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Risk & Insurance in Mergers & Acquisitions Guide 2016

Airmic would like to thank Aon, who has prepared this paper on behalf of Airmic.

Aon plc (NYSE:AON) is a leading global provider of risk management, insurance and reinsurance brokerage, human resources solutions and outsourcing services. Through its 72,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions.

Aon is the pre-eminent provider of M&A-related insurance, risk, health and benefits due diligence and transaction solutions. In the past 5 years we have completed over 6,000 engagements globally. This depth of experience means we are able to deliver value to our clients no matter the geography or industry.

For further information on our M&A capabilities and to learn how we empower results for clients then please visit www.aonasats.com or contact any of the below:

Jonathan Brisker [email protected] +44(0)207 086 8410

Rebecca Ford [email protected] +44(0)207 086 0293

Nuala Read [email protected] +44(0)207 086 4927

Aon UK Limited is authorised and regulated by the Financial Conduct Authority. FPNAT.218

Contents

1. Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2. The different types of transactions . . . . . . . . . 5

2.1 Acquisition via public share deals . . . . . . 5

2.2 Acquisition via the purchase of private shares . . . . . . . . . . . . . . . . . . . 6

2.3 Acquisitions via the purchase of assets . . 6

2.3.1 Acquisitions of distressed businesses . . . 7

2.4 Initial public offering of securities (IPOs) . . . . . . . . . . . . . . . . . . . 7

3. Transaction process for private share deals . . . . . . . . . . . . . . . . . . . . . . 8

3.1 Preliminary bid stage . . . . . . . . . . . . . . . . 8

3.2 Data room . . . . . . . . . . . . . . . . . . . . . . . . . 9

3.3 Due diligence . . . . . . . . . . . . . . . . . . . . . . 9

3.4 Documents drafted . . . . . . . . . . . . . . . . . 11

3.5 Disclosure . . . . . . . . . . . . . . . . . . . . . . . . 11

3.6 Exchange . . . . . . . . . . . . . . . . . . . . . . . . 11

3.7 Completion . . . . . . . . . . . . . . . . . . . . . . . 11

3.8 Post completion . . . . . . . . . . . . . . . . . . . 12

4. Insurance due diligence . . . . . . . . . . . . . . . . . 13

4.1 Risk profile . . . . . . . . . . . . . . . . . . . . . . . 14

4.2 Insurance profile . . . . . . . . . . . . . . . . . . . 15

4.3 Future insurance programme . . . . . . . . . 16

4.4 Directors’ and officers’ liability (D&O) . . . 17

4.4.1 D&O for IPOs . . . . . . . . . . . . . . . . . . . . . 18

4.5 Insurance-related review of sale and purchase agreement . . . . . . . . . . . . . . . . 19

4.6 Claims-made policies . . . . . . . . . . . . . . . 21

5. Risk due diligence . . . . . . . . . . . . . . . . . . . . . 22

5.1 Supply chain reviews . . . . . . . . . . . . . . . 22

5.2 Contractual reviews . . . . . . . . . . . . . . . . 23

5.3 Business continuity plans . . . . . . . . . . . . 23

6. Human capital due diligence . . . . . . . . . . . . . 24

6.1 HR risk profile . . . . . . . . . . . . . . . . . . . . . 24

6.2 Employee-related review of sale and purchase agreement . . . . . . . . . . . . . . . . 26

7. Transaction insurance . . . . . . . . . . . . . . . . . . 27

7.1 What are warranties? . . . . . . . . . . . . . . . 27

7.2 How do indemnities differ from warranties? . . . . . . . . . . . . . . . . . . . 28

7.3 SPA protections . . . . . . . . . . . . . . . . . . . 28

7.4 What is warranty and indemnity (W&I) insurance? . . . . . . . . . . . . . . . . . . . . . . . 29

7.5 Types of W&I cover . . . . . . . . . . . . . . . . . 30

7.6 How and why is W&I insurance used? . . . . 31

7.7 The process for obtaining W&I terms . . . . . 32

7.8 The cost of W&I insurance . . . . . . . . . . . . . 32

7.9 Tax or contingent insurance . . . . . . . . . . . . 33

7.10 Loss mitigation programmes (LMPs) . . . 33

7.11 Environmental liabilities . . . . . . . . . . . . . 33

7.12 Other types of insurance used in transactions . . . . . . . . . . . . . . . . . . . . . . 33

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

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Use of Insurance in Mergers & Acquisitions (M&A) DealsAirmic Technical

1 Introduction

This document provides guidance on the types of deals companies undertake and outlines the key insurance and risk management related implications, together with the insurance tools that are available to support a transaction.

In the UK, a contract to buy or sell a business is based on the principle of ‘caveat emptor’, known as ‘buyer beware’. This means that it is the buyer’s responsibility to be comfortable with what they are buying. The deal negotiations and information gathering part of the M&A process are very important to both buyer and seller and can help to avoid future value reductions in the acquired business.

Insurance due diligence can help in making informed decisions regarding the past liabilities and in structuring a cost-effective insurance programme that meets the future needs of the business. This assists the team in incorporating any unexpected costs into the deal. Further, it helps ensure that key insurance-related risks are identified and understood, as these can often have a direct impact on revenue. In particular, where the acquisition involves the acceptance of past liabilities, the quality of the target company’s historic insurance policies can be as valuable as its physical assets or market share.

In addition, transactional liability products can be used to enhance the position of the buyer or seller, or used to overcome potential issues within the deal negotiations. The main products are warranty and indemnity (W&I) and tax insurance.

For sellers, transactional liability products can be used to enhance the exit value and, for buyers, they can provide additional financial comfort or a method for them to remove a deal issue from the table.

