Frequently asked questions about warranty and indemnity insurance

Warranty and indemnity insurance (W&I) has become increasingly popular in business sale and purchase transactions over recent years. The policies are particularly attractive to buyers in circumstances where there are concerns around the seller's financial standing post-completion, or where the seller limits their exposure with a lower financial cap or shorter claim period. But they are also popular with sellers who are looking for an affordable and flexible way to manage any potential post-completion liabilities.

This blog looks at:

• the benefits of W&I (for buy or sell side);
• what a W&I policy normally covers (and excludes);
• who normally takes out the policy;
• how much it costs; and
• how long the process takes.

For further general guidance on warranties and indemnities including:

• their purpose;
• how warranties and indemnities differ; and
• how they fit in with the overall transaction,

please read this helpful Brodies blog. 

The benefits of W&I

The benefits of W&I to a buyer include:

• the ability to make a claim against the seller without damaging any existing relationship (eg. if the seller is still employed by the business post-completion);
• removing the risk that a seller will not be able to pay for any claim should it arise;
• the ability to obtain debt-funding (having W&I in place reduces the risk profile for most lenders); and
• the ability to distinguish themselves in a bidder process, where W&I can be used to (i) provide the full warranty cover the buyer requires, without leaving the seller with any liability, a benefit for both parties; and (ii) allow the seller to immediately receive the sale proceeds.

The benefits of W&I to a seller include:

• offering a clean break and the opportunity for sale proceeds to be distributed immediately on completion and removing the requirement for retention of sale proceeds;
• offering peace of mind to the seller that they will not be liable for the cost of a successful warranty claim;
• the ability to give warranties in circumstances where the sale price is nominal (eg. £1) but the buyer still expects warranties to be given with liability caps higher than the sale price; and
• maximising the sale price by offering full warranty protection.

What does a policy cover?

W&I insurance will be able to cover most of the warranties in any acquisition agreement, however, insuring against most of the warranties will have an impact on the premium. The benefit of W&I is that a buyer or seller can be selective and a W&I policy can be structured to only cover specific warranties and representations.

However, insurers have increasingly sought to exclude or partially cover certain warranties, and the insurer will generally seek to exclude liability for the following:

• forward looking warranties;
• tax liabilities;
• pension underfunding;
• bribery and corruption;
• environmental claims; and
• known risks.

The duration of a W&I policy will usually match the time limitations in the acquisition agreement, however, there is the option for a buyer to extend the coverage past those limitations. Again, any extension of the time limitations will have an impact on the premium.

Insurance will also not cover claims arising from fraud and dishonesty on the part of the insured.

Who takes out the policy?

It is possible for either the buyer or the seller to be insured under a W&I policy. In the early days of W&I it was predominantly the sellers who were the insured as there was a focus on reducing their liability, however, the majority of W&I policies are now taken out by the buyer. The primary reasons for this are:

• a claim against the policy can be made as soon as possible after a breach occurs;
• if the seller is the insured then the buyer would still need to bring a warranty claim against the seller, who would in turn need to make a claim against their policy (if they were covered for that particular breach);
• buyer policies often protect the buyer against fraud and misrepresentation by the seller, whereas a seller policy would not.

Even though the buyer is often taking out the policy, this does not necessarily mean they will bear the cost of the premium - it is more likely that the cost of the premium is borne by the seller, as it is their liability that is being reduced. This aspect is often subject to negotiation and the cost can sometimes be split between the parties.

How much does it cost?

W&I is paid by a "premium", which typically ranges from 1-3% of the policy limit. The policy limit is the maximum amount that an insurer will pay-out under that policy and is normally a percentage of the purchase price. The policy limit will vary from transaction to transaction depending on the market sector, the deal value, credit worthiness of the parties to the transaction, the underwriter's diligence and the competence of the transactions advisers.

It would be unusual for a policy limit to be 100% of the purchase price (normally it would be between 10-30%), but if a party to a transaction requires additional coverage then there is the "tower-model" option where more than one policy is obtained from different insurers in order to reach the aggregate policy limit.

It should also be noted that in the UK there is an insurance premium tax which will be applied to the total value of the premium (currently set at 12%).

How long does the process take?

W&I insurers will work to tight deadlines in order to ensure that their involvement does not have any impact on the transaction timetable, however, it should be considered that the underwriters will need time to review the acquisition agreement (with a near final set of warranties) and disclosure letter (again, in near final form), as well as any due diligence reports. For this reason, most of the insurer's work is carried out in the final stages of the transaction. Typically, a policy can now be put in place within 14 days.

Brodies can help

Brodies' corporate team has a wealth of experience in transactions involving warranty and indemnity insurance and regularly advises businesses in relation to the appropriateness of such policies and their terms. Please contact any member of the corporate team or your usual Brodies contact for further information.