Full synthetic W&I insurance coverage – fiction or shortcut to a policy 2.0?

The market as it stands

The immediate impact of the Covid-19 pandemic on the M&A market appears to have passed its negative peak for the moment. Markets experienced a record year in 2021 both in terms of number of transactions as well as of transaction volume. A total of more than 63,000 transactions moved a volume of more than USD 5.9 trillion – an increase of 64%.1 It comes as no surprise at all that such increase has led to yet another boom in the transactional insurance industry and affected the way policies are or can be placed into the market also on a synthetic basis for policy purposes.

While certain policy discussion items such as unknown tax risks, adjustments or enhancements of loss definitions and of course knowledge scrapes remain the go-to topics when it comes to synthetic coverage elements, full synthetic cover is not yet something the market seriously wants to transfer from mere discussions into reality. While recent articles and social media posts still do suggest differently and won’t stop doing so (and there is reason behind it, namely flexibility), it is worth the check to see where the market in fact currently stands – whether it is in need for yet another level of synthetic elements or whether this is and remains a theoretical discussion that is likely to pass the bore-out barrier for the moment.

Motives and motivation

Of course parties’ interests under a standard transaction matrix are quite different, no surprise at all so far. While there is natural limitation in place (the SPA) when it comes to bridging the gaps between seller and purchaser, it is of course tempting to regard synthetic coverage as the golden share and quite an elegant alternative to facilitate transactional flexibility and a positive outcome for the transaction itself. We do count at least twelve scenarios from the past two years where synthetic elements along with dedicated contingent risk policies which in fact facilitated that potential show stopper were put out of the competition. But still, it remains highly in doubt whether a full synthetic coverage can honestly be regarded as desirable from an entirely motivational perspective. Of course, problems remain and they won’t go away simply because an insurer is now stepping into the shoes of a seller or purchaser that would need to be convinced. Underwriters have recently shown great market perception when it comes to commercial decisions where synthetic elements can potentially be justified or where this would not be possible at all due to lack of information? Not only does it normally add additional complexity to the policy structure and negotiation but also it should not be regarded as an exit for any kind of due diligence gaps that were not capable of being overcome for purposes of the SPA warranty catalogue in the first place. So why would an insurer go for a risk derived from a synthetic warranty that has not made it into a “real” SPA provision?

Motivation of course is to match market demands. When brokers do see potential and the relevant portion of risk appetite to obtain a synthetic coverage for a certain risk or risk area that may well be within the limits of commercial reason for certain insurers then it is unquestionably on the agenda of the underwriters as well. Let’s take synthetic tax indemnities: They have been in the market for quite some time now but only the last two years or so really showed huge demand for providing such element as an integral part of the policy. Challenges from market competition do contribute to the development of innovative market drivers anyways.

So when there is room in the market for bridging gaps via synthetic coverage it is just and fair to discuss how this could work. While formal restrictions (if at all in place) as to the degree of synthetic coverage available do not create significant hurdles and also would be counterproductive for the entire business, there is no such thing in regard to legal limitations under most jurisdictions either. Therefore, the window seems wide open and the market motivation would need to meet reality under the current market conditions. So where do we stand?

Frequently asked synthetic coverage for dedicated areas

As everyone knows, synthetic coverage is not only used for tax indemnities. There is a broad range of examples where synthetic elements are frequently placed into the policy to mitigate certain risk levels. Obvious examples are seller’s knowledge scrapes, i.e. to add objective elements to an existing, knowledge qualified SPA warranty and a corresponding shift in the major risk from the seller to the insurer for the objective breach of the relevant warranty without referring to a subjective element of knowledge at all. The systematic approach therefore would be to skip the qualification element of the SPA warranty for the purpose of the policy. This is usually asked right at the beginning of negotiations with the insurer, and the nonbinding indication will require a dedicated pre-assessment and indication where the insurer would be willing to grant a knowledge scrape subject to further review of the due diligence information available. It is also common to then grant a knowledge scrape for various warranties, in particular the business warranties, when the insurer should have the impression of a well pursued due diligence exercise with reasonable deal specific risks to be taken into account. The transaction parties can still retain the SPA warranties in a qualified manner but the purchaser has all the upsides from the insurer to rely on their objective accuracy. Of course the insurer will hold dedicated discussions with his deal adviser whether he sees any particular risks in granting such objective elements. It is a fantastic example though of how synthetic elements have practically already become daily business. While there is significant market pressure in place to grant such enhancements, it is still a review process that would lead to such reliefs from a commercial and risk standpoint. Competition within the market, however, would make the lives of insurers difficult in case they would see factual difficulties in doing so by general principle.