This document reflects insurance and legal practice in the United Kingdom, although many of the principles will apply to other territories. This document does not constitute legal advice and members should refer to their advisors on all aspects of this guide.

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Use of Insurance in Mergers & Acquisitions (M&A) Deals

2 The different types of transactions

Transactions are either ‘private’ or ‘public’, depending on whether or not the target is listed on a public stock market.

The ownership of a business can be sold or acquired in several ways:

• By making a successful bid for the shares of a publicly traded company (a public deal)

• By buying the shares of the private company that owns the business (a share sale)

• By buying the assets of a company, for example a building or piece of machinery (an asset sale).

• By selling shares through the offering of securities (initial public offering (IPOs))

There are significant differences in how insurance due diligence and insurance deal solutions can be used depending on the type of sale/purchase.

Acquiring shares in a company usually means buying the business and also the historic liabilities accrued by that business. Such historic liabilities can include, for example, tax, defective product or environmental liability. With an asset transaction, a buyer can usually avoid transferring most, but not all, liabilities.

2.1 Acquisition via public share deals

To acquire a public company, the potential purchaser has to make an offer to the shareholders of the company for their shares. The acquisition is successful if the majority of the shareholders agree to accept the share offer.

With these deals, in many cases, the bid is supported by the target business and information is provided on the target company. However, the target company will limit the information provided, usually because it does not want to release confidential information to a competitor.

For public bids that are hostile, there is little or no information provided to a bidder in the initial stages. The buyer will have to rely on its own research and publicly available information, for example, audited accounts and public announcements.

UK publicly traded companies are subject to the City Code on Takeovers and Mergers and the EU Takeovers Directive (2004/25/EC, given statutory basis via The Companies Act 2006). These regulations are designed to ensure fairness to shareholders and bidders; for example, all bidders must be provided with the same information.

Due diligence in public offers is usually restricted compared to private sales, and there is a limited opportunity to utilise other insurance-backed deal solutions.

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2.2 Acquisition via the purchase of private shares

With the share sale of a private company, the buyer acquires the company’s assets, liabilities and obligations under a sale and purchase agreement. Most sellers agree to give warranties, indemnities or undertakings in a sale and purchase agreement relating to the historical activities and liabilities of the target company.

With this type of sale, only the shares in the company are transferred to another party and all assets and liabilities remain with the target company (as with public share deals). Customers and suppliers are usually happy to continue dealing with the company as before. With a share sale, there is no change of employer and the employees simply remain employed by the target company.

When a change in the ownership of a company is planned, certain contracts and some insurance policies may specifically require various third party consents to enable these contracts to continue.

We outline in later sections how insurance solutions can assist in private share sales.

2.3 Acquisitions via the purchase of assets

With an asset sale (by a private or public company), the buyer only acquires the actual assets detailed in the sale agreement.

With these transactions the seller may agree to give some limited warranties in the sale agreement relating to the assets being sold.

For the most part, the past liabilities and obligations remain with the selling company. However, even in an asset sale, a buyer will generally be unable to avoid accrued employee liabilities and maintaining the terms of current employment contracts, as the transaction will usually fall within the Transfer of Undertakings (Protection of Employment) Regulations 2006, known as TUPE. It is important to obtain legal advice on whether or not the transaction falls within TUPE.

Due diligence therefore needs to include information on the employees the buyer might inherit. Buyers should ensure that they are aware of any employment liabilities (and their potential costs) that arose before they become the employer. It may be possible to seek indemnities for such costs or for the purchase price to be reduced to compensate the buyer.

Buyers and sellers should be aware, for such asset sales, that they will have specific obligations to inform employees about their plans and may need to consult with employees prior to completion of the sale. Certain pension rights may also transfer to the buyer by virtue of the TUPE regulations.

Other liabilities, for example in relation to environmental issues, may, also, be assumed by the buyer and should be clarified.

As with private share deals, we outline later how insurance solutions can assist with these types of deals.

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2.3.1 Acquisitions of distressed businesses

A distressed business is either a company that cannot service its current debt or a company that has entered into administration/insolvency. Most sales of distressed businesses are of the business and assets rather than of shares in the company.

The acquisition of the business and assets of distressed companies from an administrator (or liquidator) allows buyers to avoid acquiring many of the usual historical liabilities attaching to such companies.

For example, the insolvency provisions of TUPE may allow buyers to avoid acquiring TUPE liabilities. However, this may not be the case for ‘pre-pack administration’ (i.e. a sale of the business and assets arranged before the company enters administration). Specific legal advice should be sought.

Most sales of distressed companies need to be completed quickly, which means that all due diligence has to be done very quickly and so is often limited. Issues include:

• lack of information

• deliberate underinsurance/reduced limits/covers not bought

• risk management action points required by insurers not completed.

Whilst a sale and purchase agreement will generally be used, an administrator will not provide any warranties or indemnities about the business. In addition, if a company is in administration, existing insurance policies may not survive the sale.

As detailed above, due diligence is very restricted and there is a limited opportunity to utilise insurance-backed deal solutions.

2.4 Initial public offering of securities (IPOs)

A company may look to raise funds or shareholders may wish to exit through the offering of securities to a public exchange, or they may seek admission to trade on a public exchange.

For this type of transaction, the company will need to issue a prospectus document or listing particulars. Prospective shareholders will rely on this information and the document will include detailed financial information on the company, projections of future income and details of proposed strategies.

The signatories of a prospectus or listing particulars have personal responsibility for its contents; this risk in particular falls on the shoulders of the company’s directors and officers. There are insurance solutions that can assist with these additional liabilities.

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The most common type of transaction is the sale and purchase of shares in a private company. The following section sets out the usual steps that are undertaken in this type of deal.

