Private Equity Sound Bite - September 2012

Article by Perry Yam, Mark Pedretti, Philip Taylor, Dr. Justus Binder, Marc Fredj, Lucas d'Orgeval and Emmanuel Vergnaud

Warranty & Indemnity Insurance

In a market where deal execution is proving challenging, one of the ways of addressing risk and closing the divide between buyers and sellers is insurance.

Warranty and indemnity insurance is available in private equity and M&A transactions to cover either the buyer or seller for losses resulting from breaches of the seller's warranties or indemnities. This coverage can serve as a complete substitute for or partial supplement to, other forms of financial guarantees for the seller's warranty and indemnity obligations.

A seller policy will typically pay out the indemnity owed as a result of a breached representation or warranty to the buyer. Coverage purchased by the buyer can provide the same protection, but the insurer will have a subrogation claim against the seller for any breach. An insurer can be asked to waive or limit its subrogation rights, enabling the deal to be structured so that the buyer's sole recourse in the event of a breach is the policy, absent fraud. Although policies differ in their wording, they generally provide coverage for defined risks from one specific warranty/indemnity or a whole list of representations and warranties.

Insurers may dispute whether a particular representation or warranty was fraudulent, known to be false, or should have been known to be false before the deal and the insurance purchase. Negotiations can specify that "actual" knowledge of fraud is required to exclude a loss, and the group of individuals at the seller whose knowledge "counts" can be narrowed. If the goal is to set a price for a known risk that has not yet occurred or been quantified, the policy should be written to reflect that.

These policies usually only cover existing or past conditions and do not cover covenants about future conduct or contingencies yet to occur. If there is a concern about ongoing or future risks inherent in an M&A transaction, other insurance policy forms may be necessary, such as coverage for ongoing litigation, an aborted bid, future pollution liabilities, projected profitability or income streams, future tax treatment, and liabilities of officers and directors.

The cost of a policy will vary depending on the nature of the risk covered. Premiums of 1–2% in the UK (and 3–10% in the US) are typical. If one party to an M&A transaction uses this type of coverage...

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