Warranty and indemnity insurance

Arthur J. Gallagher Sponsored Feature

Even once negotiations over the sale price are completed, due diligence done and dusted and the sale and purchase agreement (SPA) drawn up and signed, parties can end up with contractual obligations that stretch out for many years ahead.

However, there is another way. Warranty and indemnity insurance (W&I) can speed up the negotiation process and ensure a clean and quick exit for both buyer and seller. At the same time, W&I cover provides reassurance that if something unexpected does crop up, even long after the deal is done, the situation may be rectified without the need to engage in a lengthy - not to say possibly expensive - legal process.

W&I insurance has been well known to private equity houses for some time. The benefits it provides are now being enjoyed by the property world. As leading W&I broker Arthur J. Gallagher reports, awareness of W&I cover is growing significantly within the industry. However, there are still some companies that do not fully appreciate how it can be applied.

So, how does W&I insurance work? And how might the benefits it brings, so valued by private equity firms, translate to property transactions with assets held within a corporate structure (SPV)?

A process with clear disadvantages

No matter how robust the due diligence, ultimately in a commercial acquisition the buyer is reliant on the seller to assert certain information about the business - the seller is expected to provide a number of warranties or statements of fact within the SPA.

The purchase price will, at least in part, be contingent on these warranties being true - if there is a breach the buyer will seek redress against the seller to the full extent available under the terms of the SPA. This provides potential long-term liabilities to the seller and the buyer will want reassurance that if there is a breach there will be funds available for redress. As a result, a proportion of sale proceeds may be held in an escrow account that cannot be touched until a contracted period has expired.

If there is a breach of warranty, there is a pot of cash available to make amends. Negotiations around the scope of warranties and limitations around the seller’s contractual liabilities can be lengthy and contentious, not to say hostile.

While the process is as old as the hills and well understood, it has clear disadvantages for both sides of a deal. For the seller, it requires a proportion of the proceeds of a deal to be locked up for what can often be a lengthy period. In terms of the tax, for instance, a warranty can provide a contingent liability stretching to seven years, tying up money that could otherwise be distributed to investors or ploughed back into active use.

Sitting in an escrow account, it is doing very little. “When the client is selling an asset, they are selling it because they want to do something else with their money,” says George Minoprio, executive director at Arthur J. Gallagher. “They don’t want their capital to be tied up in any way.”

For the buyer, the system is also fraught with difficulties. Yes, the presence of the escrow account provides a degree of reassurance, but what if the actual cost of a breach of warranty turns out to be greater than the amount held in the account?

What appeared to be a wise purchase could turn out to be a financial albatross around the neck of the purchaser. Of course, if it turns out that a seller has been fraudulent in their statements it can be pursued through the courts, but again, who wants to be caught up in legal wrangling if it can be avoided?

The ins and outs of W&I cover

This is where W&I insurance comes in. A policy can both indemnify a seller, providing a clean exit and allowing it to move seamlessly to its next investment or immediately distribute funds, and at the same time provide a greater level of protection to a buyer. So how does it work in detail?

A W&I policy can be initiated or held by either party, but the usual best practice these days, particularly in terms of a property deal, is that the seller initiates the W&I process but the policy is ultimately owned by the buyer.

“If you are planning on selling an asset, you will probably be thinking about the warranties you’re willing to provide at an early stage - this is the ideal time to start the insurance process,” says Matthew Bates, head of risk advisory at Arthur J. Gallagher. “A lot of our work these days starts with the seller and then once they’ve got a buyer the process flips to the buy-side.”

Sellers will often seek to limit their liability wherever possible. “In real estate deals we’re often seeing the liability offered as low as £1,” says Minoprio. “You want to limit your liability on the sale of an asset through an SPV as much as possible. So you suggest to the buyer they take a W&I product and then contribute to the cost. Or maybe the process is so competitive the buyer offers to pay the full amount. It depends on the dynamic.”

Bates agrees: “It does vary, but typically the seller pays the cost to insure what is agreed as a commercial set of warranties and the buyer pays the cost to fund any higher limits or coverage extensions. The ceiling on that higher limit depends on how risk averse the buyer is.”

Either way, the very existence of the policy provides advantages to both parties. From a buyer’s perspective, the value is the ability to walk away from a deal with a clean slate. The presence of a W&I policy means, provided it has done its due diligence properly, the buyer can walk away from a deal with confidence. If a warranty is breached, it no longer has to go through the hassle of trying to extract cash from a seller’s escrow account, or worse, trying to fight a case through the courts. At the same time, the insurance policy eliminates a significant element of counter-party risk. According to Minoprio: “A buy-side policy is the clean way to do it because the buyer can go straight to the policy rather than having to pursue the seller or funds that are no longer in existence.”

A buy-side policy will typically include seller fraud. The buyer claims under the insurance policy and the legal battle is left to the insurer - this also provides an incentive for the seller to remain scrupulous. “There is an inherent advantage to a buy-side policy,” says Bates. “If I’m a buyer and it’s my policy I control it, I don’t need to sue the seller in order to get to their policy. There are good reasons for the policy to be held on the buy-side rather than the sell-side.”

Making deals possible

But from both parties’ point of view, the presence of a W&I policy can help speed up the deal process - indeed, it can help ensure that a deal gets done at all. “A lot of the value is about being able to get the deal done,” says Bates. “If you’re saying as a seller, “I am going to limit my contractual liability to £1 because I want to give the sales proceeds back to my investors”, and if I’m saying I want £10m in an escrow, then you’re never going to sell it to me. But if you get an insurance policy it makes the deal possible.”

Of course, W&I insurance won’t be appropriate in every property transaction, but lawyers are increasingly viewing it as something that should be at the very least considered. “When I was talking to a lawyer recently, he said he almost views it as negligence for a lawyer not to raise the subject of W&I insurance,” says Minoprio. “It’s very much on their agendas.”

If a deal can be done more quickly, more cleanly and with fewer overhanging ongoing liabilities then why not at least look into the option?

Warranty & indemnity insurance: market overview

Market capacity has grown considerably over the last few years. There is significant underwriting appetite for real estate transactions. Competition is driving:

• Lower premiums
• Wider cover
• Faster process

The information in this article is provided for information purposes only. If you have any questions or would like to discuss a specific scenario, please contact Arthur J. Gallagher on how W&I insurance worksand the opportunities it can provide.

W&I insurance webinar season

Arthur J. Gallagher is to publish a three-part webinar season beginning in February, entitled Warranty and Indemnity Insurance - A Guide for Real Estate Professionals. Part one will provide a product overview; part two will focus on the reasons people purchase W&I, policy coverage and general exclusions; and part three will discuss the W&I underwriting process. The firm is planning two further Q&A webinars for later in the year.

Contact Arthur J. Gallagher for more information on how W&I insurance works and the opportunities it can provide.

Matthew Bates, head of risk advisory, major risks practice, Arthur J. Gallagher
Tel: 020 7234 4670; Mob: 07770 632 133; Email: matthew_bates@ajg.com

George Minoprio, executive director, mergers & acquisitions practice, major risks practice, Arthur J. Gallagher
Tel: 020 7234 4038; Mob: 07770 632 242; Email: george_minoprio@ajg.com