The transaction process will differ slightly depending on whether the seller has been ‘approached’ by one interested buyer or if it has chosen to sell and is running a sale process for a number of buyers (an auction).

3.1 Preliminary bid stage

Ideally, sellers will prepare for a sale to maximise the price achieved and ensure that the deal does not hit any unexpected problems. Sellers will want to identify any issues that will cause concern to the buyer, or perhaps reduce the price or leave them with retained liabilities (for example, environmental issues) post close.

If the sale involves a competitive auction, the seller will typically provide a predetermined set of information to all parties that allows the bidder due diligence process to move forward (usually via a virtual data room (VDR)). Some sellers will provide vendor due diligence (VDD) reports on a variety of key areas, including insurance.

The sellers will negotiate and sign up to heads of terms, confidentiality and exclusivity agreements with bidders where applicable.

3 Transaction process for private share deals

Diagram 1: M&A process for private share deals

M&A process for private share deals

Preliminarybid stage

Due diligenceCompletion

Exchange

Postcompletion

Documentsdrafted

Disclosure

Data room

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3.2 Data room

Most deals involve the establishment of a data room. A data room is a physical or virtual space where the seller can disclose confidential information in a controlled manner to a number of other interested parties. Information will typically include documents relating to corporate, legal, contractual, financial, property, insurance, and environmental matters.

3.3 Due diligence

A buyer will want to gather as much information about the company or business as possible to understand what it is taking on – as a process, this is known as ‘due diligence’.

Due diligence is typically a thorough appraisal of the condition of the company or business being acquired. This gathering and evaluation of information is carried out by the buyer’s advisers and relevant people from within its own organisation.

Information obtained during due diligence feeds into the drafting of the deal documents and negotiations generally. The information obtained will help the buyer:

• evaluate what it is buying and identify any potential weaknesses

• understand the strength of its bargaining position – for example, is there a reduction in sales?

• identify any liabilities or risks that may affect how the deal is structured

• identify areas where warranties and indemnities need to be added into the sale/purchase agreement

• identify any third-party consents that may be required, for example, from landlords or lenders

• identify areas that may need action following the acquisition, for example, the relocation/consolidation of manufacturing overseas to maximise cost efficiencies

• decide whether to go ahead with the purchase

• establish the right price.

The following types of due diligence reports may be commissioned:

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Types of due diligence reports

Legal due diligence

Legal due diligence will focus on assessing the possible legal risks related to the transaction including in respect of the corporate status, assets, contracts, securities, intellectual property, litigation, and personnel attaching to the target company.

Traditionally, the buyer’s lawyers send a detailed information request to the seller or its lawyers. The extent of enquiries in any particular area will depend on the nature of the target business or company, the nature of the transaction, the reasons for the sale and what the buyer perceives as the risks.

Some sellers, at the outset of the transaction, provide a vendor due diligence (VDD) report which includes the main issues that may be relevant to the buyer.

The buyer’s lawyers will evaluate the information provided and provide a report for the buyer which will highlight issues of concern and suggest protective measures where appropriate.

Financial due diligence

Financial due diligence will focus on assessing the historic trading performance of the company or business to check that the assumptions the buyer is making about its future are supported. The buyer’s tax accountants will review the tax history of the target and focus on identifying any issues that could be disputed by HMRC.

Commercial due diligence

Commercial due diligence informs a buyer about the commercial and operational status of the target’s business, products and/or services, typically looking at its market, competitors, customers, proposition and future strategy.

Risk and insurance due diligence

Risk and insurance due diligence will identify the key risks faced by the target company or business and will assess how well insurance responds to these risks and how much self-insurance is carried by the target company. (See Sections 4 and 5 for more information on what should be included in risk and insurance due diligence).

Additionally, sellers’ insurance VDD reports should include information on the risk exposures (such as a risk register); current risk and insurance programme; costs of self-insurance; any collateral issues (e.g. letters of credit); and claims experience, including estimates for incurred but not reported losses. Some insurance VDD reports will also include an estimate of the cost of any future insurance programmes, especially where the transaction involves the sale of a subsidiary (spin-out).

Other due diligence

Other specialist reports may also be required as part of the wider due diligence process, for example, property surveys, pension reviews, environmental audits, health and safety investigations or actuarial valuations.

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3.4 Documents draft

Buyer and sellers negotiate the sale and purchase agreement (SPA) and other ancillary documents.

The information gathered during due diligence feeds into the terms of these documents. The drafting of the SPA is often a lengthy process and input from all parties and their advisors is required.

3.5 Disclosure

In addition to data room information provided, sellers prepare and deliver a disclosure letter and bundle.

Information may be received through disclosure which was not previously identified during due diligence and may extend or reopen negotiations. If the buyer needs additional protection (e.g. additional warranties, specific indemnities) as a result of any updated disclosures, the sale and purchase agreement may be renegotiated.

3.6 Exchange

The sale and purchase agreement and disclosure letter are finalised and signed – known as the exchange of contracts. The parties are now committed to completing the sale and purchase in accordance with its terms.

3.7 Completion

At completion, ownership of the company or business being acquired is transferred to the buyer. Completion may occur simultaneously with the exchange of contracts, but this is not always possible.

Certain conditions may need to be fulfilled or third-party consents obtained before completion can take place (consents may not be obtained before exchange or some deals may be referred to the competition authorities).

Where there is a delay between exchange and completion, the sellers will give the warranties and make their disclosures at exchange. They may be required to repeat the warranties at the completion date and, if so, may be permitted to make additional disclosures in respect of the period between exchange and completion. There may be a clause that details which significant changes in the business or issues that occur between exchange and completion need to be advised (material adverse circumstances clause), such as a significant insurance claim.

