Insuring transaction risks – a potential deal stabiliser

Updated on 23 September 2020

Although the coronavirus crisis has slowed down the deal flow, it has by no means come to a standstill. However, the market is adapting to the shift in challenges posed by the COVID-19 pandemic, meaning that, for example, material adverse effect clauses are being given a much higher priority.

Nevertheless, despite the billions that are to be made available to the economy by way of state and supranational support programmes, in such unprecedented times the following mantra applies perhaps more than ever: Cash is a fact! Company valuations are struggling to properly price in the risks added by the pandemic, and fears on the part of sellers that warranty breaches could be used to at least partially “refinance” a deal will certainly not diminish in the current situation.

In this respect, the notion takes hold that at least the latter doubts concerning the intentions of a party in the context of a transaction should be dispelled by taking out appropriate insurance, and that the economic consequences of a breach of warranty should be set out in a way that is comprehensible to the parties.

Now that warranty & indemnity (W&I) insurance has become standard in private equity, these products are also becoming increasingly popular in corporate M&A deals. This steadily increasing demand on the part of insurance buyers in recent years (the vast majority of W&I insurance is a buy-side policy) corresponds to a significant increase in the number of providers, a noticeable reduction in premiums or extension of coverage, as well as a steadily growing range of complementary services, which already include contingent legal risk insurance in addition to tax liability insurance. In addition to the classic unknown risks in those areas scrutinised as part of due diligence, even known risks with a low or moderate probability of occurrence can be the subject of insurance.

However, whether an insurance policy benefits a deal in times of COVID-19 is to be questioned in several respects.

W&I Insurance

As mentioned above, the question of the liquidity required for a transaction is of considerable importance for both parties: The decisive factor for the buyer is that, in the event of a breach of warranty, he can turn to a solvent claimant, i.e. the excess purchase price share paid with regard to the breach of warranty can also be recovered. For the seller, it is without doubt of considerable importance at present that the purchase price is also paid in full upon closing and does not remain in an escrow account as a security for potential claims and, therefore, would only become available to the seller after the expiry of the corresponding warranty period. These expectations held by the parties can essentially be met by taking out W&I insurance. However, expectations here should not be too high.

Firstly, it depends on which deductible has been agreed between the parties prior to performance by the insurance company. If this is high, the buyer can insist on the retention of purchase price to secure this deductible to be borne by the seller even if an insurance policy is taken out. At the same time, the coordinated structuring of the insurance cover and the warranty catalogue is of considerable importance. Should there be more extensive gaps between the risks covered by W&I insurance benefits and the catalogue of warranties provided by the seller, the purpose of “extensive” liquidity from a retention of purchase price pursued by taking out W&I insurance can quickly become limited.

As a result, the use of such an instrument in a transaction should be planned from the outset and taken into account throughout the entire process. As there is, of course, also a considerable interest on the part of the under-writers of W&I insurance solutions in avoiding reduced due diligence scopes for the consultants commissioned with the audits due to liquidity considerations on the part of the buyers and, thus, potentially overburdening them with increased risks, a number of underwriters expect an early involvement in the entire structuring and sequence of the due diligence process. Similarly, the required coordination of the sales and purchase agreement (SPA) – not only between the parties and their advisors, but also the corresponding coordination of the contents of the insurance policy with the insurance provider – may increase the transaction’s complexity.

Title Insurance

The reasons for taking out a title insurance policy are, in part, different from those for W&I insurance. The following key rule applies: title insurance is recommended in the event of legal risks arising during the due diligence process in relation to the seller’s title to the shares or the target’s title to the property. Nevertheless, in similar fashion to W&I insurance, title insurance in the private equity sector is now taken for granted in certain regions.

As mentioned above, title insurance is primarily used to insure the title and its characteristics (such as, for example, possession, use) of the target’s shares and/or property against the assertion of a challenge by a third party. The results of the due diligence process are regarded as so-called “known risks” by the insurer and can be insured on the basis of the insurance policy against a deductible of the insured. Otherwise, the results of due diligence and the risks mentioned therein will be excluded from the insurance cover.

Nowadays, however, we are noticing an increased risk tolerance on the part of insurers, so that title insurance policies are issued for shares and property, including in regions with less legal security (such as in South-Eastern Europe). In addition to broadening the geographical scope, the spectrum of risks covered has also been extended. In the case of the shares, for example, all corporate law risks are insured. With regard to property, in addition to the right of ownership, other additional issues are insured, such as construction rights (building permits, urbanism plans), rights of use, rights of way, and income from rents.

To add to the complexity of the transaction, insurers usually have specialised teams for W&I and title insurance. The insurance premium – with or without deductible – is also determined differently for each insurance policy.

Conclusion

If well prepared, taking out insurance against transaction risks in times of the coronavirus crisis can have a positive effect on liquidity considerations, which are not insignificant.