Insurance Options for Identified Risks in M&A transactions - Preparation and Process

While warranty and indemnity (W&I) insurance cover for unknown issues in connection with seller warranties is now established in the M&A market, the demand for insurance products to cover also identified risks (and potential deal breakers) has increased strongly in the last three years. Many insurers have therefore set up dedicated underwriting teams to offer contingent risk insurance products for identified (already made public as well as potentially materialising) tax risks (tax liability insurance), IP risks (intellectual property liability insurance), environmental risks (pollution legal liability insurance), title risks (title insurance) or other risks in connection with existing or threatened litigation (litigation buy-out insurance).

This article will address fundamental questions on the insurability of such risks and will discuss the optimal integration of these insurance solutions into the M&A process in order to avoid possible procedural pitfalls.

Which known risks are insurable?

In principle, it is possible to insure known risks that are based on legally (or otherwise scientifically) assessable facts. A risk that depends on purely factual circum-stances or on the behaviour of a third party and which cannot be clearly foreseen or assessed is therefore generally not insurable, as the insurer cannot assess these factual circumstances. However, in some instances universally recognised and generally valid empirical principles may nevertheless permit an assessment of the risk, which open up the possibility of insurance cover.

For example, the question of the existence or, more fre-quently, non-existence of a permanent establishment in Germany can be insured on the basis of factual indi-cations such as contractual documents, documentation relevant for decision-making, minutes of meetings or travel confirmations (flights, hotel, etc.). Valuation issues (choice of valuation method and the valuation result) can also be insured in principle.

Risks that have already been taken up by authorities or are already the subject of extrajudicial or judicial proceedings are in principle insurable, albeit usually at a higher premium. However, cases in which the occur-rence of the risk depends on the outcome of such proceedings and where the policyholder is neither directly nor indirectly involved and thus cannot influ-ence the outcome are problematic.

Since the insurability of an identified risk is subject to a case-by-case assessment, one should not consider insurability in purely schematic categories (such as the type of risk or the industry of the target in question). For example, insurers may have to reject risks in one financial year that they would have insured in another financial year, as some insurers are only allowed to cumulatively insure a certain number, or a certain maxi-mum liability amount, of similar risks in one financial year. For this reason, it is advisable to clarify the question of insurability at an early stage of the M&A process with an insurance broker.

Dealing with known risks in the M&A process

Unlike W&I insurance, which is regularly taken out by the buyer (although often already initiated by the seller), contingent risk insurance is taken out by the seller, the buyer or even the target company itself depending on the type of risk and the impending loss scenario. However, even if the buyer or the target company takes out the insurance, it is often still nec-essary to involve the seller in the process, as often only he is in a position to provide the insurer with sufficient information about the risk.

In practice, however, often the seller takes out a policy when preparing the sale in order to then make the policy available to the bidders or the buyer. There are various reasons for the seller to insure a known risk at such early stage of the process. We have seen transactions, for example, where it was doubtful whether bidders for the target could be found at all due to the looming scenario of significant loss. Furthermore, we have often seen cases in which sellers took out the contingent risk insurance to achieve a higher purchase price assum-ing that the insurance premium would be lower than the potential purchase price deduction by the buyer.

In cases where the policy is not to be taken out by the seller but by the buyer or the target company, it is advisable for the seller, or his advisor, to manage and control the insurance work stream together with the insurance broker as the number of insurers offering cover for the risk in question is often very limited. Depending on the nature of the risk, specific exper-tise may be necessary and further limit the number of potential insurers. For this reason, auction processes should be structured to prevent bidders from contacting, and thus potentially conflicting, insurers at an early stage. This ensures that the most suitable insurer with the best cover is available to the preferred bidder. Bidders should be prevented via a process letter, or ideally already in the NDA (Non Disclosure Agreement), from approach-ing insurance brokers or insurers in relation to M&A insurance without the prior written consent of the seller. Otherwise, in the worst case, no insurer is available for the preferred bidder.