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3.8 Post completion

There will be a certain number of practicalities to deal with following completion, including:

announcements and notifications (for example, on a share sale, Companies House forms and filings)

payment of stamp duty/taxes

preparation of completion accounts where relevant

assignments/novations of supplier and customer contracts

other administrative or practical matters to help integrate the target into the buyer’s group or organisation, such as amalgamation of insurance programmes.

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A comprehensive due diligence exercise is a detailed review of the target’s business activities and its insurance programme. From an insurance standpoint, there are several key areas of concern that need to be covered in the due diligence:

• identifying and addressing the target company’s pre-closing liabilities that may be acquired

• managing future risks by determining the optimum structure and cost of the risk and insurance programme post-completion

• highlighting any changes in the risk and insurance budget – the cost of insuring or funding risks can be significant and large changes need to be considered within the financial due diligence

• identifying areas where insurance can provide transaction solutions

• minimising integration costs of the post-completion programmes.

It is relatively rare for the insurance due diligence to identify anything that will derail the deal, but it may, for example, uncover issues that will affect the purchase price of the target company, and this is especially relevant in highly leveraged deals.

Lenders often insist on sight of the insurance due diligence as a loan condition and may even insist on the purchase of additional insurance limits or policies.

Additionally, the information provided may affect the drafting of the SPA and how liabilities are transferred or retained. In fact, a review of the SPA from a risk and insurance viewpoint can help prevent future serious issues. For example, the SPA may include the buyer accepting liability for products already in circulation without consideration of whose product liability insurance will provide cover for any claims arising. The cost of buying retrospective product liability cover can be significant for a buyer and so could impact the value obtained from the acquisition.

The key areas of enquiry are detailed in Section 4.2, and the Appendix provides a generic checklist of insurance-related documentation that should be requested in the first instance. However, the due diligence providers do need to check the level of review the buyer wants. Some buyers only want to review key issues whilst others may request a full review, and the information requests need to be drafted accordingly.

4 Insurance due diligence

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4.1 Risk profile

Information obtained during the financial and operational due diligence should be communicated to the insurance review team, specifically, details of:

• premises and production facilities, including construction and protection

• markets, products and services, both current and discontinued

• patents, intellectual property rights and licences

• research and development programmes

• key personnel on whom the business is dependent

• key dependencies, e.g. on suppliers, customers or inter-company

• statutory compliance (insurance/health and safety)

• outstanding risk improvements (and cost implications).

• A number of other keys issues which can impact the target’s insurance requirements should also be investigated, such as:

• What is the geographical spread of the target company? Is there a need for a separate investigation in each major territory?

• Is there any outstanding litigation that may create uninsured exposures?

• Have recent environmental audits been carried out in respect of owned and occupied locations?

• Have there been any previous incidents involving actual or alleged pollution? (Pollution should be considered in its widest sense, including electromagnetic fields, asbestos and PCBs).

• Are there any sector specific or emerging risks which need to be considered; e.g. should specific attention be given to the cyber risks of the target company.

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4.2 Insurance profile

When reviewing the insurance profile of the target company, a number of key areas should be addressed:

• Identify breadth of current insurance cover

• Determine current insurance premium spend

• Are policies in the name of the target company or is the target part of a group programme?

• Can the existing policies continue post acquisition or will the buyer need to arrange a new programme?

• If the buyer already has an insurance programme, can the target company be included, and what are the renewal dates or cancellation provisions?

• If the existing policies are cancelled, who will receive the return premiums?

• Do the existing policies adequately cover and limit all the risks of the target?

• Are there additional policies that need to be bought, and what is the cost impact of any gaps in cover?

• Will there be access to any of the seller’s pre-acquisition insurance policies?

• For group programmes, have any aggregate limits of indemnity been eroded by past claims from other members of the same group?

• The security rating of each of the seller’s past and current insurers should be established

• If any of the insurers have gone into liquidation, it may not be possible to obtain a full claim recovery and the operation of any scheme of arrangement should be reviewed. The cash flow impact of recovery through government-backed recovery arrangements should be reviewed, together with the buyer’s entitlement to such proceeds.

• Is there a significant level of self-insurance under the seller’s programme (i.e. captive or retained by the operating company)? If so, how is this funded? Will the buyer have access to that fund for pre-completion incidents notified after completion?

• If a captive has ever provided direct coverage, the security of the captive should be reviewed, whether it is transferring as a subsidiary of the target or remains as a vendor subsidiary. Was the captive programme fronted? Long-tail risks in captives are usually fronted, in which case, it is the fronting

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insurer’s security that is relevant. For any risks that are not fronted, the captive’s financial accounts and insurance programme will need to be reviewed. What is the financial position of the captive now? What were/are the reinsurance arrangements and is there potential access to reinsurers through ‘cut through’ clauses in the reinsurance contracts?

• Has a ‘mutual’ been involved in the insurance programme? Are there any outstanding or potential cash calls from the mutual? How long is the liability for cash calls from the mutual?

• Where there is a pronounced frequency or severity of claims, it may be advisable to obtain an actuarial valuation of open claims. If outstanding claims are understated or inadequately reflected, this will have a distortive effect on the company’s operating costs and trading performance. The accrual practice and process for open and notified claims should be reviewed and understood. Have insurers accepted liability for any significant outstanding claims?

• What is the position in respect of the directors’ and officers’ liability policy? (See Section 4.4 – Directors’ and officers’ liability (D&O))

Please note that this is not an exhaustive list but is provided for guidance only. A review should also identify additional cost issues that could lead to one-off additional risk and insurance-related costs, which could be taken off the purchase price.

4.3 Future insurance programme

The insurance due diligence report should include some commentary on the recommended future insurance programme structure and cost. Any significant increases in the cost of the insurance will need to be included in the financial projections and may affect the purchase price.

