus: stapled insurance.
In most cases, W&I insurance protects the buyer in the event that the risks covered by the warranties and indemnities provided by the seller in the purchase agreement (SPA) materialize. The insurance then fully or partially covers the materialized risk. The shift from a buyer’s to a seller’s market has also made W&I insurance more interesting for sellers. Sellers have increasingly decided to exclude their own liability for guarantees from their initial drafts of the SPA, and instead refer to coverage via an insurance policy. In these cases, the insurance is structured as a buyer’s policy in which the insurer undertakes vis-à-vis the buyer to assume responsibility for the seller’s warranties and indemnities under the SPA.
Since, as part of an auction process, the seller is not only interested that the buyer takes out the W&I insurance but also that this is done in a quick and efficient process, he often prepares the W&I insurance solution. This form of transaction insurance is often referred to as stapled insurance.
Stapled insurance has become increasingly common in recent years. In auction processes, in particular when financial investors sell, but it also applies to well-advised selling small-to-medium enterprises (SMEs), sellers expect to take out W&I insurance. Conversely, such a request does not surprise a buying private equity investor. The instrument ensures transaction security and accelerates the process, making it favorable.
Stapled insurance distinguishes between soft stapling and hard stapling.
Soft stapled insurance means that the seller—mostly with the help of an insurance broker—obtains quotes and submits non-binding offers to conclude a W&I insurance policy to the potential buyers. The broker first checks the seller’s sample SPA and obtains offers from insurers on this basis. For the offers received, the broker prepares a summary [a so-called Non-Binding Indications (NBI) Report], which the relevant bidder(s) can view in the data room. The buyers can then choose to go either with the proposed insurer or with another insurer of their choice.
For the early stage, when limited information is available, the NBI Report sets out in relatively granular terms, the following for the various insurers:
- Policy amount (coverage amount)
- De minimis
- Entry threshold (first loss piece)
- Legal expenses
- Buyer due diligence requirements
- Accepted liability regime
- A concrete statement as to which guarantees of the seller’s draft can probably be insured (depending on subsequent buyer due diligence, etc.) and with which qualifications, if any, or which aspects will be excluded from insurance.
At the appropriate time in the process, the buyer takes over the communication with the broker and selects one of the insurances (or another one favored by the buyer) with which they then take up the usual underwriting process.
The underwriting process is about the insurer being able to understand the deal and the negotiations between the buyer and seller. To that end, they will specifically ask to see:
- The SPA, including all attachments, namely disclosures, etc.
- Access to data rooms, including the index
- Any due diligence reports on the part of the buyer and, if available, the seller
- The latest audited financial statements of the target company
- The Information Memorandum, the Management Presentation and other documents and information prepared by the seller as part of the sale process.
The final step of this process is the underwriting call between the buyer, the insurer, and the involved consultants. This is primarily about:
- How the sales process played out
- The type and quality of information disclosed by the seller
- The buyer’s approach to due diligence; also related to the different advisors and the scope of their mandate
- The relative strength of the negotiating positions of the two parties and how that affects the final SPA
- Any remaining known concerns or identified issues that are outstanding on the insurer’s side as part of the underwriting process.
- This process usually takes at least three to five days, although, to be on the safe side, seven days should be allowed to clarify any outstanding issues and provide comfort to the insurer concerning clarifications and information where necessary.
Hard stapled insurance is characterized by the fact that the seller specifies an insurer. The seller will usually go for this option if he expects a highly competitive process, and he is in a particularly strong negotiating position. In this case, the insurer starts the underwriting process on the sell side based on sufficiently thorough vendor due diligence reports. He gets access to the data room, takes part in underwriting calls on the sell side and negotiates the policy with the seller.
The purpose of the underwriting call is to provide the insurer with an understanding of the way the information deposited in the data room was compiled, the placement of the data room, the approach to the disclosure of information, the approach and scope of vendor due diligence reports, and the sales process.
In the underwriting process of a hard stapled insurance, the seller also negotiates the fees and premium with the insurer. As a result, the insurer is ideally already able to attach a final draft policy to the draft SPA.
As soon as the buyer is involved in the sales process, the underwriting process on the buyer side then runs parallel to the buyer’s due diligence and the purchase agreement negotiations, as described above in the soft stapled section. If necessary, the terms of the policy are adjusted. As regards timing, hard stapling should allow at least 48 hours for the underwriting process on the buyer side.
Effects on the purchase contract
The draft purchase agreement of a sale process is typically provided at the end of the due diligence process. If a W&I insurance is to be included in the process, the parties negotiate the SPA and the buyer policy in parallel with the underwriting process. If there are any changes to the guarantees in the company purchase agreement, the insurance policy is adjusted accordingly.
In case of a stapled insurance, the SPA is supplemented by a “W&I insurance clause” under which the buyer undertakes to take out a standard W&I policy; the respective policy is typically provided as an annex. The W&I clause provides for a limitation of the seller’s liability to an amount of €1 for the warranties and indemnities, irrespective of whether the policy has been validly concluded or whether the insurer will pay in the event of risk realization. Recourse claims are excluded.
Overall, the insurance solution shifts any materializing risks to the insurance company, which is why, on the one hand, deadlocks can be avoided when negotiating the liability regime and the SPA can be negotiated more quickly overall. On the other hand, the need for collateral (escrow) is also eliminated.
W&I insurance has become an integral part of transaction practices. Its importance for the involved parties is likely to increase even more in times of economic and geopolitical uncertainty, as it is a highly efficient instrument that can significantly increase the speed and safety of an M&A transaction. Considering stapled insurance in close cooperation with a broker in the early stages of any transaction can add a completely different dynamic to a sales process, to the benefit of both parties.