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Warranty and indemnity insurance in South Africa's M&A environment
![Image source: Getty/Gallo](https://biz-file.com/c/1908/511798-700x364.jpg?2)
This has led to a remarkable increase in the use of the product to cover for losses arising from a breach of a warranty and claims under a tax indemnity arising from a merger or acquisition (M&A) contract. Some statistics show that in 2017, 47% of private equity sales and 27% of all other deals in Europe had W&I insurance as part of the deal. This has increased since then.
In South Africa, however, this picture is somewhat different. Generally, M&A lawyers do not have favourable views of the product, largely because it is misunderstood. The fact that W&I underwriters who work on South African deals do so mostly from London, does not assist the South African market gaining insights as to the benefits of the product. This is slowly changing as there appears to be a growing interest and understanding of the benefits of making use of W&I insurance in South Africa.
Global claims study
AIG has reported that in 2019, claims notification frequency increased from 21% to 26% for deals ranging between $500m and $1bn. Put differently, the larger and more complicated the deal, the more frequent the claim notifications have become. Their data further revealed that the severity of claims have also increased from 8-15%, with claims valued at over $10m doubling, and one in five deals resulting in a claims notification.
The study further indicates that the majority of claims notifications arise from breaches of warranties and indemnities of financial statements, tax, compliance with laws and material contracts. From a tax perspective, tax breaches continue to dominate in Europe, the Middle East and Africa, and span a wide variety of issues, led by corporate income tax (34%), employment taxes (23%) and inter-group arrangements (6%). It may appear unusual, given the nature of the international deals taking place, that only 6% of breaches relate to inter-group arrangements. What must be kept in mind, is that W&I insurance does not cater for every type of warranty and tax indemnity contained in the transaction agreements, and typically will exclude any transfer pricing risks from cover, such as management fees between group companies, as well as other exclusions relating to inter-group arrangements.
Seventy-four percent of claims are brought within the first 18 months from the date of the policy inception, with an estimated 29% of those claims being brought within the first six months. An increase in the claims frequency, coupled with a competitive market, has resulted in a decrease in profits for W&I underwriters, which may necessitate an increase in the cost of insurance premiums.
With the increase in claims notifications, together with the statistics relating to breaches of warranties and indemnities, it is understandable that we have seen an increased interest in W&I insurance products in South Africa, as well as globally.
Criticism of the product in South Africa
Two common points of criticism in South Africa are that W&I insurance does not provide adequate cover and that it is too expensive.
The first point of criticism is often a misunderstanding of the insurance product and that it is not meant to replace a proper due diligence investigation of the target. Underwriters expect that the buyers and sellers still properly negotiate the content of the warranties. Looking at this content, the majority of warranties contain wording which relate to the actions and thoughts of third parties, which the warrantors will have no knowledge of. They can provide those warranties, but do so as a risk allocation mechanism, and not because they are comfortable to talk to the actions or circumstances of third parties. Similarly, some warranties refer to future performance of the target. Forward-looking warranties are excluded by underwriters and rightly so because the insurance product is not aimed at protecting the buyers against a bad bargain. Similarly, W&I insurance is not aimed at replacing, but rather complementing other insurance solutions, such as directors and officers liability insurance, professional indemnity insurance, and cyber insurance.
The second point of criticism, relating to costs, is perhaps more understandable given the pressure on the South African economy. But the reality is that one in every five policies attract a claims notification, which testifies to the benefit of the coverage in relation to the insurance premium.
Despite the availability of the product, it is vital that a due diligence investigation is undertaken when considering a deal and ensuring that the warranties and indemnities are adequately negotiated between the parties. When deciding whether a party wants to make use of W&I insurance, the legal advisors counselling the underwriters must ensure that the scope of the due diligence, during the negotiation phase, matches the warranties and indemnities contained in the transaction agreements and correctly identifies the risks pertaining to the transaction.
Of concern is that when providing advice to the underwriters, we often see a large disconnect between the transaction and the actual drafting of the warranties and indemnities. Some internal and external legal advisors will attach a precedent warranty catalogue to the transaction agreements, without tailoring the warranties for the specific target. This leads for example to pages of environmental warranties for a small information technology service company where environmental matters are not necessarily relevant. Considering that the buyers did not see environmental issues as a risk, no environmental due diligence was conducted and yet the legal advisors still expected those environmental warranties to be covered. We have seen several pages of tax warranties included in the transaction agreements, but the tax due diligence was extremely limited in scope and it was clear that the warranties did not speak to any of the findings contained in the due diligence report, or alternatively, warranted aspects had not been diligenced.
It must be remembered that the rationale for W&I insurance is not to replace the due diligence investigation during the negotiation phase, nor is it meant to cover all warranties and indemnities in the transaction agreements. The due diligence and the negotiations which take place prior to the signing of the transaction agreements remain fundamental for M&A transactions. Bear in mind that when we provide coverage advice to underwriters, and critique warranties and indemnities included in the transaction agreements, the level of detail and accuracy expected when drafting warranties and indemnities for M&A transactions result in more bespoke warranties and indemnities tailored to the specific transaction.
The way forward
Although only a portion of the South African market has had the opportunity to make use of W&I insurance products, the evolution of W&I insurance in South Africa is yet to be seen. The misconception that the product is not worth the money paid for it stems from a misunderstanding the offering and the benefits provided by coverage of certain warranties and indemnities.
It appears that larger M&A transactions which include increased risks for the parties, have spurred an increased interest in South Africa regarding W&I insurance products and the benefits provided when obtaining coverage. Those who have considered W&I insurance, or who have already purchased the product, will most likely have seen the value that the product can offer.
With the increased interest of W&I insurance products in South Africa, we can expect to see a decrease in the disconnect between the warranties and indemnities contained in these transaction agreements, and more bespoke transaction-specific warranties and indemnities being negotiated between the parties.
About Candice Gibson and Adriaan Louw
Candice Gibson and Adriaan Louw work for Norton Rose Fulbright![](/res/img/s.gif)