Areas that will be covered include:

• additional policies that need to be bought (including any run-off policies)

• increases in limits required

• coverage gaps

• new/additional collateral required

• insurance-related capital expenditure required

• minimum solvency requirements of insurers (often a requirement of lenders).

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The Insurance Act 2015 will come into effect on 12th August 2016. In line with the current insurance law for England and Wales, all material information which is not confidential in nature should be disclosed to the insurers. This obligation applies at inception and at the point at which there is a material change to the risk (e.g. signing).

For some policies, the size of the transaction will be a relevant factor with the revised disclosure obligations and should be considered in the context of their duty to make a reasonable search. Please discuss this with your insurance advisor.

4.4 Directors’ and officers’ liability (D&O)

The purpose of D&O insurance is to indemnify the directors and officers of an organisation for claims brought against them personally. M&A activity represents an increase in the D&O’s exposure in view of the representations made during the due diligence process.

We would highlight that this policy would not provide cover for the D&Os for any contractual liabilities incurred under the sale and purchase agreement, unless such liabilities are a direct result of their role as director or an officer of the company. Please consider Section 7 for insurance solutions available for contractual liabilities incurred under warranties in the sale and purchase agreement.

The majority of D&O policies contain a ‘change in control’ clause that automatically puts this policy into ‘run-off’ following a change in the control of the company. This means the policy will only cover any claims made after the change in control date relating to allegations of wrongful acts occurring prior to that date.

It is common for the current policy to be put into ‘run off’ for a period of up to 6 years. This will ring-fence historical liabilities of the past and current directors. A new policy can then be incepted at transaction completion for post close wrongful acts or the buyer can incorporate the target business into its own group arrangements. This means that the go forward programme is not eroded by historical claims over which the new owners had no control.

D&O cover issues should be included in the SPA – for example where the target business is the subsidiary of another company, provisions/cover issues relating to historical indemnification and access to the parent company policy should be addressed.

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4.4.1 D&O for IPOs

Where a company raises funds through a public exchange, certain liabilities are incurred above those undertaken in the usual course of business. Such liabilities incurred in the issuance of a prospectus or listing particulars include a duty of care towards the proposed shareholders and additional regulatory obligations.

Whilst many of these obligations fall under the directors’ and officers’ usual remit, we would highlight that most D&O policies will not cover these additional liabilities as standard. If it is included, the limits and cover provisions under this policy may be insufficient to cater for the specific exposures incurred when issuing a prospectus or listing particulars.

Depending on the amount of capital raised or the listing exchange, there are a number of insurance routes to consider. Firstly, the existing D&O policy of the company could be extended; this is often the best route for small capital raisings on AIM (Alternative Investment Market) for example. Secondly, for larger listings, the company will usually consider whether a separate policy is required for this exposure. A public offering of securities/prospectus liability insurance can ring-fence these liabilities and ensure that there is adequate cover in place for both ongoing and retiring directors.

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4.5 Insurance-related review of sale and purchase agreement

Although the transaction may take the form of the purchase of shares, which usually involves the acceptance of past liabilities or an ‘assets only’ purchase where most past liability is left with the seller, in practice, the allocation may not be so absolute and the sale and purchase agreement (SPA) needs to be closely reviewed.

From a risk and insurance point of view, the SPA should allocate responsibility for liabilities that arise from:

• incidents occurring and notified prior to completion (these will be detailed in the claims experience)

• incidents incurred before completion but not yet notified

• incidents arising after the completion date but caused by an error, an omission or a defective product manufactured and/or supplied prior to the completion date

• pre-completion acts of directors or officers of the target company

• occupational disease or other injury claims where harm may be caused both before and after completion. Please note that if the deal falls within the EU Transfer of Undertakings (Protection of Employees) Directive, it may not be possible to allocate such liabilities within a sale and purchase contract – advice from legal advisers must be obtained

• movement in reserves on outstanding liability claims after completion, particularly where the risk is subject to a large deductible

• open business interruption claims where a seller’s insurer may cease settlements post disposal

• operating levels of self-insurance that may differ from insured excess level, i.e. the target company may be protected by the head office funding of losses in excess of a lower level and up to a level at which insurance is purchased.

If the SPA cannot be amended, then the cost of insuring the pre-closing liability needs to be quantified, for example, by the purchase of retrospective products liability. The buyer can then use this information in the price negotiations.

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For some pre-closing liability, it may be preferable to seek indemnities from the seller; however, this is not the preferred route if the seller has limited funds or will not provide indemnities (for example, a sale by an administrator). In such cases, there are insurance solutions available to give comfort to the buyer (see Section 7 – Transaction insurance).

Additional insurance-related issues that should be considered in the SPA include:

• Which party receives any return premiums?

• Which party is responsible for paying any premium adjustments on pre-completion policies?

• Which party has responsibility for paying deductibles or excesses on pre-completion claims made post-completion?

• The costs of providing administration support to the buyer to make post-completion claims arising from pre-completion incidents (for example, providing payroll information on employers’ liability claims)

• Which party will pay for any retrospective or run-off cover needed?

• How will future and outstanding claims be handled?

• The provision of up-dated claims experiences.

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4.6 Claims-made policies

Professional indemnity, errors and omissions, directors’ and officers’ liability, and financial loss extensions to general liability contracts are customarily written on a claims-made basis. The general issues of acquiring a company with claims-made insurance need to be considered:

• If a policy is cancelled then all cover is terminated and of no further effect (subject to the existence of an extended reporting period clause in some cases).

• If the seller deletes a subsidiary from its group policy, this may have similar results.

• A claims-made policy may not automatically cover claims made after completion for pre-acquisition events or products made pre-acquisition.

• It may be impractical to arrange cover for retrospective incidents.

