Emergence Of Synthetic Warranties: Shifting Dynamics In The Warranty & Indemnity (W&I) Insurance Market?

The evolving landscape of Warranty & Indemnity (W&I) insurance, particularly with the advent of so-called “synthetic warranties”, transforms the market's approach to managing risks in transactions. This analysis seeks to elucidate the distinctions between traditional and synthetic W&I insurance products and their impact on transactional negotiations, with a particular emphasis on developments within the French market.

Evolution of W&I Insurance Structure

One of the key factor in successful merger and acquisition (M&A) transactions is the negotiation of the representation and warranties set and limitations. These representations and warranties made about the sold business serve as assurances to the purchaser to be indemnified, subject to negotiated financial and time limitations, for breaches or inaccuracy of the seller’s representations and warranties.

W&I insurance policy became increasingly popular within the French market over the last few years, seen as an alternative facilitating negotiations between the parties and providing additional value to the deal.

That being noted, the structure of W&I insurance has undergone significant evolution, particularly influenced by the practices of private equity investment funds.

Historically, W&I insurance served as an additional layer of coverage atop the seller's liability under warranties.

However, the emergence of the "clean exit" scheme, driven by private equity funds unable to make long-term off-balance sheet commitments, has established a model where declarations and warranties come with a liability capped at a symbolic one euro level. Under this scheme, sellers are incentivized to offer more comprehensive warranties, given the minimal financial risk involved.

This shift towards a €1 cap standard has streamlined negotiations, which now focused on the accuracy of warranties to prevent claims based on fraud or intentional misrepresentation.

Synthetic Warranties: Definition and Impact

As explained above, the new standard of traditional W&I insurance typically involves warranties provided by sellers or the target company's management, with liability for inaccuracy or breaches capped at a nominal (€1) amount.

In contrast, synthetic warranties represent a paradigm shift, wherein warranties are negotiated directly between the insurer and the purchaser but not provided by any party – neither by the seller nor the management. Synthetic warranties exist independently, on a “stand-alone basis”.

This model is offered by some insurers on a case-by-case basis, predominantly in scenarios where sellers are materially unable to provide warranties, such as delisting or liquidation situations. In the latter case, the liquidated company’s assets are sold “as is” by a court-appointed liquidator to pay creditors, while no warranty can be given or survive the liquidation process.

The absence of a warranting party in synthetic schemes poses some challenges to insurers. Under a traditional W&I insurance policy, the sellers or managers ensure to avoid warrantying what they know to be false or incorrect, as fraud or intentional misrepresentation allow the insurer to be subrogated in the rights of the purchaser against the warranting party without any limitation of liability (i.e. the agreed €1 cap of liability would not be applicable).

In the context of a synthetic W&I insurance policy, such subrogation process – where the insurer “steps into the shoes” of the purchaser to pursue claims against the warranting party – does not apply to the extent that the representations and warranties are not actually provided by any party involved in the transaction. Therefore, there is no warranting party against whom the insurer can subrogate in the event of a breach.

For this reason, most of the insurers are viewing the synthetic scheme as being more risky than the traditional W&I insurance scheme. Consequently, some insurers are reluctant to implement synthetic schemes, which leads to less competition among insurers for providing these types of policies and, therefore, has a significant impact pricing wise. The main terms of synthetic W&I insurance policies (such as premium amount, deductible, and sometimes the cap) are often less favourable and more costly to the purchaser compared to traditional W&I insurance.

The Future of THE W&I INSURANCE MARKET

The synthetic scheme, despite its challenges, is posited as a potential future standard for W&I insurance.

Insights from other markets, particularly the United Kingdom – a market with a more mature W&I insurance landscape – demonstrate that synthetic warranties are being negotiated in an increasing number of transactions where sellers are capable of offering warranties but refrain from doing so. Their primary motive being to avoid any residual commitments, especially the risk of subrogation.

This scenario raises questions about the potential for the synthetic scheme to become the predominant model in France and other markets, supplanting the current €1 liability cap model.

The emergence of synthetic warranties in W&I insurance policies thus promises significant future developments, given that the W&I insurance market has previously shown its ability to innovate and adapt to changes driven by the policyholders.