The use of M&A insurance products, in particular Warranty & Indemnity (W&I) insurance, has become commonplace in the US and European M&A markets over the last five years, with a number of major law firms reporting that it is used on 20-25% of deals that they have advised on. Whilst the product has been somewhat slower in gaining traction in India, the gap is starting to close.
What is M&A Insurance?
W&I insurance policies provide cover for losses suffered in connection with warranty or indemnity claims, and may be taken out by either the seller or the buyer.
Under a buyer policy, the buyer typically claims against the seller up to the liability cap agreed in the sale documents, and then claims against the insurance policy for any losses above the cap.Under a seller policy, the buyer would claim against the seller under the sale documents in the normal way and may not be aware of the insurance policy.
W&I insurance typically covers unknown risks, however in certain circumstances bespoke insurance policiesmay be available for known but contingent and/or unquantifiable risks, including certain tax risks, that may otherwise be dealt with as an indemnity from the seller. Policies may also be available to facilitate the winding-up of an investment vehicle by insuring residual liabilities of the fund.
Strategic benefits of M&A Insurance
There are typically four key drivers for a buyer or seller to seek to insure an Indian transaction:
1. Achieving a clean exit with certainty of sale proceeds;
2. Increasing the level of recourse or time limit for claims beyond the limits offered by the seller;
3. Avoiding enforcement risk against the seller in the event of a successful claimor the need to make a claim against a seller at all in the Indian courts;
4. Reluctance to claim against the sellers, e.g. a private equity sponsor not wanting to make a claim against a management team.
Seller to buyer “flips” are increasingly being used in auction processes, whereby sellers procure indicative pricing and coverage terms from insurers for a policy that will ultimately be taken out by the buyer. The insurance coverage then used as a tool to resist any attempts by the buyer to seek a liability cap from the seller above the attachment point of the policy, particularly where the seller is paying the cost of the premium. In doing so, the seller puts itself in a position to achieve a better and more certain valuation as there is no need to tie up proceeds in escrow to cover unknown risks.
The importance of diligence
As insurance is intended to cover “unknown unknowns”, it is important that buyers intending to insure a transaction agree a due diligence scope with their advisers that covers the areas that the warranties relate to. This will avoid warranties which would be insurable if a reasonable level of diligence had been carried out from being excluded from cover under the policy.
While the cost of W&I insurance is still generally higher in India than in Europe, the cost has fallen significantly in recent years and the market for Indian policies has increased in response. Although market data remains somewhat distorted due to the number of smaller limits placed at a fixed minimum premium rather than a percentage of the limit, Indian policies are typically priced at a rate of between 2% to 3.5% of the limit with an attachment point of 1% of enterprise value. Parties often obtain insurance for between 10% and 40% of enterprise value, with rates reducing as larger proportions of the enterprise value are insured.
Any purchaser of insurance will want to know that the policy will respond in the event of a valid claim, and M&A insurers are increasingly being asked to provide information regarding their specific M&A claims handling experience and capabilities.
In 2016, AIG released a global claims study of over 1,000 transactions with a value of more than $200 billion, which revealed that nearly 14% of the M&A insurance policies written by AIG globally between 2011 and 2014 resulted in a claim. Data for an extended period to 2015 will be released later this year, and is expected to show that the proportion of policies resulting in a claim has increased further.
As confidence builds that M&A insurance policies will respond to claims and the use of insurance as strategic tool rather than a means of allocating risk becomes better understood, it is expected that the recent growth in the use of M&A insurance will continue in the years to come.
Authors: Sushant Sarin, Senior Vice President – Commercial Lines, Tata AIG General Insurance Company Ltd and Mark Storrie - Senior Underwriter - M&A, AIG.