What is the future of M&A insurance - as a risk management tool for financial institutions?
In a world where you never know what will happen next, M&A insurance is one way of protecting your business against the risk of the unexpected. We have been seeing significant changes in the M&A market in recent years – a trend that Covid-19 is likely to exacerbate – meaning that firms that previously would not have contemplated purchasing this type of insurance, might now consider it; and insurers providing this type of cover need to reassess their risk strategies to reflect the level of uncertainty inherent in the ‘new normal’.
The rapid evolution of M&A insurance has been driven by increasing demand for the product and an increasingly sophisticated product offering. The challenge for underwriters and managing general agents (MGAs) will be to match ever more assertive policyholders with a need to calibrate risk in a highly uncertain business environment. M&A insurance has traditionally meant warranty and indemnity (W&I) insurance, which covers M&A buyers or (less commonly) sellers in relation to the risk of inaccurate warranties in their sale and purchase agreement (SPA). Insurance brokers Paragon estimated that 4,355 global transactions were backed by insurance M&A in 2018 (870 in UK and Ireland). The product is particularly popular (indeed it has become the norm) in private equity M&A to give sellers a “clean break” from ongoing SPA exposures.
What has changed?
In the last few years, new features of the product have emerged. Examples include:
- Contingent risk insurance – which tends to cover “low risk, big number” items. We have seen this used in tax, title, litigation and environmental.
- W&I coverage enhancements – for example:
- “scrapes” whereby the policy disregards awareness or materiality qualifications in the SPA or extends time limits;
- synthetic policies whereby the SPA contains no warranties but the insurer nevertheless agrees to cover a set of warranties on the sale;
- zero excess/retention in some sectors (such as real estate) and a small “de minimis”; and
- “new breach cover” where the insurer covers issues discovered between exchange of contracts and completion.
It is likely that COVID-19 will increase the demand for all these features and drive the creation of new ones as buyers, sellers and insurers seek to allocate risk in a highly uncertain climate.
Why does this matter?
The features are clearly advantageous to policyholders and mark a sea change from the old complaints that the product had so many exclusions that it was not worth taking out. The question is whether some insurers are moving too far the other way, i.e. chasing new business by covering risks that cannot be properly calibrated or assessed. It will be interesting to see whether the current squeeze in M&A volumes changes market dynamics.
What about claims?
Insurers are focused on M&A valuation, particularly EBITDA multiples. Their natural concern is that if there is a warranty breach, their loss will be assessed on the basis of the buyer’s valuation metrics (regardless of the law on measure of loss and causation). This is a particular issue in some sectors such as tech, but also since the pandemic.
W&I claims in the UK remain relatively rare but they are increasing in volume, perhaps unsurprisingly in the current environment. AIG’s recent claims study quotes global claims frequency at c. 1 in 5 deals but the figures in UK/Europe are lower. According to the Marsh 2019 EMEA claims study, notifications in EMEA amount to c. 11% of policies, and this will include notifications that never actually lead to claims.
The real risk to insurers, therefore, is not so much a flood of claims but a few big claims in the context of very low premiums (sometimes as low as 0.7% of cover limit).
In our experience, only a limited range of W&I insurers will cover UK financial services M&A deals. They tend to exclude certain areas from coverage such as anti-bribery, conflicts of interest, client money handling, E&O liability including mis-selling, breach of Lloyd’s binders, professional liability and of course capital adequacy. (Some of these areas can potentially be covered if full “clean” due diligence reports are available.) Premiums are also likely to be higher in this sector. For these reasons, W&I insurance tends to be less commonly used in financial services M&A deals than in other sectors but we have seen it used successfully in the sector.
All crises drive innovation and change. In a “risk-off” environment, demand for innovation in W&I and contingent risk policies is only likely to increase. The big question is whether the recent drop in M&A volumes and increase in claims will give rise to a more cautious attitude amongst underwriters.
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This document provides a general summary and is for information/educational purposes only. It is not intended to be comprehensive, nor does it constitute legal advice. Specific legal advice should always be sought before taking or refraining from taking any action.