‘Run-off’ cover should be maintained until such time as any claims arising from prior events have materialised.

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5 Risk due diligence

In tandem with insurance due diligence, wider risk due diligence may be undertaken which assists in identifying key risks to which the target company may be exposed. Some risks can be transferred and addressed through an insurance solution. This is not possible for all risks; where this is the case, the risks need to be managed through other means.

The three key areas that can be considered during due diligence are:

• supply chain issues

• contractual obligations

• business continuity plans

5.1 Supply chain reviews

The supply chain architecture should be thoroughly reviewed to ensure that the business is viable on a going concern basis. In addition, the following aspects have particular relevance to the insurance programme:

Supply chain characteristics of relevance for property damage / business interruption (BI) policy:

• Are property asset values known?

• Which sites have significant business interruption exposure? The supply chain may have many significant single-point exposures, e.g. reliance on a single packaging site, or raw materials from a single source, capacity restrictions, export through a single terminal, etc.

• Is there any redundancy/contingency built into the supply chain architecture; this gives an indication of how resilient the supply chain may be in the event of a large-scale incident?

• Do the new assets add to an existing exposure, e.g. are acquired assets in the same flood plain/earthquake zone as existing company assets?

• Are critical suppliers identified?

• Is key information (e.g. design data) stored in a secure manner?

• Where are inventory levels/safety stock kept along the supply chain?

• Supply chain characteristics of relevance to product liability:

• Are products and components traceable throughout the supply chain?

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• Is there a clear policy for returns/end-of-life usage?

• Is there a mechanism to spot where products may be misused or cause an adverse reaction?

• Does the supply chain hold any long-term liabilities (e.g. environmental liabilities, occupational health exposures, etc.?)

5.2 Contractual reviews

It is also useful to review the main contracts entered into by the target company. There are various issues that should be considered, including:

• Terms about insurance in standard purchase/service/sale agreements such as providing/requiring certain cover limits/conditions

• Uninsured liabilities accepted in contracts

• Waivers of subrogation given by contracts and how these could affect future policies

• The extent of cover required and any gaps between full repairing leases and landlord’s insurance.

5.3 Business continuity plans

Business continuity plans, commonly referred to as BCPs, describe the arrangements in place and the actions required to ensure that the critical business activities of the target company can be recovered and continue to operate, following a disruption, within an acceptable time frame.

If, as part of any planned M&A activity, there are plans to merge or share previously separate business activities or processes, the BCP needs to be reviewed and potentially amended to reflect the way in which these processes will be carried out post-merger.

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6 Human capital due diligence

From a human capital standpoint, there are several key areas of concern that need to be covered in the due diligence:

• identifying and addressing the target company’s employee benefits pre-closing liabilities that will be acquired

• managing future risks by determining the proposed structure of the employee benefits provision after considering the costs of the post-closing employee benefits programme

• understanding the HR infrastructure cost, such as payroll, HR information systems and shared services, especially in a spin-off where there will be separation costs and issues

• reviewing the pre- and post-organisation structure, including management team, role changes, and potential retention and compensation solutions

• highlighting changes in the HR budget – the cost of HR infrastructure, insuring or funding employee benefits provision can be significant and large changes need to be considered within the financial due diligence

• minimising any integration costs or identifying synergies of the post-closing programmes.

6.1 HR risk profile

When reviewing the HR profile of the target company a number of key considerations should be addressed:

• What is the geographical spread of the target company and is there a need for a separate investigation in each major territory? Employee benefit provisions are typically dependent on local country practices and requirements, but may be driven by global principles

• Are there collective bargaining agreements in each territory?

• Will there be loss of group HR and employee benefits-related plans and functions that need to be replaced or set up?

• Has HR-related allocated cost been appropriately accounted to the buyer?

• Will there be a change in control provision in management contracts or triggers in pension plans requiring immediate cash payments?

• How will new compensation and benefit plans impact cash flow and P&L?

• What are the consultation and communication requirements to unions, works councils and employees?

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Information obtained during the financial and operational due diligence studies should be communicated to the human capital due diligence team, specifically, details of:

• headcount by geography

• management team

• employment transfers

• accrued Rights Directive/TUPE

• collective bargaining agreements

• employee benefit provisions on the balance sheet

• employment contracts and change in control provisions

• local and global short-term and long-term incentive plans

• organisation structure, including job grading and compensation benchmarking

• employee benefits, including pension and perquisites

• pension plan documents, including actuarial valuation/reports

• insured employee benefit policy and contracts

• notice period and severance policy

• statutory HR compliance

• employee handbook

• restructuring plan

• HR policies.

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6.2 Employee-related review of sale and purchase agreement

The SPA should allocate responsibility for:

• past and future provisions related to employees, such as pension and medical liabilities

• terms and conditions and employee transfers, such as providing comparable compensation and benefits

• purchase price adjustment for employee benefit provisions

• severance in cases where employees decline transfer

• transition services that will be provided post transaction

• HR-related disclosures, warranties and indemnities.

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Transaction insurance can be used by parties to facilitate the deal. The use of transaction insurance has significantly increased over the past five years and we expect to see this trend continue.

Generally, in a private transaction, the seller wants to:

• maximise sale proceeds

• accelerate distribution of funds

• minimise contingent liabilities

• retain a minimum amount of financial recourse/no escrow (clean exit).

But the buyer wants to:

• minimise the price paid for the target company

• have an adequate set of warranties or specific indemnities

• maximise its post-closing amount of financial recourse

• provide comfort for lenders/its board/shareholders.

Where there are gaps between the deal parties, the main products that provide transaction insurance solutions which can assist, are:

• warranty and indemnity insurance (W&I)

• tax insurance

• loss mitigation insurance.

