W&I Insurance: The rise of synthetic warranties?
Warranty and indemnity (W&I) insurers are seeking innovative ways to service the M&A market in a Covid-19 pandemic induced downturn. This article discusses the potential uses for W&I insurance policies with synthetic aspects in meeting the market's current needs.
What are synthetic warranties?
Synthetic warranties are standalone warranties negotiated outside of a sale and purchase agreement (whether on a business sale or a share sale) (SPA) between the insured and the insurer. Synthetic warranties are insured on a "deemed" basis, as if they had been given by a seller to a buyer in the normal way. The insurer then covers any financial liability for a breach of the synthetic warranties.
The synthetic concept is not new. On a smaller and more specific scale, insurers in the W&I market have been providing synthetic policy enhancements alongside their W&I insurance policies for many years. Synthetic policy enhancements have enabled W&I policies to bridge the gap between the protections a buyer is seeking under an SPA versus those which a seller is prepared to give (see "synthetic policy enhancements" below).
The first fully synthetic W&I policy was placed in the UK in 2018. However, fully synthetic W&I policies have been limited and largely confined to transactions involving the acquisition of relatively simple businesses, such as the acquisition of property holding SPVs or asset rich businesses.
How is a W&I policy with synthetic warranties different from conventional W&I Insurance?
A traditional W&I policy sits behind the warranties given by a seller and negotiated with the buyer in the SPA. There is a negotiation exercise between the insured and insurer around the scope, limitations and the extent to which the warranties in the SPA are covered by the W&I insurance policy. However, this is normally limited with only a few warranties excluded from cover or where partial amendments to specific warranty wording is deemed made. The process of underwriting a W&I policy usually runs concurrently with the negotiation of the main transaction documents (including the negotiation of the warranties under the SPA). The W&I policy then binds at either exchange or completion.
As a full set of synthetic warranties are anticipated for scenarios where there are limited or no warranties between the buyer and seller under the SPA the underwriting process requires a greater level of negotiation between the insured and the insurer to agree the synthetic warranty "package". The negotiations are undertaken in the same timeframe as the underlying transaction. In practice, the overall time demand on an insured is similar to a typical transaction. The warranty negotiation has simply moved from the SPA between the buyer and seller to the W&I policy between the insured and the insurer.
Under a traditional W&I policy the insured is expected to have undertaken a comprehensive legal, tax and financial due diligence exercise to provide the required level of comfort to the underwriting insurer. This would involve an exchange and flow of information and due diligence materials between the seller and the buyer through the usual due diligence Q&A and/or data room processes. Any perceived "gaps" in the due diligence can often lead the insurer to exclude certain warranties from cover. The limited number of fully synthetic W&I policies that have been placed have historically relied on the same, if not a higher standard, of due diligence to compensate for there being no buyer and seller warranty negotiation process.
What are the different types of synthetic policies?
The extent of the gap between the warranties a seller is willing to offer and the comfort a buyer is seeking will dictate whether either synthetic policy enhancements or a full set of synthetic warranties would be appropriate.
Synthetic policy enhancements
Where a buyer is seeking additional protection, an underwriter may (for an additional premium) agree to "synthetically" extend cover through the W&I policy beyond the wording or provisions of the SPA. The range of typical synthetic policy enhancements includes:
- knowledge scrape: which effectively removes the knowledge qualifiers in the warranties in the SPA;
- materiality scrape: which effectively removes the materiality qualifiers in the warranties as drafted in the SPA;
- basis of recovery: permitting any recovery made under the W&I policy to be made on an indemnity basis of damages; and
- extension of limitation periods: extending the warranty limitation period beyond that set out in the SPA.
Synthetic tax deeds are also becoming increasingly commonplace in the W&I market. Like synthetic warranties, a synthetic tax deed provides cover when no tax deed is offered by the seller and negotiated separately between the insured and buyer.
Fully synthetic warranties
A set of fully synthetic warranties may be a possible solution where (i) the regulatory environment does not permit the seller or management to give warranties to the buyer directly; or (ii) the seller and/or management are not prepared or are not in a position to offer warranties and/or disclose against them. For example, in distressed sales or public to private transactions.
What are the advantages of fully synthetic policies?
A fully synthetic W&I policy may expedite the timeframe of a transaction. There will be no negotiation with the seller over the warranties and limitations and only one negotiation of the warranty coverage (between the insurer and the insured) rather than two. Seller's awareness is also no longer relevant in the negotiation process. A fully synthetic policy may also provide insurance coverage where it would not otherwise have been available to a buyer (as noted above).
Advantages for a buyer would include:
- a reduction in risk associated with the acquisition;
- strategic differentiator at auction or in a competitive process; and
- it enables the buyer to tailor its due diligence around the synthetic warranty coverage (thereby potentially saving cost).
More specifically, if a buyer were able to take out a W&I policy incorporating a full set synthetic warranties this might be advantageous to a seller in:
- widening the pool of potential buyers (e.g. by potential buyers being able to differentiate themselves in a competitive/auction sale); and
- maximising the purchase price.
The availability of a fully synthetic W&I policy will be determined by the extent to which there is (i) available and sufficiently comprehensive due diligence (tax, legal and financial); (ii) engagement with the seller/management; (iii) a reasonable timeframe; and (iv) a favourable sector/jurisdiction.
A comprehensive due diligence exercise is still critical. A synthetic warranty suite would closely reflect those areas where comprehensive due diligence has been completed on the target business. This can be a challenge or severely limited in certain distressed sales or public to private transactions.
The disclosure process also remains a challenge for fully synthetic policies, with insurers still typically requiring some engagement from the seller or management in that process. Any impact on the quality of the due diligence and the disclosure process due to the lack of seller/management engagement is likely to have a knock-on impact on the scope of cover. Fully synthetic policies in any case often provide a narrower set of warranties than traditional (nil recourse) W&I policies and at a higher price. To date, market participants are also unfamiliar with synthetic warranty deeds.
In the current market, a synthetic policy is also likely to be challenging in a competitive process due to the potential impact such a policy would have on timing. That is why to date fully synthetic policies in the distressed sale space have been limited to non-competitive situations and sales involving relatively straight forward businesses (e.g. not heavily regulated or multi-jurisdictional). However, synthetic cover does provide an important tool in bridging the gap from seller to buyer and it remains to be seen how the market navigates these challenges to ensure wider application.