In parallel, the seller should conduct an initial market approach through their broker. This market approach will show how many insurers will consider insuring the risk and how many clean teams (trees) these insurers could offer in order to negotiate a policy with the respective bidders. With this information in mind, the remaining process can then be planned and in par-ticular at what point the bidders may contact the selected insurer. In this context, it is advisable that a broker tree remains with the seller to steer the W&I process (behind the wall); i.e. setting up confidentiality barriers (chinese walls) and providing each bidder with an exclusive broker. In the case of a global field of bidders, it is recommended that the selected broker has experi-enced M&A broker teams available in the respective bidder jurisdictions.

The two established approaches in a seller-initiated process for M&A insurance are:

Hard-stapled process

In a hard-stapled process, the seller, together with the broker and his advisors, negotiates the policy with the insurer. The buyer will be presented with a policy that has already been finally negotiated and is ready to be signed. In this case, the underwriting process with the insurer takes place on the sell-side. In some processes the buyer will still have be involved in the underwriting and his knowledge and due diligence reports may be required for the policy wording. In these cases, the pol-icy should be pre-negotiated as far as possible on the sell-side so that the buyer can finalise the policy as quickly as possible.

Example: During the preparation of an auction process, his advisors informed the seller that, on an extremely strict interpretation of statutory law, state aid received at the level of the target might have to be repaid. Although this risk was considered to be low, it was nevertheless likely that this issue would be picked up by the bidders in their due diligence. Due to the potentially high clawbacks, the seller was unwilling to grant an indem-nity in the sale and purchase agreement (SPA). The seller and his advisors had initially provided us with the documents necessary to assess the risk (in particular the legal assessment). After evaluating these docu-ments, we contacted the relevant insurers and found an insurer willing to consider the risk. The insurer was able to give a relatively clear estimate of the expected premium and possible costs. As a result, the seller instructed us to start the underwriting process with this insurer. After the insurer had assessed the existing documentation (as well as the answers to some underwriting questions), a near-final policy was submitted to the seller within 3 weeks. This policy was then negotiated between us and the insurer for another week and was then made available to the bidders via the data room, removing the need of negotiate the allocation of this risk between the seller and the buyer. The bidders had the opportunity to discuss the policy with their assigned broker tree to clarify any outstanding issues. The winning bidder signed the cor-responding policy at signing, with the risk then being assumed by the insurer.

Soft-stapled process

In a soft-stapling process, the seller, together with the broker, initiates the insurance process by conducting a market approach and obtaining non-binding indica-tions (NBI) from the insurers. These NBIs will then be summarised by the broker in a NBI report and made available to the bidders. Alternatively, the seller may also already select the one insurer deemed most suitable and only this offer is presented to the bidders.

Example: The target was located on a former chemical park. The seller had already commissioned a Phase I envi-ronmental report, which did not show any negative findings. Nevertheless, the seller was not prepared to include an environmental indemnity in the SPA. Therefore, he asked us to clarify the possibility of insuring any potential damages due to contaminated soil by way of a pollution legal liability insurance. After we had found a suitable insurer willing to cover the risk, we negotiated a suitable insurance offer. This pre-negoti-ated offer was then placed in the data room together with the SPA, which already contained a note stating that no environmental indemnity would be given, but that the buyer could protect himself via the accompa-nying insurance offer. As this was an auction process, we and the insurer provided various trees who advised the bidders on the insurance protection. At the same time, the seller managed the process so that the final bidder was given ultimate access to the insurer to finalise the policy.

Other possibilities in a bilateral M&A process

In practice, there are also situations where the seller starts the insurance process with the intention of insuring specific identified risks and is hence not willing to give the respective warranty or indemnity under the SPA. However, in the course of the SPA negotiations, the parties may agree that the buyer will in fact need the warranty or indemnity under the SPA, but will take out the insurance and such costs are reflected in the pur-chase price. As a result, the seller will bear the costs for the buyer’s policy, but by including a corresponding provision in the SPA, the seller is only liable for damages if or insofar as the policy does not provide cover. In our experience, the main reason for this arrangement is that a buyer’s policy also provides insurance cover in the event of seller’s fraud or wilful misconduct, whereas this would be excluded in the case of a policy taken out by the seller. Depending on the respective circumstances, a significantly better insurance cover can thus be achieved.