Same applies to materiality scrapes. Any materiality limitations as set out in the SPA would not apply or apply on another materiality level for the purpose of the policy. The same can be applied for an extension of the applicable limitation periods which is particularly popular in the field of private equity transactions. Clean exit strategies can be undermined by limitation periods. If, however, such limitations can be shifted to an insurer who would still be liable for breaches months or years following the expiry of the statutory limitation periods, a purchaser would still enjoy adequate coverage while a seller would be put in a position to disburse the proceeds promptly.

Bridging from part to full – is a full synthetic coverage entirely off market?

While certain synthetic elements of coverage are well established must-haves of any tailored policy, it remains in doubt whether this can ever be true for full synthetic policies. Why is that? A huge argument still is whether there is in fact need for having one. The SPA warranties still do carry the factual elements of the deal, and it would carry rather absurd consequences to renegotiate every single warranty for policy purposes. Timing is of the essence anyway so there is little room for any such extensive conversations. The term “enhancements” illustrates quite well where synthetic elements do carry the extra benefits for the parties, namely to mitigate between party risks and to facilitate an efficient process, which is obviously hugely important for competitive auction processes. While magazines, podcasts and social media posts argue differently are all over the place, market reality still fails to provide for different arguments. Of course everyone can tell that there is a smart element in discussing an entirely synthetic policy: it would introduce a maximum of flexibility that, from a theoretical standpoint, could help to bring deals over the finish line that would be off market in the first place. Spiced up with dedicated contingent risk policies for known risk areas such as title, environmental and cyber, this would lift things policy-wise on another level along with maximum freedom to shift deals into an even stricter market environment as we currently see it.

So while timing would be a huge barrier to overcome, transaction complexity for sure is another. Putting the relevant parties into a situation where they formally agree on a certain set of warranties and then doing the heavy lifting with the insurers does lack a logical element of providing a deal that still is manageable if it breaks the barrier of being super straight forward, e.g. only involving one jurisdiction or only few subsidiaries with almost the same quality of due diligence information packages, while of course carrying few to no black boxes in any form.

Also distressed scenarios, most commonly referred to as the ideal field to introduce full synthetic policies, still fail to date to demonstrate a suitable market environment for broader synthetic coverage. Insolvency administrators are often told that they do not have the relevant knowledge of the target to facilitate swift provision (timing is again key!) of the required due diligence information. The same applies to the intention to limit their liability from the entire process. Things might be changing in the future in case the long anticipated insolvency waves related to Covid-19 would appear on the horizon but it should be extremely difficult to argue that, of all things, it would be in fact such potential bulk of distressed deals that would finally overcome the hurdles described above.

Conclusion

Full synthetic coverage remains an interesting playground dealing with artificial scenarios to gain the obviously always welcomed increase of flexibility within the market. From the current perspective though, there is little need for a full synthetic coverage. The given set of warranties still can be supplemented and beefed-up with well-established synthetic enhancements. This also increases deal efficiency when the insurers need to look into things closely, most often pre-signing. It would come as a surprise if things would change in the nearer future in such regard. What will happen though is an increase of dedicated, specified synthetic elements to supplement the standard policies as we do currently see them.

1 Marsh, Transactional risk insurance 2021: Year in review, page 2.

*Sincere thanks to legal trainee David Nieendick for the background researches and discussions.