W&I insurance- The market environment in 2023 at a glance

1. Introduction

In 2023, the entire EMEA region experienced a challenging year for M&A, with a significant decline in transaction volume. Despite the overall market conditions, the market for transactional risk insurance (Warranty & Indemnity, W&I) only saw minor declines, as the product is increasingly utilized regionally, and market penetration continues to grow - particularly in the Southern Europe and Central & Eastern Europe regions. For 2023, we estimate the total premium in the EMEA market for transactional risk insurance to be approximately USD 1 billion.

Fewer transactions also mean fewer opportunities for insurers, leading to intense competition among providers. This development was fueled by the ongoing influx of new insurance capacity entering the market. These ‘soft’ market conditions were most evident in a decline in insurance costs, as well as in terms of coverage scope and insurance terms, which we will discuss in more detail below.

For the first time in at least a decade, Marsh globally placed transactional risk insurance in a majority of transactions on behalf of strategic insureds (51%) versus PE firms (49%), reflecting the challenging market for PE firms. The lower volume of private equity transactions was particularly evident in the lower average transaction sizes compared to the previous year. Specifically, in the mid-market segment with transaction values between EUR 250 and 750 million, the number of insured deals significantly declined. At the same time, it was observed that strategic investors continued to pursue larger transactions (although not to the same extent as in previous years).

In our Global Transactional Risk Report 2022, we reported a shift in bargaining power from the sell-side to a more balanced distribution between parties. This trend continued in 2023. In particular, transactions conducted through bidding processes tended to slow down due to reduced competition amongst bidders. We also observed an increase in deals where bidders were granted exclusivity earlier in the process. The slowdown in transactions also allowed buyers to focus more on due diligence and gain a better understanding of the risk factors associated with a potential transaction before concluding a purchase agreement.

2. Premium, Retention, De Minimis

In 2023, the average base premiums of W&I insurance were mostly below 1% rate-on-line (RoL, which is the premium in relation to the liability limit under the policy). For some transactions in Q2/Q3 of the year, the average base premiums even dropped to as low as 0.6% RoL, although the market saw some price recovery in Q4. Based on our assessment, we expect the current premium levels to stabilize at this low level at least for some time.

Lower insurance costs resulted in buyers purchasing a proportionally higher insurance capacity for a transaction compared to previous years. On average, the sum insured under W&I policies was approximately 33.6% of the enterprise value (EV) in the EMEA region. The increase in average sums insured can also be attributed to the market's heightened focus on the risk factors of a target company in light of an uncertain macroeconomic and geopolitical environment.

In face of fierce competition among insurers, the retention amounts for W&I insurances fell as well in 2023. At a time when sellers are rigidly limiting their liability for warranty breaches in insured transactions, often reducing it to EUR 1 or eliminating it altogether, the retention has become even more important over the past year. This is because any losses falling below the retention are typically economically borne by the buyer due to the lack of insurance cover. Against this backdrop, market pressures continued to shape retentions, resulting in a further reduction in the typical level of retention in W&I policies over the past year. While a few years ago a retention of between 1.0% and 0.5% of the EV was the European market standard, in 2022 the retentions offered were as low as 0.25% of the EV. By 2023, insurers were already offering retentions as low as 0.1% of the enterprise value in some attractive large/mid-cap transactions. Yet, it is worth noting that the elimination of a retention in its entirety (except for real estate and infrastructure transactions) was, not evident.  In the whole EMEA region, the average retention level for non-real estate deals in 2023 was at 0.36% of the EV. For real estate deals, the average retention was lower and amounted to 0.09% of the deal value.

A more recent development regarding the retention is the return of so-called ‘tipping concepts,’ where the retention is not a fixed amount (deductible) but rather a threshold. If the total damage incurred during the insured period exceeds this threshold, the retention drops to a lower amount defined in the policy or even to zero. For many years, tipping concepts were the exception in insurance practice, but they have become more common in recent times. A popular variation was a retention ranging from 0.25% to 0.5% of the EV, which would then ‘tip’ to zero. Generally, lower retention amounts or the implementation of a tipping concept only have a limited impact on premiums, which only become marginally more expensive as a result.

