The New Standard in M&A: How Insurance is Changing the Game

Mergers and Acquisitions (M&A) are pivotal strategies for businesses seeking growth, diversification, or strategic realignment. However, these transactions do carry certain risks. Consequently, insurance products have become essential instruments for effective risk management, fundamentally transforming how M&A deals are now approached and executed.

Warranty and Indemnity insurance (W&I insurance) is a specialized type of insurance policy used in M&A transactions to protect buyers and sellers from financial losses arising from breaches of representations and warranties made during the sale. Representations and warranties are statements of fact about the target company’s condition, operations, or business. The warranties can also relate to fundamental aspects such as authority to do the transaction, valid title to assets and business, no encumbrances and absence of tax liabilities. If these statements turn out to be inaccurate, W&I insurance covers the insured from resulting financial losses. The insurance comes to the rescue in case of a breach, especially in scenarios where the seller is unwilling to provide an indemnity to the buyer for breaches. It helps ensure that both parties can proceed with the transaction confidently, knowing they are protected against unforeseen issues that may arise post-acquisition.

One notable trend in the M&A arena is the evolving ownership structure of target companies. Nowadays, it is increasingly common for promoters/ founders to retain only minor stakes by the time the target company has achieved substantial growth and scale for it to undertake M&A transactions. This shift occurs because, as the company grows, various investors come in, leading to significant dilution of the promoter’s stake. As a result, the target company is majorly held and controlled by Private Equity (PE) and Venture Capital (VC) funds. Financial investors typically lack day-to-day operational involvement and are therefore unwilling to accept extensive liability for business warranties. In this backdrop and to address these challenges, W&I insurance has emerged as an essential tool.

The utility of W&I insurance becomes even more important in scenarios where PE investors are selling their stake, and the relevant fund entity is intended to be wound up post-exit due to the fund cycle nearing its maturity. In such cases, the acquirer needs a mechanism to obtain requisite protections, as the selling PE investor may no longer be available to address any post-transaction losses. Even if the exiting PE investor offers an indemnity, it may not be effective if the relevant fund entity has already wound up or is about to be wound up shortly. From the PE investor’s standpoint as well, W&I insurance helps avoid complications in closing the fund, as outstanding liabilities, contractual indemnities, and obligations can hinder the winding-up process. Thus, W&I insurance provides a reliable solution for both acquirers and PE investors to mitigate risk exposure and facilitate the M&A deal-making.

Additionally, there are specialized insurance products designed to cover specific risks. For instance, tax liability insurance has become common to address tax exposures. Similarly, legal contingency insurance offers a way to mitigate risks in situations involving legal uncertainties that could impact the transaction. Further, in case treaty benefits are denied, tax withholding obligations under Indian tax laws arise, and the Indian acquirer can be held liable for failing to withhold taxes and may also become subject to representative assessee proceedings. In such cases, appropriate withholding tax insurance policies are now generally obtained to cover these risks. Such specialised insurance policies have become common as they offer financial security and support the deal’s financial stability.

A significant use case for W&I and tax insurances also arises in competitive bidding situations. Sellers, particularly PE/ VC investors, often use auction processes when divesting their controlling interests, expecting to offer limited or no representations and warranties. Consequently, acquirers are expected to obtain insurance to protect their interests. This reduces their post-closing liabilities and ensures a clean exit for the sellers. Acquirers who secure such insurance signal proactive risk management thereby making their offers more attractive. This approach also smoothens negotiations by minimizing disagreements over representations and warranties. By strategically using these insurance products, acquirers tend to increase their chances of success, especially when pursuing high-value and sought-after assets.

The M&A insurance market has evolved significantly especially over the last couple of years. Earlier policies were often not marketable and heavily favoured insurers, with wide exclusions and numerous limitations that made them less viable options. However, increased competition has led to more pragmatic insurance solutions that offer more realistic terms, and broader coverage to the insured. Additionally, underwriters are now more likely to honour claims and not deny liability arbitrarily, with insurance brokers supporting their clients in the claim process.

Nevertheless, certain aspects do require careful consideration during the negotiation phase. These policies typically come with limitations and exclusions. Common exclusions include fraud, known matters, risks discovered during due diligence, and Anti-Bribery and Anti-Corruption (ABAC) exclusions etc. Since known matters and specific indemnities, especially those arising from the due diligence exercise, are also typically excluded, these become the subject matter of discussions and negotiations between the buyer and the seller as to how these issues will be addressed. The insurance policies also contain de minimis and retention amounts, requiring the insured to assume a certain level of risk. There are also monetary caps and time period limitations for making claims under the policies. Despite specific exclusions and limitations, they are clear and manageable, providing coverage for crucial unknown risks. In terms of the claim process, the insured is required to cooperate with underwriters, who actively participate in the defence process. The insured cannot settle claims without the underwriter’s consent. All these requirements underscore the importance of carefully understanding and negotiating the terms and conditions of the insurance policies.

In conclusion, the strategic use of insurance products in M&A transactions has transformed how these deals are now executed. These solutions provide essential protection, facilitate smoother negotiations, and enhance transaction stability. While earlier policies were heavily insurer-friendly with wide exclusions, the evolving insurance market now offers more pragmatic and comprehensive coverage. By carefully reviewing and negotiating these policies, both acquirers and sellers can effectively navigate M&A complexities, manage risks, and ensure a smooth and efficient deal-making process.