M&A and the role of Warranty and Indemnity insurance in Asia

The use of Warranty and Indemnity (W&I) insurance in transactions is becoming much more commonplace across Asia as sellers, especially private equity firms, seek exits for their investments on a no- or limited-recourse basis. It’s worth understanding how this type of insurance works and how policies respond in the event of a claim.

How W&I insurance works

In general, W&I insurance is used by buyers looking to give added protection to their investment and sellers looking to protect or reduce their liability after a transaction. Most commonly, it is introduced to deals by private equity firms that wish to exit an investment held in one of their funds. It takes the place of the traditional recourse mechanisms buyers use to ensure they are not exposed in the event that unforeseen issues are discovered within the target business potentially causing loss to the new owner.

Traditionally sellers have been required to hold a certain amount of money in escrow for a specified period in the event that unknown issues are discovered in the target which give rise to a breach of the warranties in the sale and purchase agreement (SPA). Funds held in escrow are used to make good any damages incurred by the business that was acquired.

Recently however, we have seen parties to a transaction start to use the prospect of W&I insurance to fully replace the escrow mechanism. Rather than rely on funds in escrow, W&I insurance allows sellers to manage the transaction on a fully nil-recourse basis, allowing private equity funds to close the fund after the sale and return all proceeds to investors. This may not be possible if funds are held in escrow as the main recourse for buyers.

This recent trend is known as a “sell buy flip”, whereby a seller will work with an insurance broker right from the start of the sale process and often, the SPA will establish that the insurance policy is the only recourse available to the buyer. At the start of the sale process the seller will usually approach the insurance market through a broker indicating a policy is required. A note about the seller’s requirement for the buyer to take out W&I insurance as part of the sale is uploaded to the data room with initial due diligence documents, so the bidder understands they are required to take out a policy.

Once a bidder is successful, the broker’s relationship will “flip” to working with it to ensure the policy is fully underwritten and in place at the time the transaction signs.