Conceptually, the retention is not applicable to each individual claim but rather cumulatively to all claims occurring during the insured period. This cumulative approach distinguishes the retention from the De Minimis, which is typically included in a W&I policy as well. The De Minimis applies to each claim and is designed as a threshold. In recent years, commercial dynamics have also changed the parameters of the De Minimis. While a De Minimis provision of 0.1% to 0.05% of the EV was offered as the smallest possible amount by insurers a few years ago, in recent years, an amount of approximately 0.01% to a maximum of 0.02% of the EV has established (assuming that the materiality thresholds of the respective due diligence reports are not above this amount). However, in small-cap transactions we saw in 2023, the De Minimis threshold was usually not lower than EUR 10,000. In a few exceptional cases, some insurers were willing to waive the De Minimis entirely against an additional premium and a higher retention. In any case, this was always contingent upon the quality of both the seller's disclosure and the due diligence reports.

3. Risk appetite of the Insurers and product innovation

With fewer transactions to compete for, we have observed that insurers seek to differentiate themselves through innovation and an expansion of their risk appetite. This dynamic has had different effects on various insurers. For example, some insurers began to focus on transactions in regions where there had been less interest in the past. These include several African countries, Central Asia, and Latin America. The cover for transactions in these regions has been aligned in substance with the W&I cover in Europe.

As a further innovation, individual insurers offered framework agreements for W&I coverage to clients who planned a series of transactions with a similar profile over a certain period (e.g. as part of buy-and-build strategies). Such framework agreements provide investors with more favorable conditions for W&I coverage. Additionally, they can significantly streamline the placement process for buyers and, if needed, be expanded to include synthetic W&I coverage when no warranties are available from the sellers and/or management.

Due to the highly competitive market environment in the W&I insurance market, we also saw broader synthetic policy cover elements in deviation to the purchase agreements.

4. New synthetic elements in W&I cover

The fundamental principle in the design of W&I policies is that the policy follows the purchase agreement’s warranty system and scope. Specifically, the scope of the W&I insurer's liability is determined by the warranties given to the buyer in the purchase agreement, the tax indemnity, and the contractual provisions regarding the legal consequences in the event of a claim for breach of warranty or under the tax indemnity. In deviation from this principle, synthetic cover extensions have played an increasingly important role in W&I policies in recent years. These extensions provide coverage by the W&I insurer that goes beyond the seller's liability under the purchase agreement. Through such extensions, buyers can significantly improve the coverage of the W&I policy compared to what the seller is usually willing to grant under the purchase agreement.

With respect to synthetic warranties, the market in 2023 offered synthetic coverage usually only for individual warranties. We saw full synthetic warranty catalogues only in special transaction scenarios, such as distressed M&A transactions, real estate transactions and in public M&A transactions.

Apart from these scenarios, synthetic cover for balance sheet warranties was recorded in some cases last year. Some insurers were occasionally willing to provide cover for a synthetic balance sheet warranty at a ‘true and fair view’ standard in the case of audited annual accounts of the company (with an unqualified audit opinion), which are the reference point for the balance sheet warranty, without the purchase agreement containing a corresponding warranty. Furthermore, in some cases, it was possible to obtain a synthetic balance sheet warranty at a ‘true and fair view’ standard for small companies not subject to mandatory audits under section 316 (1) of the German Commercial Code (HGB) even if the purchase agreement provided for a balance sheet warranty only at a lower standard.

In the area of synthetic coverage, there has been an increase in the use of ‘scraping’ concepts. In recent years, the scraping concept was used in transactional practice primarily for seller's knowledge qualifications. in the form of so-called ‘knowledge scraping’. Almost every W&I policy included such a concept last year. While in the past, the scraping concept was less commonly seen in the context of materiality qualifications, we observed an increase in the so-called ‘materiality scraping’ last year. Materiality scraping can be applied to several types of materiality qualifications, for example to phrases such as ‘in all material respects,’ ‘material adverse effect’, or to specific qualifications such as ‘material IP rights’ for IP warranties or a ‘material breach’ for warranties relating to the target’s contractual relationships. Similar to knowledge scraping, W&I insurers require a moderate additional premium (often around 5% on top of the base premium) for materiality scraping.

In the past year, some W&I insurers have occasionally been willing to soften vendor-friendly definitions of knowledge qualifiers for warranties where traditional knowledge scraping is not possible through synthetic cover enhancements. In such scenarios, the purchase agreement included a knowledge definition that limited the knowledge to actual knowledge of the seller or its knowledge bearers, thereby significantly increasing the impact of the knowledge qualifier and devaluing the warranties in scope of the knowledge qualifier. The new synthetic cover element removed this obstacle by modifying the knowledge definition for policy purposes including gross negligent lack of knowledge of the seller (or relevant knowledge bearers) besides their actual knowledge.

