Is Warranty and Indemnity Insurance the Key to Mitigating Risk in Your Business Sale/Purchase?

In business sales and acquisitions, managing risk is not just important – it is essential for a smooth and successful transaction. One of the most powerful tools to mitigate these risks is warranty and indemnity (“W&I”) insurance. W&I insurance provides vital protection for both buyers and sellers against unforeseen liabilities that may arise after the deal is completed.
 

For sellers, having W&I cover means that they do not have to worry about warranties or tax covenants long after completion and potentially having to return money that has already been spent or invested.

For buyers, W&I insurance is especially valuable when sellers remain involved in the business post-sale. It offers peace of mind in that if issues arise, they do not have to take legal action against key management personnel/staff.

By providing financial security, W&I insurance helps to streamline negotiations, allowing all parties to reach an agreement with confidence and minimising the risk of costly disputes. Understanding how W&I insurance integrates with the sale and purchase agreement is key to navigating the complexities of the deal and ensuring that all risks are clearly defined and adequately covered. This strategic use of W&I insurance can be the difference between a smooth, worry-free deal and one fraught with potential pitfalls.

What is warranty and indemnity insurance?

Under a business sale and purchase agreement, a seller may give certain warranties (statements of fact about the condition of the target business, which, if untrue or inaccurate, can cause financial losses) and/or tax indemnities (promises made by the seller to meet specific tax liabilities). W&I insurance is a bespoke product that offers coverage for losses arising from breaches of warranties and/or claims under tax indemnities in such transactions.

Which party takes out the policy?

The decision of whether the seller or the buyer takes out W&I insurance is ultimately a matter of commercial negotiation, though in most cases, it is the buyer who secures the policy.

Buy-side policies are usually without recourse to the sellers – all potential liability of the seller in respect of the warranties and indemnities covered is offset and the insurer cannot try to recover what it pays out for claims through subrogation. The seller also typically covers the cost of the policy premium by way of a reduction in the purchase price.

You may also encounter the term "stapling" W&I insurance, which refers to a scenario where the policy is initially arranged by the seller but is ultimately taken out by the buyer, ensuring both sides are protected while streamlining the process.

How does W&I insurance work with the sale and purchase agreement?

In a business acquisition, the principle of caveat emptor (buyer beware) applies, meaning the buyer must take steps to protect themselves. This is where warranties come in - contractual statements that help mitigate risk by outlining the condition of the business. Common areas of warranty protection include financial accounts and post-balance sheet date activity, commercial contracts, finance and banking, real estate and other assets, employees, and intellectual property. If a warranty is breached, the buyer may have a right to claim for damages if it can show that a breach has caused quantifiable loss. Warranties are often heavily negotiated with sellers looking to limit their liability by capping financial exposure, restricting scope or making disclosures to reduce their risk.

In cases where specific risks are flagged during due diligence, such as a potential doubtful R&D claim, the buyer may seek an indemnity from the seller to ensure that it can recover losses directly from the seller on a pound-for-pound basis in respect of that specific liability.

It is important to recognise that whilst W&I insurance adds a layer of protection, it does not eliminate the need to negotiate warranties and tax indemnities in the sale and purchase agreement. W&I insurance only covers the specific warranties and tax indemnities outlined in the policy and where these do not mirror the warranties and indemnities in the sale and purchase agreement, the seller will ultimately remain liable. The insurer may also seek to amend warranties within the policy to manage its own risk. If they do, there is often the argument as to whether the underlying warranty should be rewritten to match the cover. Additionally, some risks may be deemed too high for insurers to cover, which the parties will need to address.

Provisions on limitations of liability in the sale and purchase agreement will also align with risk allocation under the W&I policy. For example, the limitation period for breach of warranty claims may be extended to match the W&I insurance coverage, or the seller's liability might be reduced to cover only exclusions from the policy or be capped at a low or nominal amount. Where a buy-side policy is taken out, liability for covered claims will often be limited to the aggregate of £1.

A key point that sellers and buyers should bear in mind is that W&I insurance does not replace the need to carry out a thorough due diligence and disclosure exercise, as relevant risks will still need to be identified. What’s more, insurers will look to rely on findings in the due diligence process to price and structure the policy, and the risks, exclusions and coverage limits will be directly influenced by what is uncovered during the due diligence process. Ultimately, W&I insurance provides additional protection, but it is no substitute for a comprehensive risk assessment.

When do insurers get involved in the transaction process?

Insurers are usually approached once there is a fairly set form of warranties (with policy terms often negotiated at the same time as the sale and purchase agreement terms) and are often able to put policies in place within a matters of a few weeks in order to minimise any negative  commercial impact of the transaction. Nonetheless, the earlier insurers are approached, the more efficiently the process can be managed. 

What are the pros and cons of W&I insurance?

The main benefit of W&I insurance is risk allocation. W&I insurance can help bridge the gap between a seller offering limited warranties, low financial caps on liability and/or short limitation periods and a buyer wanting fuller warranties, a higher financial cap on liability and longer limitation periods. W&I insurance offers a neutral option to minimise both parties’ exposure to liabilities post-transaction and acts as a layer of protection in addition to those negotiated in the sale and purchase agreement. Sellers then have the benefit of a “clean” exit as liability can be transferred to the insurer, and buyers can claim damages in the event of a breach directly from the insurer without having to first pursue the seller.

W&I insurance may also be useful where a seller continues to have a role in the target business post-transaction. Bringing breach of warranty claims can strain the business relationship between buyer and seller and W&I insurance offers a means for buyers to be compensated for a breach of warranty without having to seek recourse against sellers.

For a buyer, W&I cover can offer a layer of financial security where there are concerns about the likelihood of recovery of damages from, e.g. individual sellers or distressed sellers. It can also be used as a negotiating tool to make a buyer’s offer more attractive than its competitors.

Whilst W&I insurance is becoming more and more popular in transactions, given the costs of obtaining a policy, realistically, getting cover would only really be commercial with deal values starting at around £3-4 million, where premiums will generally be around 0.6 to 1%. Premiums will vary from deal to deal and will be influenced by a number of factors, including the target sector, the complexity of deal terms, the identity and financial stability of the parties, the scope of cover and the risks involved.

W&I insurance offers a valuable tool to mitigate risks in a business sale and purchase transaction and provides an additional layer of financial protection. Policies are customisable and can help streamline processes and preserve commercial relationships. Whilst W&I insurance can help to bridge the gap between buyer and seller expectations, it is important to remember that it complements, rather than replaces, thorough due diligence and commercial contract negotiations. As W&I insurance continues to gain traction in transactions, understanding its role, costs, and limitations are crucial for securing successful business outcomes.

Further Information

If you have any questions or concerns about the topics raised in this blog, please contact Mei Chung or any member of our Corporate, Commercial and Finance team.

About the author

Mei is an Associate in the Corporate, Commercial and Finance team and joined Kingsley Napley in August 2021 from a regional firm. She advises entrepreneurs, investors and established businesses across a variety of sectors on a broad range of corporate and commercial matters.