7.1 What are warranties?

The meaning of ‘warranty’ in M&A deal documents is very different to that in an insurance contract. In the context of a company share sale, warranties are statements about the company being sold that are made within a sale and purchase agreement. The main purpose of these statements is to produce information about the company for the buyer to consider and evaluate before the deal concludes. In share and asset deals, sellers are typically required to give a number of warranty statements covering all aspects of the company, against which they ‘disclose’ relevant information.

If any of these statements are untrue and, as a result, the value of the company is less than the buyer paid for it, the seller may be liable to pay damages. However, if the seller has provided information (disclosure) about the matter before the sale, the buyer has no recourse under the terms of the sale and purchase agreement.

7 Transaction insurance

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7.2 How do indemnities differ from warranties?

As well as warranties, if there are identified issues of potential losses within the target company, it is normal practice for the buyer to request indemnities from the seller. Indemnities are used to protect the buyer against particular risks or identified liabilities, for example:

• the tax deed may contain indemnities relating to specific tax issues, or

• indemnities against issues identified during due diligence, such as environmental.

Sellers are generally more reluctant to provide indemnities as an indemnity claim requires reimbursement to the buyer on a pound-for-pound basis. This applies regardless of whether it has affected the value of the company or if the seller previously provided information relating to that matter.

7.3 SPA protections

Once the seller has committed to providing warranty and indemnities and accepted the subsequent liabilities, it is standard practice to negotiate certain protections into the SPA. These limit potential liability (quantum and time) under the warranties and indemnities. The level and extent of these provisions will be negotiated between the buyer and seller.

These typically include:

• a time limit on when claims can be brought by the buyer – up to seven years for tax and two years for business warranties

• claims below an agreed sum are excluded – a small claims bar (or de minimis)

• claims must exceed a certain threshold amount before any claim can be brought (threshold)

• a warranty cap – the maximum amount the seller can be liable for under the sale agreement.

In such situations, there may be a gap between the warranty cap requested by the buyer and the one the seller is willing to give and there are insurance solutions that can assist the parties in closing this gap.

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7.4 What is warranty and indemnity (W&I) insurance?

The type of buyer or seller strongly influences its attitude to the importance of title, business or tax warranties and indemnities in an SPA. For example:

• - private equity or trustee sellers are usually unwilling to provide warranties or accept a post-completion financial cap

• - target companies’ management are usually prepared to give warranties but will cap their financial liability to their sale proceeds

• - oversea buyers (often trade) require a full set of warranties with a financially significant financial cap to ‘back them up’

• - certain sellers, i.e. offshore SPVs or individual sellers, may be willing to provide warranties and a financial cap, but there may be concerns about the buyer’s ability to recover.

When there are gaps between the buyer and the seller on the warranty cap, there are specialist insurance products that can assist. These policies cover many of the liabilities incurred in M&A transactions.

The most popular of these is the W&I policy.

This has been designed to sit behind the main deal warranties (title, business and tax) in a share or asset sale agreement and covers losses incurred by a warranty breach or claim against the tax indemnity. Cover is provided for matters unknown to the insured at inception of cover.

The product covers the business warranties for two years and title/tax warranties/indemnity for seven years. Whilst most parties tend to put the policy in place at signing, it can be done at any point, including after completion.

Diagram 2: The structure of a W&I policy

Buyer policy gives additional protection

above seller warranty cap to required level

Insurance Excess

SPA De Minimis / Threshold

Deal size - €100m

Warranty cap €1m

Buy

er’s

“r

isk”

Sel

lers

“

risk”

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7.5 Types of W&I cove

The W&I policy can be taken out by either the seller or buyer in the transaction.

Types of W&I cover

Seller W&I policies

A seller W&I policy covers damages resulting from a breach of warranty or tax claim under the sale agreement and also the insured’s defence costs.

The seller provides warranties under the sale agreement and a policy is placed to cover the liability. In the event of a claim, the buyer seeks recourse under the sale agreement and the seller makes a claim against its W&I insurance policy.

Seller W&I policies have declined in use and represent approximately 5% of all W&I policies currently being placed in EMEA.

Buyer W&I policies

Buyer W&I policies cover the insured for losses arising from a breach of warranty or tax claim (and also defence costs for third-party claims). The key difference is that, if there is a loss under the terms of the sale agreement, the buyer makes a claim directly against the insurance policy.

This policy is now used where the seller offers a financial cap that is insufficient for the buying party. It can provide buyers with the comfort that they would have otherwise gained from a higher warranty cap, or replace an escrow.

In addition, in some deals, it may be that the warranty survival period offered by the seller is insufficient. The buyer could take out a W&I policy that covers it beyond the sale agreement limitations (up to seven years).

Buyer insurance has also been used to provide additional financial security to that offered by sellers. This has been of most help where there are concerns about the collectability of claims under the sale agreement.

Seller to Buyer proposals

Increasingly, sellers are being proactive in their use of W&I insurance, suggesting the ‘Seller to Buyer’ proposal at the bidding stage.

Sellers are including initial W&I insurance terms (similar to heads of terms) in the data room. The seller’s broker will then discuss with the potential bidders the terms of the proposed policy and the placement process. If the policy is bought, it will be a buyer’s policy.

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7.6 How and why is W&I insurance used?

W&I insurance can be used to secure ‘A’ rated financial security for warranty and tax indemnity claims for up to seven years.

W&I insurance is used for a variety of reasons in M&A deals, including:

• selling shareholders’ concerns that they cannot fully utilise their consideration due to the long-term nature of the financial cap

• selling company’s concerns that the company balance sheet may be insufficient to cover claims

• private equity seller’s or trustees’ refusal to give business or tax warranties

• buyer’s worries about collectability if the seller is based outside the UK, is a group of individuals or has a solvency issue

• alleviation of buyer concerns about having to sue the other party and damage a potential future business relationship

• allowing close end funds to avoid residual liabilities when winding up by using W&I to achieve clean exits.

