In the legal documentation formalizing an M&A transaction, agreements are typically made regarding who bears the risk of ‘hidden defects’ that may come to light after the transaction date. These agreements often take the form of warranties and tax indemnities provided by the seller to the buyer. If a breach of these warranties or indemnities occurs post-transaction, the seller is generally liable for compensating the buyer’s damages. The specific ‘rules’ governing such claims are usually detailed in the transaction documentation.

However, negotiating these ‘rules’ in a way that is acceptable to both parties is legally complex and often involves extensive discussions between the attorneys involved. The parties may have differences in approach to these ‘rules.’ For example, the seller may seek to exclude or further limit their liability for claims related to ‘hidden defects’ beyond what the buyer find acceptable. Alternatively, the seller may be unwilling to provide the level or form of security that the buyer requires.

In such situations, it may be advisable to consider taking out warranty & indemnity insurance (W&I insurance). W&I insurance is a specialized insurance product designed to transfer the financial risks of a breach of warranties or tax indemnities provided by the seller to the buyer after the transaction date to an insurer - meaning the insurer, rather than the seller, compensates the buyer’s losses. 

Although sellers can also take out W&I insurance, in Dutch small and mid-market M&A transactions, it is almost always buyers who purchases this coverage. This article, therefore, focuses on W&I insurance from the buyer’s perspective.

Whether W&I insurance is advisable depends on several factors, which we will explore in the next section.

Time pressure 

If there is pressure to close the transaction quickly, W&I insurance can help accelerate the process. With W&I insurance in place, fewer negotiations are needed regarding the warranties and security the seller must provide to the buyer. Since the financial risks of warranty breaches are transferred to the insurer, the seller can take a more flexible stance on warranties, and the need for seller-provided security becomes less relevant or even irrelevant. 

However, this comes with the caveat that an insurer will only issue a W&I policy for risks that have been thoroughly assessed through comprehensive due diligence by the buyer. This aligns with the insurance industry’s fundamental principle that “a burning house cannot be insured.” To obtain broad coverage under a W&I policy, a comprehensive due diligence process - conducted by experienced external advisors - is essential. If the parties opt for a limited or ‘practical’ due diligence process, or if the buyer intends to conduct part of the due diligence internally, W&I insurance will likely not be an option.

It is also important to note that a comprehensive due diligence process is not only an additional burden for the buyer but also for the seller. After all, the seller must provide the necessary information for the comprehensive due diligence, and the additional time and effort required should not be underestimated, especially since, in addition to facilitating the due diligence process, the seller remains responsible for managing the day-to-day operations of the target company

Costs

The W&I insurance market has become increasingly competitive in recent years. As a result, W&I insurance premiums are relatively modest compared to the transaction value. The premium is calculated as a percentage of the insured amount, which typically ranges between 10% and 30% of the enterprise value. In general, premiums are approximately 1% to 1.5% of the insured amount. For example, if the enterprise value is €40 million and the insured amount is €10 million, the premium would range from €100,000 to €150,000. 

Exclusion of known risks

Known risks - whether identified during the due diligence or commonly associated with the relevant industry - are typically excluded from W&I insurance coverage. If the W&I policy excludes known risks and the likelihood of covered risks materializing is low, one might conclude that taking out W&I insurance offers little added value.

Competitive advantage

In a competitive transaction process, such as a controlled auction, a prospective buyer may consider taking out W&I insurance to gain an advantage over competing bidders. The presence of a W&I policy ensures that claims for insured risks do not need to be made against the seller, allowing the buyer to present a more attractive offer.

The seller can also take the initiative to arrange W&I insurance. This can be done by making W&I insurance a requirement for bids submitted by prospective buyers. The seller may even provide initial findings from a preliminary assessment of the insurance market’s willingness to cover the transaction.

Fostering a good working relationship

It is common practice for the seller to remain involved with the target company for some time after finalizing an M&A transaction or even reinvest a portion of the sale proceeds in the buyer. In such cases, it is important for the seller and the buyer to foster a good working relationship. If the buyer were to file a claim against the seller for breaches of warranties or tax indemnities, it will understandably become more challenging to maintain that good relationship. When W&I insurance is taken out, the risk of such claims is transferred to the insurer, reducing the likelihood of compromising the working relationship between the parties.

Some buyers have a negative stance 

Some buyers have a negative stance toward taking out W&I insurance. Beyond the cost aspect and the drawbacks of the additional due diligence efforts required, some argue that the availability of W&I insurance might discourage the seller from disclosing all relevant information upfront. The reasoning is that the seller may assume that the W&I insurance will cover any “hidden defects.” Additionally, some buyers have had less positive experiences with insurers when filing claims under the W&I policy.

In a competitive transaction process, such as a controlled auction, a prospective buyer may consider taking out W&I insurance to gain an advantage over competing bidders. 

In recap

The decision to enter into a W&I insurance policy depends on the specific circumstances of the transaction, where factors such as the negotiating power of the parties, the additional due diligence efforts required, the costs, the likelihood of “hidden defects,” potential exclusions or restrictions in coverage, the desire to ensure a good working relationship between the parties in the future, and the desire to close a smooth and competitive deal all play a role. 

While securing W&I insurance can sometimes be an effective way to transfer the risk of claims for warranty breaches or tax indemnities to an insurer and can facilitate transactions, the associated pros and cons must be carefully weighed. Each transaction should be assessed individually to determine whether W&I insurance offers sufficient added value. Seeking legal and insurance advice is essential when making this assessment.