W&I: Making due diligence reports insurance-friendly

Warranty & Indemnity (W&I) insurance serves to cover liability risks that may arise in corporate transactions in the context of warranty breaches or in connection with (tax) indemnities. To this end, warranties and indemnities are insured in corresponding policies.

The insurability (as comprehensive as possible) of guarantees and tax indemnities in the purchase agreement (share purchase agreement (SPA) or asset purchase agreement (APA)) largely depends on the quality, structure, and granularity of the due diligence. For fully insurable due diligence, all relevant topics must be documented precisely, clearly, and with a focus on risk. 

What characterizes a fully insurable due diligence report

The course for the most comprehensive coverage possible and a quick process leading to the conclusion of the W&I policy is already set during the preparation of the legal/tax/financial due diligence report. Two aspects are of central importance in this respect.

Scope

A fully insurable due diligence report is characterized first and foremost by a clearly defined scope of work that takes the desired coverage positions into account. A classic red flag report, which focuses exclusively on deal breakers, is often not entirely suitable for W&I purposes. This is because such an abbreviated report often leads to gaps in the coverage position, which are disclosed during underwriting and then lead to exclusions or only limited coverage of the list of warranties in the policy.

If the transaction is to be insured and if this is already known at the start of the transaction, the scope of work must be agreed with the client accordingly and, if necessary, expanded in specific areas; otherwise, the key points should be revised during the course of the due diligence process.

Wording

Insurance-friendly wording that adequately reflects the disclosure mechanism is also particularly important. This means clear risk qualification and, as far as possible, corresponding risk quantification.

In all other respects, the respective topics should also be presented in the due diligence report in a precise, risk-oriented, and clear manner. If a target has industry-specific characteristics, the W&I insurer will examine these in more detail during the underwriting process. If a corresponding focus was also set during due diligence and this is clearly reflected in the due diligence report, the W&I insurer can immediately and clearly see what has been examined and where possible risks may lie.

If this is implemented accordingly, deal-specific exclusions can be defined in the W&I policy as narrowly as possible on the basis of the report, so that the most comprehensive coverage possible will be guaranteed.

The advantages of fully insurable due diligence reports:

• Avoidance of “unpleasant surprises” in underwriting in the form of a lack of insurability of certain types of taxes, certain guarantees, etc.
• Acceleration of underwriting by reducing the number of underwriting questions and eliminating the need for an additional underwriting call
• Clear coverage positions in the warranty spread sheet and in the policy from the outset, i.e., shortening negotiations between W&I insurers and policyholders via the broker
• Identification of opportunities for the targeted use of endorsements (i.e., specific additions to the policy) to subsequently improve the coverage position (e.g., “true and fair view standard” in the context of the accounts warranty)

Selective due diligence vs. “full package”

It is advantageous for both the policyholder and the W&I insurer if the due diligence reports for all three workstreams – legal, tax, and financial – come from a single source.

The advantages are also obvious from the buy-side advisor’s perspective: Integrated due diligence reports avoid gaps (and contradictions) – both in terms of due diligence and coverage under the W&I policy – and contribute to an appropriate and clear risk assessment of issues at the interface between two workstreams (e.g., any freelancer issues).

In some transactions, however, the full package of fully insurable tax/legal/financial due diligence reports may not be desirable or necessary, e.g., due to the target or other factors such as the preparation of due diligence for certain workstreams by an in-house (M&A) department of the buyer.
 
One possible solution in this respect could be the creation of (selective) due diligence reports for the W&I insurer, which supplement or even completely replace buy-side due diligence. To date, selective due diligence for insurance purposes has often been used in new energy deals, where a fully-fledged financial due diligence can be replaced by a focused financial due diligence for insurance purposes, which primarily focuses on insuring the accounts warranties in the SPA. Similarly, the scope of legal due diligence in these deals often has different (i.e., less in-depth and less comprehensive) priorities than in deals involving operating target companies. In new energy deals, for example, this is often done using a so-called sample approach with a view to examining the title of the various project companies that are part of the overall transaction. Such focused due diligence reports are also conceivable for other types of deals, possibly with a different focus.

Outlook & conclusion

Overall, private equity investors – and strategic investors too – should consider the requirements for insurance-friendly structuring of the necessary due diligence reports as early as possible in the M&A process. By anticipating the requirements of W&I insurers and carefully analyzing the specifics of each transaction, fully insurable due diligence enables them to achieve comprehensive coverage under the policy without unnecessary detours. Working with interdisciplinary teams of advisors who are familiar with the insurers' perspective pays off in this respect.