Exits: making warranty and indemnity insurance work for your sale process

A practical guide 7 min read

Warranty and indemnity insurance (W&I insurance) is now a near staple in sale processes run by sellers seeking a clean exit from an investment, especially in the private capital context. However, some processes—and parties—are able to make better use of the product than others.

In this Insight, we step through, in practical terms, how both sellers and buyers can optimise their use of W&I insurance in these processes.

Key takeaways 

• For sellers: sellers should ensure they put in the work before launching a sale process so that the W&I program is set up for success. This means engaging the right broker and selecting the right insurer early and doing the necessary preparatory work so that the insurance terms are well defined and bidders are well placed to secure acceptable coverage. Leaving the W&I insurance to the bidder to solve is fraught.
• For bidders: bidders should leverage, rather than duplicate, any Vendor Due Diligence (VDD) that has been carried out and focus their top-up due diligence on the areas required to close coverage gaps or that really go to value, all with a view to presenting a bid that balances their recourse requirements with something that is easy for a seller to readily execute.

Is warranty and indemnity (W&I) insurance right for your process? A quick recap on the product

W&I insurance only covers unknown risks. All known issues are carved out from coverage, including matters identified in due diligence.

This means that if the business being sold has several known issues, sellers should carefully consider whether it makes sense to require bidders to obtain and pay for W&I insurance (as said known issues will be excluded under the policy, leaving an exposure for somebody to stand behind). If a clean exit is a non-negotiable and the issues are major, sellers may need to consider coupling it with (more expensive) known risk insurance.

On rare occasions, we have seen pressure from bidders to cause sellers to rethink the W&I program/recourse proposition mid-process, which can undermine the seller's leverage in negotiating a clean exit and disrupt the overall auction process.

Sell-side

Select the right broker

A critical initial step is to select an experienced W&I insurance broker, and to do so early. A good broker actively negotiates pricing, coverage/exclusions and other policy terms, knows the bidder universe (eg if that is sponsors) and their typical requirements and has the bandwidth for the transaction. A seller's 'house' insurance broker for ordinary course business may not necessarily fit this bill.

Select the right insurer 

The W&I broker should test the insurance market for indicative proposals, focusing not only on best pricing, but also on the best terms and fewer exclusions. For example, a lack of a pollution/contamination exclusion, cyber exclusion or AML exclusion may be more valuable for the particular transaction than a lower premium.

Practical considerations are important too. For example, not all insurers have boots on the ground or the capacity to 'run trees' and take multiple bidders through pre-preferred underwriting in parallel. In addition, some insurers no longer require  underwriting calls and get comfortable underwriting based on written responses to tailored sets of underwriting questions (which are prepared either way) – this saves real time and cost and is a more efficient process. In our experience, a good broker has a gauge on all of this.

Vendor due diligence? Settle scopes, identify gaps

Done well, Vendor Due Diligence is a worthwhile investment that cuts down the buy-side work bidders need to do to obtain appropriate coverage and, in turn, streamlines the often extensive demands on management time during the sale process itself.

To make it most efficient, sellers should look to the W&I broker to help settle the scope of each adviser's VDD exercise before work gets underway. Once the VDD reports are ready, they should be shared with the preferred insurer to enable the insurer to prepare a 'gaps memo' that outlines for bidders what top-up due diligence the insurer does (and does not) expect in order to be able to provide fulsome coverage. Most insurers will require a sell-side underwriting fee for this exercise, however the fee is nominal in the context of the overall process and only payable if the process collapses, making it a worthwhile investment.

Payroll compliance sampling

Regardless of whether broader VDD is being carried out, if the target group has a reasonable sized workforce, sellers should seriously consider undertaking payroll compliance sampling – which is now a near pre-requisite for underpayment/misclassification coverage – prior to launching the process. Particularly if a clean exit is critical, getting ahead of this work stream is important to be able to obtain coverage.

At a minimum, the scope of required sampling should be settled with the broker and preferred insurer and all required sampling information collated in advance (this can take considerable time) and made available to bidders at the start of the confirmatory phase so that they can do it themselves.

The sampling scope is best framed with the input of both accounting and legal advisers. Key considerations include whether all or only some of the following are covered:

1. underpayment against entitlements (in enterprise agreement(s) and award(s));
2. misclassification of permanents vs casuals; and
3. misclassification of contractors vs employees.

A 5% sample size across three consecutive pay periods and a range of pay bands is a common rule of thumb, however this may be reduced for larger workforces.

Documents for bidders

W&I insurance expectations and process requirements should be outlined in the process letter for the auction, with the program proposal, gaps memo and draft policies made available to bidders from the outset of the binding bid phase so that bidders can move quickly. Ideally, sell side counsel should have done a first round of negotiation on the draft policies (primary and excess) so that the documents are in a sensible starting position for bidders.

The draft sale agreement should accurately reflect the ask on recourse, including who is obligated to pay the premium (usually the buyer in a competitive process). Sellers should give careful thought in particular to whether and in what circumstances they are prepared to stand behind title claims – for what period, from 'dollar one' or only above the policy limit, at the group level or only at the target entity level and so on. While sellers regularly open with a sale agreement that contemplates zero recourse for title claims, the negotiated position often sees them get comfortable standing behind these for a short period (say 2 years or so vs the 7 years available under the policy) and for amounts up to the sale price above the policy limit.

A tip on sale agreement limitation of liability regimes – the kitchen sink often isn't necessary in a no or limited recourse deal, so sellers are often better off asking only for those they really need rather than engaging in protracted negotiation on those they don't or eroding the bidder's coverage position unnecessarily.

Buy-side

Top-up due diligence only

Some bidders have a tendency to effectively ignore the VDD that is made available and do ground up buy-side due diligence, which can be time consuming and costly. Where the VDD is high quality and reliance is being extended by the report providers, bidders should take advantage of it and look to confine their buy side work to top-up due diligence where necessary to plug gaps the insurer has identified (there are always some) or otherwise stress test areas of real focus or value.

Price the risk

The W&I premium is tied to the chosen policy limit and typically reduces (as a percentage of the limit) as the insurance tower grows and the rate is 'blended' across the primary and excess policies. However, beware of paying for a limit you do not need – the larger the deal the smaller the W&I insurance policy limit usually needs to be, with limits below 20% of enterprise value being common for bigger deals. Bidders are usually also better off accepting or 'pricing' the premium as a transaction cost, rather than seeking to split it with the seller in the sale agreement.

Make the broker work for you

Although bidders don't usually get a say in the broker (firm or individual) in a sell-side arranged W&I program, it's important for bidders to work effectively with the broker assigned to them to help secure the best possible terms. The best brokers earn their commission by proactively using their relationships and precedent transactions to push the insurer to provide better coverage terms. 

Take a view on known risks or accept exposure?

In hotly contested processes, making the bid executable is key. For bidders, this could mean committing to paying for underwriting early (before being selected), getting comfortable with business as usual risks inherent to the asset being sold or taking a view on known issues where the exposure can be quantified and priced (rather than seeking recourse to the seller). In more extreme circumstances, this could mean signing the sale agreement before completing underwriting (and incepting or endorsing the W&I policy post signing, without the comfort of a W&I condition precedent). In the right circumstances, confident bidders can differentiate themselves and gain a competitive advantage by doing so, as it's possible for their bid to be signed within a matter of hours after they are selected preferred (if the other transaction terms are settled).

Conclusion

W&I insurance is now a near-universal feature of private capital (and increasingly, corporate) sale processes. It is undoubtedly a useful product, but its true value turns on how well it is prepared for and used by the parties insisting and relying on it.