Another innovation in the area of synthetic cover extensions were synthetic closing warranties. The basis for such coverage extensions are warranties that are only given at the time of signing the purchase agreement and that are not repeated at the time of closing. By means of synthetic cover, the temporal scope of warranties given only at signing was synthetically extended to closing, thereby extending coverage for warranty breaches that occurred during the interim period between signing and closing. As is generally the case with closing warranties, insurers required a bring-down disclosure for such cover. This means that the seller must provide a statement on the day of closing (or a few days prior) that, to the best of their knowledge, there are no breaches of closing warranties at the time of the bring-down disclosure. In case of awareness of a warranty breach, the seller must disclose the underlying circumstances in the bring-down disclosure declaration. The consequence of the bring-down disclosure is that all closing warranty breaches based on circumstances disclosed in the bring-down declaration are excluded from coverage of the W&I policy. This dilemma can potentially be resolved through the New Breach Cover enhancement which we explain below.

We saw in 2023 new synthetic coverage elements also in respect of contractually agreed legal consequences in purchase agreements. Depending on the relevant transaction, insurers were willing to agree to a stand-alone loss definition in the W&I policy, thereby overriding the principle of the policy following the purchase agreement. Such stand-alone loss definitions in the W&I policy were broader than the loss concepts in the purchase agreements. In some cases, they referred to the statutory loss definition pursuant to section 249 et seqq. of the German Civil Code (BGB) and (unlike a traditional loss definition in a purchase agreement) did not impose any further restrictions on the calculation of damages. Most insurers have now also started, in individual cases and for additional premiums ranging from 10% to 20%, to accept a stand-alone loss definition in the W&I policy that does not exclude the use of multipliers, even if in contrast to the loss definition of the purchase agreement.

A more recent manifestation of the scraping concept in our market practice was the so-called data room scraping. The background is that purchase agreements regularly stipulate that any circumstances known to the buyer cannot form the basis for a warranty breach. This limitation of liability goes even further by deeming all circumstances disclosed through the data room as known circumstances. Due to the principle that the W&I policy follows the purchase agreement’s warranty system, the disclosure limitation also applies under the W&I policy and is in claim cases a defensive argument frequently used by the insurers.  As a cover enhancement, some insurers offered to waive this liability limitation in their W&I policy, which enabled buyers to achieve a significantly better position under the W&I policy compared to their position under the purchase agreement. The benefit for the buyer was that the buyer was confronted only with a limited amount of information limiting coverage (i.e. the information contained in the disclosure schedules of the purchase agreement and the due diligence reports) as opposed to the information of the entire data room. A further benefit was that the buyer does not forfeit any cover if its advisors happen to overlook documents in the data room during their due diligence review. We noted, however, that data room scraping was not offered for every transaction and by every insurer. Common areas of application were transactions with good data availability, reasonably effective information disclosure to the buyer and its advisors, and a corresponding review of this information by the buyer and its advisors. In addition, insurers assessed during underwriting the quality of the buyer's advisors and analyzed whether they had reviewed all or at least most of the documents available in the data room. If offered in a transaction, the additional costs for this enhancement amounted to 10% to 25% on top of the base premium.

5. New Breach Cover

Towards the end of 2023, we saw numerous projects where so-called ‘New Breach Cover’ was offered as a cover enhancement by an increasing number of insurers. The aim of enhancing cover by means of New Breach Cover is to cover closing warranties without the otherwise necessary bring-down disclosure and the corresponding coverage exclusion for closing warranty breaches disclosed through it. However, insurers often excluded from New Breach Cover warranty breaches that correspond in their economic significance to a ‘material adverse change’ (MAC) event. In addition, insurers required a so-called No Claims Declaration from the buyer after a certain period has elapsed in order to extend the New Breach Cover. These time periods varied by insurer and were usually between 20 and 30 business days. Insurers charged an additional premium of between 20% and 30% per coverage period on top of the base premium to extend the New Breach cover. Some insurers offered New Breach Cover for a maximum of two periods, and therefore for a maximum of 60 business days. It should be noted that New Breach Cover was only offered by insurers on a deal-by-deal basis and is not yet a standardized cover extension.

It remains to be seen whether other insurers will also add this coverage element to their repertoire, as it is certainly a highly attractive coverage element for transactions with a short interim period between signing and closing and is therefore likely to influence competition between insurers. It may be possible to reduce the costs slightly or to extend the periods just mentioned by setting a higher De Minimis or higher retention for the duration of the New Breach Cover.