THE SUBJECT MATTER

When companies (or assets of companies) are sold, the vending shareholders are usually required by the purchaser to make statements about the company at the point of sale. These statements, or warranties, cover every aspect of the company from financial information and trading environment to litigation and pensions. If the vendors are aware of matters which would make any warranties incorrect they should disclose such matters to the purchaser. If, however, the vendors give warranties which are, subsequently, shown to be incorrect and the offending matter has not been disclosed, the purchaser has the right, under contract, to recover the difference in the purchase price between what he paid and what he would have paid had he been made aware of the offending matter. This is warranty liability.

TYPES OF W&I

Vendor Cover

Traditionally, W&I was bought by vendors as a way of protecting themselves against the possibility of warranty liability claims eating away some or all of their proceeds from the sale of their shares. This is known as vendor cover and is the most frequently bought form of W&I. A feature of vendor cover policies is that the purchaser can be named as loss payee, thereby finding comfort in the knowledge that if he succeeds in proving breach of warranty and the vendor’s policy pays out, the proceeds from the policy will pass to him without having to pass through the vendor. The benefit here is that many of the concerns the purchaser may have regarding the vendor’s inability to pay in the event of a proven claim are satisfied.

With an increasing number of transactions at the turn of the century involving exits by private equity and venture capital funds came the problem that such funds were unwilling to give warranties other than to title. This would have been a far larger problem had it not been for W&I. For a while insurers provided vendor cover to managers for their liability over and above their share of the consideration, on the basis that the purchaser agreed not to enforce such excess liability unless the insurance responded. This method was sadly seen as potentially flawed on the basis there might not have been an actual insurable interest. An alternative soon emerged which circumvented the insurable interest question and broke new ground, it was purchaser top-up cover.

Purchaser Top-Up Cover

This type of cover is based on managers providing warranties in the normal way and accepting liability to the purchaser under contract for their percentage of the consideration. If the purchaser is not satisfied with the protection this affords, he can buy a policy in his own name covering his loss arising from his inability to recover the full extent of the damage flowing from the breach of warranty due to contractual limitations. Instead of the traditional third party liability policy, this is a policy which covers first party loss.

Although purchaser top-up cover is ground-breaking in introducing first party coverage, it is still based on the premise that the purchaser must always prove breach of warranty by the managers under contract before being in a position to recover under his policy. There are two further extensions to the first party theme which go even further away from third party liability, these are purchaser first resort cover and purchaser last resort cover.

Purchaser First Resort Cover

Where the vendor is willing to provide warranties but is not prepared to accept any liability for the consequences of any of them being incorrect, the purchaser can buy his own policy covering his loss arising from any of those warranties being incorrect. Instead of having to prove breach of warranty against the vendors he has to prove he has suffered loss to insurers.

Purchaser Last Resort Cover

Occasionally, purchasers enter into transactions with concerns regarding the vendor’s ability to pay proven warranty claims. They could insist that the vendor takes out W&I and names the purchaser as loss payee, however, there is a risk that the policy fails to respond as a result of events outside the purchaser’s control, thereby leaving the purchaser out of pocket. In such circumstances, the purchaser can buy his own policy which covers his first party loss arising out of his inability to recover on a justified claim due to the impecunity of the vendor. The policy will stipulate that the purchaser has exhausted all other avenues of recovery before any claim is paid.

WHAT DO THESE VARIOUS FORMS OF COVER COST?

Insurers look at a number of factors when determining what premium to charge, such as the type and amount of cover required, attachment point (excess), size of the transaction, activities of target, jurisdiction, scope of warranties and more. As a rough guide, the following rating bands applicable to a typical limit of indemnity of £5m highlight the differences in perceived exposure between the various types of W&I:

Vendor: 1.5-2.5%
Purchaser top-up: 2.0-3.5%
Purchaser first resort: 2.5-4%
Purchaser last resort: 2.0-4.0%

As a rule, the rate should reduce as the limit and/or excess increase and vice versa.

THE MARKET

Since the terrorist attacks on New York, the amount of capacity in the insurance market has shrunk considerably. The capacity that is available is generally used to write classes of business which are considered safe and predictable. As a result, niche classes such as W&I have seen available capacity drop significantly from a peak of c.£250m per risk in early 2001 to c.£100m today.

Another effect of the hard market is a reduction in the number of insurers prepared to lead risks. The number of viable lead insurers has shrunk from 6 in 2001 to 4 today.

In view of this reduction in overall supply, rates increased somewhat from the levels available in early 2001, however, with capacity increasing rates have softened materially over the last three years and should continue to do so in the short to medium term.

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