The interplay between W&I insurance and the M&A process

published on 17 May 2023 | reading time approx. 2 minutes

W&I insurance, if used, influences the M&A process at several points.

W&I insurance (W&I stands for Warranties and Indemnities) is a product covering damages arising in particular from the breach of warranties given in enterprise purchase agreements. W&I insurance has become widespread especially in the following cases influencing the M&A process:

no agreement between the transaction parties as to the distribution of risk could be reached;
there are both a limited scope of warranties and a small amount liability cap due to a strong negotiating position of the seller or in a distressed M&A scenario;
a private equity sponsored fund acts as seller (clean exit).

Although W&I insurance is a legally separate agreement, it relates to the provisions on the seller's liability in the purchase agreement. This is because the legal consequences of breaches of a warranty are usually regulated in the purchase agreement and specifically concern the extent of the damage to be compensated, liability amounts caps, deductibles, baskets, and de minimis amounts.

Basically, W&I insurance can be taken out either by the seller or by the buyer. The sell-side W&I insurance is, technically, a liability insurance policy. In this case, the policy protects mainly the seller as the policyholder. It insures the seller against the risk of the buyer asserting claims against him in the case of a breach of a warranty. The buyer's insurance however is, technically, direct insurance. Here, the buyer is the policyholder and thus mainly protected. On the basis of the W&I insurance, the buyer can claim damages resulting from the breach of warranties by the seller directly against the insurer. One advantage of the buyer's insurance is that the buyer can raise the claim for damages directly against the insurer without having to take action against the seller first.

The interplay between W&I insurance and the purchase agreement

The areas where the W&I policy and the purchase agreement interplay include both the factual prerequisites and the legal consequences of a breach of a warranty. It is important to coordinate the provisions of both contracts – which are generally independent of each other – in order to reflect the interests of the parties involved as best as possible and avoid interpretation-related difficulties later on, and not have to fill any gaps or supplement any provisions.

Also, the shape of the seller's warranties can be strongly influenced by the existence of an W&I insurance policy. For example, it is often easier for the seller to accept large liability caps and low deductibles, baskets, and de minimis amounts, as well as long limitation periods if liability claims are covered primarily from the W&I insurance. Conversely, it is easier for the buyer to accept liability caps and high deductibles, baskets, and de minimis amounts from the seller if a W&I insurer is willing to provide cover in excess of these limits.

As regards the period to which a warranty refers, W&I insurance does not cover any forward-looking statements because these would be associated with risks that are hardly calculable. Forward-looking statements that relate to the point of transaction closing can exceptionally be acceptable to an insurer provided that the period between signing and closing remains within a specific time frame. From the insurer's point of view, it is fundamental that the issuance of a confirmation of cover is accompanied by the so-called bring-down certificate of the seller in order to ensure that the insurance does not cover circumstances that have become known in the meantime.

The legal consequences of a breach of a warranty included in the purchase agreement are not per se insured in the same way as in the W&I contract. The insurance contracts, however, often include provisions that mirror those in the purchase agreement.

In the case of transactions covered by W&I insurance, the seller's liability is often limited to a very small symbolic liability cap so the seller practically bears no remaining liability risk on his own. In such cases, the sum insured by the insurer is decoupled from the limit in the purchase agreement and exceeds it many times over.

W&I insurance only covers unknown risks. The insurance therefore generally does not cover disclosed risks and risks that were known to the buyer at the time of concluding the agreement.

The interplay between W&I insurance and due diligence

As with known risks, a W&I insurer will generally not assume risks for warranties related to matters that could not be examined or not sufficiently examined during due diligence. Such examination is a core element of the underwriting process because in these cases there is usually no sufficient basis for performing a valid risk assessment. The use of W&I insurance therefore influences the scope of work of due diligence.