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Rise of warranty and indemnity

  • Adroit Insurance and Risk
  • May 4, 2015

Often businesses take over existing businesses or merge with former competitors, and trust us when we say that it’s a very difficult and uncertain period.

In many cases, one of the most contentious parts of the acquisition agreement are the warranties and indemnities that provide crucial information to the buyer about the business they’re purchasing.

That’s where warranty and indemnity (W&I) insurance comes in. By transferring the risk of any of those warranties being breached to an insurer, it can – at the very least – help buyers sleep a little easier.

W&I cover enables parties to restrict potential liability if the buyer takes a loss from incorrect information provided during a sale. The insurance process can also force the seller to provide more information, allowing the buyer to make a more accurate assessment of the deal.

W&I insurance can be taken out by either buyer or seller, and can also be extended to include other parties, such as a guarantor.

With seller W&I, the buyer claims against the seller for breach of warranty in the usual way. The policy covers damages suffered by the seller from the buyer’s claim, whereas buyer W&I responds directly to damages following insured breaches of the warranties. This type of cover is usually used when a private company is the target of an acquisition.

It’s quite easy to find information on public companies, but buyers of private businesses can feel like they are leaping into the unknown and thus, need the added security of warranty and indemnity insurance.

There’s also an increasing trend for sellers seeking a “clean exit” from a transaction to require the buyer to hold a warranty and indemnity policy. This means that the buyer’s sole recourse for any loss incurred from a breach of seller warranty (except for fraud) is to that insurance, which can then allow the seller to move on.

It can be advisable from the buyer’s perspective for the seller to retain some liability. Why, you ask? Because the risk of a warranty claim creates a strong incentive for comprehensive due diligence and a detailed warranty verification process. If the buyer’s only recourse is to claim on warranty insurance, then this incentive is reduced.

There’s also an argument that to have effective liability insurance, there must actually be a liability. If the seller has zero liability, the buyer may not be covered for a warranty breach because there would be no liability on the part of the seller for the insurer to indemnify.

Although warranty and indemnity insurance hasn’t yet fully taken off in Australia, it’s grown significantly over the last two to three years as businesses of varying sizes realise they can quickly boost their growth and profit by merging with or acquiring other businesses.

It certainly can calm the sometimes choppy waters of mergers and acquisitions, but it’s not a one-size-fits-all product and needs to be carefully tailored to each individual’s circumstances. That’s where your risk adviser can come in and tailor a W&I solution to give you peace of mind in your business’ expansion.

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