W&I Insurance in M&A Transactions: Stapled Insurance

Forward-looking risk management is particularly important in uncertain times. While the transaction market has reached new heights in recent years, players have also increasingly hedged their risks (not least because of global crises). While warranty & indemnity (W&I) insurance was not widely used in the past, it is now found in most transactions. Stapled insurance, which is brought into the process by the seller, is another structure that is becoming more established.

W&I Insurance in transaction practice

Warranty & indemnity (W&I) insurance protects buyers and sellers against the liability risks that can arise from corporate transactions. In many cases, their purpose is to protect the buyer in the event that the risks covered by the warranties and indemnities provided by the seller in the purchase agreement materialise. The insurance then fully or partially covers the materialised risk. W&I insurance is often combined with tax liability insurance, which considers the tax risks of mergers and acquisitions (M&A) or private equity transactions.

W&I insurance is not new, it has been used in M&A transaction practice for many years. However, the Covid-19 pandemic and the accompanying economic uncertainties have once again significantly increased the demand for W&I insurance. According to a market survey, some insurers even had to close their books for the current year starting with the fourth quarter of 2021.1

Additionally, the shift from a buyer’s to a seller’s market has also helped W&I insurance reach new heights. The more difficult it is for investors to win the bid for an attractive target company, the less eager they are to possibly diminish their chances even further by demanding liability from the seller. This is particularly true in auction processes.

Sellers are taking advantage of this and have increasingly decided to exclude their own liability for guarantees from their initial drafts of the sale and purchase agreement (SPA) and instead refer to coverage via an insurance policy. The insurance is generally structured as a buyer’s policy in which the insurer undertakes vis-à-vis the buyer to assume responsibility for the seller’s warranties and indemnities under the SPA.

A special case of Stapled Insurance

Since it is not only in the interest of the seller that the buyer takes out the W&I insurance, but given that the buyer is also interested in a process that is as quick and efficient as possible, the seller often already prepares the W&I insurance solution as part of the auction process. This form of transaction insurance is often referred to as stapled insurance and distinguishes between soft stapling and hard stapling.

Soft Stapling overview

In soft stapling, the seller – with the help of an insurance broker – takes charge of obtaining quotes and selecting a group of attractive indications, which they present to the buyer for selection. The buyer then has the choice of going with one of the insurers proposed by the seller or with another one that the buyer favors.

Soft stapled insurance is characterised by the seller submitting non-binding offers to conclude an W&I insurance policy to the potential buyers in coordination with a broker. The broker first checks the seller’s sample SPA and obtains offers from insurers on this basis. For the offers received, the broker prepares a summary (a so-called Non-Binding Indications (NBI) Report), which the relevant bidder(s) can view in the data room.

The NBI Report sets out (for the early stage and given limited information), in relatively granular terms, the following for the various insurers:

• Policy amount (coverage amount)

• De minimis

• Entry threshold (first loss piece)

• Premium

• Legal expenses

• Buyer due diligence requirements

• Accepted liability regime

• A concrete statement as to which guarantees of the seller’s draft can probably be insured (depending on subsequent buyer due diligence, etc.) and with which qualifications, if any, or which insurance exclusions there will be.

Over the past few years, premiums have settled at between 0.7% and 1.5% of the sum insured, with a minimum of approximately EUR 60,000 to 75,000.

With this approach, the buyer cannot claim that there are problems with an insurance solution. At the appropriate time in the process, they take over communication with the broker and select one of the insurances (or another one favored by the buyer) with which they then take up the usual underwriting process.

The underwriting process

The underwriting process is about the insurer being able to understand the deal and the negotiations between the buyer and seller. To that end, they will specifically ask to see:

• The SPA, including all attachments, namely disclosures, etc.

• Access to data rooms, including the index

• Any due diligence reports on the part of the buyer and, if available, the seller

• The latest audited financial statements of the target company

• The Information Memorandum, the Management Presentation and other documents and information prepared by the seller as part of the sale process.

The climax of this process is the underwriting call between the buyer, the insurer and the involved consultants, which is primarily about:

• How the sales process played out

• The type and quality of information disclosure by the seller

• The buyer’s approach to due diligence; also relating to the different advisors and the scope of their mandate

• The relative strength of the negotiating positions of the two parties and how that affects the final SPA

• Any remaining known concerns or identified issues that are outstanding on the insurer’s side as part of the underwriting process.

