There was a time when warranty and indemnity insurance (“W&I”) was available only for the larger property transactions in the market, where high minimum premiums applied and exclusions for the more contentious risks made the insurance policy less attractive for a purchaser. This is no more.
As ever greater capacity has poured into the W&I market, insurers have had to think hard about how to differentiate themselves from the competition, not just on the larger deals but also the smaller ones with property transaction values as low as £10m.
The general principle of W&I is to provide the seller with a clean exit and the buyer with recourse should a breach of a warranty occur or if an indemnity event occurs. This is achieved by the transfer of risk from the seller or buyer to the insurer.
The starting point is to provide what is known as “back-to-back” cover. In other words, the policy will mirror the warranties and indemnities in the sale purchase agreement and cover all risks arising from a breach of a warranty or indemnity.
However, risk underwriters will start excluding certain warranties or indemnities that they feel less comfortable with during the due diligence process.
So why W&I?
From a seller’s point of view, the policy will provide it with a clean exit from the transaction. This means that it will be free of any liability arising from a claim that is covered by the policy.
In the context of a corporate property transaction, one of the main issues that can arise involves tax liabilities. If the seller agrees to indemnify the buyer for a tax indemnity event, then it may have to reserve the claim amount for up to six years. This is obviously not attractive and W&I can provide an ideal solution to this problem.
It is also possible to cover off risks arising from title issues or restrictive covenants. A broker with expertise in the property space will be able to use a combination of W&I and other insurance policies, such as a legal indemnity, to keep the price down and offer the maximum scope of cover.
For a seller, it can be a valuable negotiation tool to approach W&I insurers for an indication of the cost before negotiations with the buyer commence. The buyer may use risks that they discover during the due diligence process to negotiate the price of the asset. Insurance provides the seller with a fixed sum, being the premium plus excess, for an unknown liability. If the buyer raises concerns about these risks in order to negotiate a price reduction the seller can use W&I as a countermeasure.
From a buyer’s perspective, W&I offers comfort that breaches of the agreement will be dealt with quickly and recourse is available for the agreed period. If the buyer is purchasing a distressed asset, it may not be possible for the seller to provide comfort that someone will be there to meet its liabilities should a claim occur.
W&I also provides the buyer with the “price of the risk”. This is a valuable figure and will allow the buyer to better consider if the investment is a worthwhile one.
In addition, relevant to both the buyer and the seller, the underwriters may pick up on items of risk that the parties were not aware of during their due diligence process. It is in effect an extra set of eyes looking at the risks.
The broker’s perspective
It is also important to point out that W&I is not perfect and it has limitations. Not all risks will be insurable and buyers should be aware that W&I is not a substitute for carrying out due diligence on the purchase. The potential insured needs to act as if it is not insured in the first instance.
An experienced broker should point out from the outset the product limitations and walk the client through the process, which can sometimes take a long time. Another important area where a broker can add value is in using a combination of insurance products to widen the scope of insured items and also to keep the costs down.
For example, legal indemnity is a much more cost-effective way of covering title risks. There are also insurers that will offer cover for items that are considered “live risks” which are likely to be excluded from the W&I policy. Some insurers will even insure the underlying excess after a period of time has elapsed since a W&I policy was incepted.
In summary, W&I is a valuable product for both buyers and sellers but it also has limitations and is among the more complicated of insurance products. Having a good lawyer, accountant or broker on board giving sound advice about the policy is key and expectations should be carefully managed.
Case study
Our client was one of several bidding for a property portfolio and took out a buyer’s policy so that it could obtain a more competitive and strategic advantage over the other bidders. This allowed the client to offer an attractive proposition requiring a low warranty cap from the seller, who may otherwise have needed to hold significant funds within an escrow or a hold-back sum for a long period of time.
Nick Mace is commercial risks director at specialist broker Clear Insurance
