M&A Outlook 2022: W&I insurance | a resilient factor in M&A transactions
Global | Publication | March 2022
Although the first ever Warranty & Indemnity insurance (better known in the US as Representation & Warranty insurance) (W&I insurance) policy was written more than twenty years ago, it is only in the past five to ten years that W&I insurance has become a mainstream and widely applied M&A solution for larger and smaller M&A transactions. Both private equity and strategic parties have come to realise that W&I insurance not only facilitates clean exits for sellers by replacing escrows or contractual claims under an SPA with an insurance policy, but also provides buyers with extended warranty coverage (in terms of scope and time periods) as well as a solid and professional counterparty in case of a warranty claim.
The standard W&I insurance process presents a tension between the commercial advantage and overall appeal of using a W&I insurance product on the one hand, and the requirement by underwriters that the insured and their advisors still conduct comprehensive due diligence to confirm the accuracy of the representations and warranties on the other hand. Notably, the W&I insurance product is not intended to be an alternative to an insured party conducting a fulsome diligence process. W&I insurance policies offer protection in the event of unknown breaches of representations and warranties, but they are not meant to cover blanket risks that could be identified during the course of standard buyer diligence. In addition to adequate diligence, insurers expect to see a healthy negotiation of representations and warranties (i.e., not grossly buyer-friendly representations and warranties) in the underlying agreement and a thorough disclosure exercise evidencing involvement of key target company parties in the disclosure process. Both a comprehensive due diligence and disclosure process as well as a relatively balanced set of representations and warranties remain key for a smooth underwriting process and for W&I insurance to remain sustainable in the long run. Nevertheless, for the time being, W&I insurance continues to be widely used and available.
Not only has W&I insurance thrived as a consequence of the record-breaking deal activity as witnessed over 2021 (which trend is generally expected to continue over 2022), but demand is likely to remain strong even in the event of an economic downturn. This is partly due to the maturity of the W&I insurance product, but also to the potential of W&I insurance to unlock distressed M&A transactions, e.g. by synthetic W&I insurance products (in which warranties are included in a W&I insurance policy only and not in an underlying SPA). This enables a buyer in a distressed M&A transaction to still get a certain level of comfort on the target it acquires by means of the warranties included in a synthetic W&I insurance policy. Neither a distressed seller nor a trustee in bankruptcy would normally be able to give any warranties at all. Also in a non-distressed scenario, we expect further growth in synthetic W&I insurance products, particularly in respect of tax.
The market of contingent risk insurance (in which known matters are insured, which are ordinarily excluded under a W&I insurance) is also growing and is expected to continue to grow in the foreseeable future. The most common area in which contingent risk insurance is taken out is again tax, both within an M&A deal context as well as on a standalone basis such as in corporate reorganisations. In the United States, we are also seeing growth in contingent liability insurance in the area of judgment preservation policies for litigation matters that are up for appeal.
Although COVID-19 has obviously also had an effect on the W&I insurance market, it appears that the key market players in Europe have meanwhile settled on COVID-19 merely being an area of attention. Only in certain specific cases, certain warranties would need to be (partially) excluded due to COVID-19 concerns, and then particularly in industries that are strongly affected by it. In the United States, however, the market has generally seen a presumption of a standard, relatively broad COVID-19 exclusion in policies at the outset. The COVID-19 exclusion in the NBIL is likely footnoted with a note that the exclusion can be narrowed during the underwriting process. If, during the underwriting process, the insurer is able to confirm there has not been a material impact to the target company as a result of COVID-19, the presumed exclusion is sometimes narrowed or removed altogether on a deal-specific basis.
In view of the ever-increasing reliance on IT platforms by all kinds of companies (particularly in recent times, fuelled by COVID-19) as well as the number of actual and threatened cyberattacks, the areas of IT and cybersecurity have received much attention, both in terms of due diligence by buyers and scrutiny from W&I insurers in the underwriting process. This is not surprising in view of the significant consequences a successful cyberattack may have, including data breaches, reputational damage, requests for ransom payments and even a potential threat to business continuity, of which numerous examples have made headlines recently. At the same time, due diligence into IT and cybersecurity has become substantially more sophisticated over the past few years. We expect IT and cybersecurity to remain key areas of focus in underwriting processes, not only for technology companies, but also in other industries, such as financial services, energy, infrastructure and health care transactions in particular.
The percentage of policies under which a notification of a claim under a W&I insurance policy is made has remained constant over the past years at around 20% globally, of course with some deviations across jurisdictions. We do not expect this to materially change in the foreseeable future, unless the economic tide turns (in which case this percentage is likely to increase). However, the large number of W&I insurance policies that have been written over 2021 will almost inevitably translate into a higher absolute number of claims notifications for the next few years. The warranty areas in which most claims are filed have remained, and are likely to remain, constant over time and include financial statements, tax and compliance with laws.