Warranty and indemnity insurance (W&I insurance) can cover financial loss arising from breaches of specified warranties or indemnities in a business or share sale agreement. Its usefulness depends on the cover available, the due diligence undertaken and how the policy works with the parties’ contractual rights.
For a seller seeking to limit continuing liability, or a buyer concerned about recovering a future claim, W&I insurance is worth considering early in the transaction. The proposed cover needs to be understood before the sale agreement’s liability provisions are settled.
How W&I insurance works
A sale agreement normally contains warranties about matters such as ownership, accounts, contracts, employees and compliance. An indemnity can allocate responsibility for a particular liability. W&I insurance covers specified loss under the policy if an insured warranty or indemnity is breached.
A buyer-side policy gives the buyer a direct claim against the insurer for a covered loss. Under a seller-side policy, the buyer claims against the seller and the seller seeks cover under its policy. The identity of the insured party matters even where the other party contributes to the premium.
An insurer’s product summary can explain the intended scope, but the agreed policy wording determines the cover.
What the parties are trying to achieve
A seller may want to distribute the sale proceeds without retaining a substantial amount for potential warranty claims. A buyer may want an identified insurer to respond to covered losses where there are several sellers or concerns about their future financial capacity.
Where a seller remains as a shareholder or manager, buyer-side cover may allow a covered claim against the insurer without first claiming against that seller. Check any rights the insurer retains against the seller.
When W&I insurance is used
W&I insurance is most common in private equity transactions, competitive sale processes, sales by a large group of shareholders, and deals where the sellers stay on as managers or minority shareholders and the buyer does not want to sue its own management team. A seller running a competitive process will often obtain indicative terms early and hand them to bidders, sometimes called a seller-flip or stapled policy, so that bids are made on the basis of a nominal seller liability cap.
Because insurers set minimum premiums, W&I insurance is rarely economic for transactions below roughly $10 million in value. In most smaller owner-managed sales, the parties rely instead on contractual protections such as retentions, escrow arrangements, deferred payments and personal guarantees.
What does warranty and indemnity insurance exclude?
W&I cover usually focuses on unknown risks. A problem identified during due diligence will generally require a separate contractual response. What the buyer’s deal team actually knows at signing is excluded, and the buyer is usually asked to confirm this in a no-claims declaration at signing and again at completion. Other exclusions depend on the insurer, the business and the proposed policy.
Areas of limited or excluded cover can include forward-looking statements, matters insufficiently investigated, purchase price adjustments, underpayment of wages, environmental contamination, transfer pricing, the availability of tax losses and fines, penalties and other liabilities that cannot lawfully be insured. The treatment of fraud also differs between buyer-side and seller-side arrangements: a buyer-side policy generally still responds to a seller’s fraud, leaving the insurer to pursue the fraudulent seller, while a seller-side policy will not cover the seller’s own fraud.
In the Australian market, cover commonly extends to a general indemnity for pre-completion tax, which is one of the policy’s main attractions for a buyer. Known matters that the policy excludes can sometimes be insured separately under a contingent risk or specific tax policy, at an additional premium.
Consider a buyer that identifies an unresolved employee underpayment during due diligence. It should establish how the exposure will be addressed in the transaction, whether by remediation, an indemnity or another agreed measure. It should not assume that a policy described as covering employment warranties will pay for that known issue.
The sale agreement must allocate responsibility for uninsured risks. Reducing the seller’s liability without checking those gaps can leave a buyer with less recourse than it expected.
Why due diligence still matters
The insurer needs information about the business and the investigations completed by the buyer’s advisers. A gap in diligence can lead to questions, a restricted warranty or an exclusion. The practical rule is that cover follows diligence: an area that was not reviewed will generally be excluded. Insurers typically expect legal, financial and tax due diligence reports, and now commonly ask for a wage compliance review before covering employment warranties.
Match diligence to the business’s risks. A software business may need closer scrutiny of IP ownership and customer contracts; a large workforce may call for detailed employment review. A standard report may not cover those issues.
If the seller commissions vendor due diligence, the scope and reliance terms should be checked with both the buyer and the insurer. The buyer’s advisers may need to make further enquiries, and material questions and answers should be recorded for the policy negotiations.
Aligning the policy with the sale agreement
The legal and insurance work should progress together. Before the documents are finalised, check:
- Which warranties and indemnities are insured, including any qualifications imposed by the insurer.
- The policy limit, minimum claim amount and any retention the insured must bear.
- The insurer’s rights of subrogation against the seller, which should be limited to fraud.
- The sale agreement’s W&I clause: the buyer’s recourse against the seller, who pays the policy costs, the obligation to bind the policy and what happens if it is not bound.
- Whether any gap arises between signing and completion, and how new information must be disclosed.
For example, a sale agreement may allow a claim for a different period from the policy. It may also use a different definition of loss, including whether loss can be calculated on an earnings multiple. Identifying those differences before signing allows the parties to decide who carries the resulting exposure.
When to involve an insurance broker
An experienced transaction insurance broker can seek indicative terms and explain the available cover. Engage the broker while the transaction timetable and risk allocation are being developed, leaving time for underwriting questions and negotiation. Indicative terms can often be obtained within a few days, and underwriting completed in one to two weeks once the due diligence reports are available.
Underwriting usually involves providing the draft sale agreement, disclosures and due diligence reports, then answering the insurer’s questions. The parties and their advisers review the proposed cover and exclusions before the insurer confirms the requirements for binding the policy.
The premium is the price paid for the policy. The retention or excess is the amount of covered loss the insured must bear before the policy responds, subject to its terms. The policy limit is the maximum cover available. These amounts serve different purposes and should be considered separately.
The parties should agree who pays the premium and any underwriting or broker fees. A seller may contribute to a buyer-side policy, but payment does not determine who is insured. Obtain terms for the proposed transaction before budgeting for cover.
A seller may seek indicative insurance terms before selecting a buyer. The successful buyer still needs to review the proposed cover and complete underwriting.
Does insurance remove all seller liability?
No. The seller’s liability depends on the sale agreement, while the insurer’s obligations depend on the policy. Specific indemnities, completion obligations, price adjustments and other promises may sit outside the insured warranty package. Fraud remains the seller’s own liability under any structure.
Under a buyer-side policy, the seller’s liability under the sale agreement is commonly capped at a nominal amount, often $1, or at the policy retention, with the policy providing the buyer’s real recourse. That structure only works if the sale agreement, the policy and the buyer’s due diligence are aligned, because any gap between them falls on the buyer.
Before agreeing to a low liability cap, a buyer should know which risks are insured and which remain with the parties. Before expecting a clean exit, a seller should understand the obligations that will survive completion.
Advice on the transaction documents
Our mergers and acquisitions practice advises on warranties, indemnities and liability arrangements in private company transactions. Contact Rouse Lawyers to discuss the proposed allocation of risk.
Disclaimer
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Accordingly, the information on this site is provided with the understanding that the authors and publishers are not providing legal advice. As such, it should not be used as a substitute for consultation with professional legal advisers. Before making any decision or taking any action, you should consult with a professional lawyer from Rouse Lawyers.
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