This process usually takes at least three to five days, although to be on the safe side, seven days should be allowed to clarify any outstanding issues and provide comfort to the insurer concerning clarifications and information where necessary.

Development of Stapled Insurance over the years

Stapled insurance has become increasingly common in recent years. In auction processes, when selling to financial investors in particular, as well as appropriately well-advised small-to-medium enterprises (SMEs) on the sell side, expect to take out W&I insurance. Conversely, such a request does not surprise a buying private equity investor. The instrument ensures transaction security and accelerates the speed of the process, making it favored.

Effects on the purchase contract

As is common in the sales process, the draft SPA is typically provided at the end of the due diligence process.

The parties negotiate the SPA and the buyer policy in parallel with the underwriting process. If something changes with regard to the guarantees in the SPA, the insurance policy is also adjusted accordingly (if possible) as part of the underwriting process with the insurer.

For stapled insurance, changes are made to the SPA by inserting a “W&I insurance clause”. Under this clause, the buyer undertakes to acquire a standard W&I policy, with the policy itself typically being provided as an annex. The clause provides, insofar as the insurance solution is to take effect, for a limitation of the seller’s liability to an amount 1 EUR for the warranties and indemnities, irrespective of whether the policy has been validly concluded or whether the insurer pays in the event of risk realisation. Recourse claims are excluded.

Another fundamental issue that plays a more important role in practice than before because of the rise of W&I insurance solutions is the question of the seller’s liability for “statements made in the dark” (Angaben ins Blaue hinein) in the case of guarantees that are provided without further verification. The case law has established an intentional liability of the seller in case of nonfulfillment of such guarantees, which leads to the fact that a limitation of liability does not apply. This is relevant in the case of W&I insurance because the agreed liability cap would not apply and the seller cannot escape liability, (i.e. they are liable despite the insurance provided). In practice, this leads to the fact that the warranty catalogs, despite the insurance solution, are to be evaluated very finely by the seller as to whether he can provide them consciously and with due diligence.

Overall, the insurance solution shifts any risk realizations to the insurance company, which is why, on the one hand, deadlocks can be avoided when negotiating the liability regime and the SPA can be negotiated more quickly overall. On the other hand, the need for collateral (escrows) is also eliminated.

Hard Stapling overview

Unlike soft stapling, in hard stapling the seller specifies one insurer.

This variant may be used if a highly competitive process is expected, and the seller has a strong negotiating position. In this case, the insurer starts the underwriting process on the sell side based on sufficiently thorough vendor due diligence reports, access to the data room, underwriting calls on the sell side and negotiation of the policy with the seller.

The purpose of the underwriting call is to provide the insurer with an understanding of:

• The way of compilation of the information
deposited in the data room

• The placement of the data room

• The approach to the disclosure of information

• The approach and scope of vendor due diligence
reports

• The sales process.

In the underwriting process, the seller also negotiates the fees and premium with the insurer. Hard stapling results in the insurer ideally being able to attach a finalised draft policy to the draft SPA already.

With the involvement of the buyer in the sales process, the underwriting process on the buy side then proceeds parallel to the buyer’s due diligence and the SPA negotiations, as described above in the soft stapling section. This can naturally lead to policy adjustments.

Time-wise, hard stapling should allow at least 48 hours for the underwriting process on the buy side.

Conclusion and outlook

W&I insurance has become an integral part of the transaction practice. Its importance for the involved parties is likely to increase even further in times of economic and geopolitical uncertainty. For providers in the insurance market, while it is a sector that is expanding further with a tendency towards increasing demand, it also represents a highly efficient instrument that can significantly increase transaction speed and transaction security.

It is recommended to consider the option of W&I insurance in the early stages of any transaction in order to be able to act quickly if its usefulness or necessity is confirmed. Doing this in close cooperation with a broker and considering stapled insurance at the same time can add a completely different dynamic to a sales process, to the benefit of both parties.

1 https://www2.deloitte.com/de/de/pages/mergers-and-acquisitions/articles/w-und-i-versicherungen.html