W&I insurers always try to offer cover that mirrors the warranties in the SPA as closely as possible, but there are some areas for which full cover is not available or difficult to obtain. These areas include:

• fraud of the insured or known matters

• forward-looking statements

• completion price adjustments

• pension underfunding

• bribery, corruption and sanctions

• fines and penalties

• tax risks such as transfer pricing, availability of tax losses or secondary tax liabilities

• pollution.

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7.7 The process for obtaining W&I terms

Placing a W&I policy usually takes approximately two to three weeks, in parallel to the deal timetable. There are two stages in the process:

• Stage 1: non-binding indication – insurers will provide feedback based on an initial review of limited deal documents. They will give estimated pricing and policy excess, and highlight any potential problem areas. These are similar in nature to heads of terms provided in deals.

• Stage 2: binding quotation – if the initial offer is of interest, a binding quotation will be obtained from one selected insurer. The insurer will conduct a detailed review of the deal information, which includes a call with the deal team, before offering binding terms.

7.8 The cost of W&I insurance

Premiums for W&I insurance normally range between 1% and 2% of the insured limit. There are of course exceptions to this rule. Pricing factors include:

• the size of the deal – smaller and larger deals tend to incur higher premium ‘rates’

• the amount of insurance bought in relation to deal size

• the level of policy excess or policy attachment point

• the breadth of warranty statements, quality of disclosure and due diligence

• the geography of the target business.

In addition, at the second stage, W&I insurers use external lawyers to assist in their underwriting review. Whilst insurers require the insured to agree to pay these fees, most will also waive them if the insurance is bought.

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7.9 Tax or contingent insurance

Sometimes known issues can become an obstacle to the successful completion of a transaction. Whilst the parties may have obtained the necessary expert and legal opinions, sometimes these still do not provide the necessary comfort to enable the buyer to accept the risk on their balance sheet. The most common area where this occurs is in relation to tax.

A contingent policy is designed to ring-fence known liabilities that may arise despite an expert’s favourable review. This type of insurance covers the risk of an adverse outcome and the policy will cover both the quantified risk and, if required, legal costs.

These policies tend to be most useful in situations where there is a disagreement on the interpretation of the risk and can provide certainty for all parties. Other areas where this may arise is ongoing or pending litigation.

7.10 Loss mitigation programmes (LMPs)

Deal negotiations can also run into difficulties where problems have been identified, a quantum has been established but there is uncertainty surrounding the final loss amount.

It is possible to use insurance to cap known losses and transfer this type of contingent liability to an insurer’s balance sheet. This type of insurance differs to Contingent Insurance, in that cover is only offered above the identified specified quantum with insurers taking the risk that the final amount is greater.

The use of a loss portfolio transfer policy avoids reliance on a captive insurer for long-tail liabilities. This may be of particular relevance to an acquisition where there is a history of industrial disease amongst the workforce or where no fronting insurer exists.

7.11 Environmental liabilities

Pollution insurance is available from specialist markets; different types of policies are offered for both identified and unidentified environmental issues on properties.

This is subject to an environmental audit by an approved consultant for each location. Where there are concerns, environmental surveys are usually commissioned as part of the mergers and acquisitions process and form the basis of the underwriting data requirements.

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7.12 Other types of insurance used in transactions

Other types of insurance that can be used in a transaction to remove deal impediments or unlock additional value include the following:

Other types of insurance used in transactions

Classes of Insurance

Description of Cover

Key person Insurance can be taken out if it is perceived that the death or disablement of a key person employed by the target company would have a material effect on business performance and cause an unexpected loss which would be difficult for the target company to recover from.

Credit Newly reorganised companies need secure and low-cost finance and this can be a challenge when there is no financial track record. There are insurance solutions available to help enhance a company’s receivables asset and to assist in growing the business and protecting shareholders’ investment.

Defective title indemnity

For many reasons, title to land may not be good, e.g. there may be an absence of rights of way, title deeds missing, etc. A defective title policy covers capital, damages, loss and legal expenses should another party be able to show better title to the land or prevent the use of rights of way or services.

Title insurance may also be used to avoid the need for extensive legal reviews of all leases and speed up the purchase process.

Restrictive covenant insurance is also available if it is thought that a property may have been used in breach of a restrictive covenant or the buyer intends changing the use of a property that may breach such a covenant.

Rights of light issue

In today’s environment with the ever increasing presence of skyscrapers, many clients are facing issues with regard to their neighbours ‘rights to light’ for new developments. There are now insurance policies that can protect clients from unexpected outcomes in relation to these issues.

Transaction at under value policy

When buyers purchase a distressed business, or part of one, there is the risk that the transaction is set aside by the courts for being deemed to be at ‘undervalue’.

A specific insurance policy may be obtained, depending on the details of the transaction. Cover will include cost of entire transaction being set aside, additional amounts needing to be paid, interest and defence costs. Policies are for six years or the period that a transaction can be challenged.

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Appendix

Recommended information to be obtained from prospectivesellers for insurance due diligence

General a) Full schedule of subsidiary and associated companies, with structure chart, in all territories

b) The business description as declared to insurers

c) Product brochures

d) A list of key customers and suppliers

e) Details of any discontinued products and/or services

f) A record of past acquisitions and divestments by the target company itself (further enquiries may be required)

g) Any high-risk exposures, e.g. nuclear or other energy or products supplied to the aviation or automotive industries

h) Draft SPA.

Policy records a) Copies of current policy documents for all major classes of insurance, including excess layers. For the purposes of this document, ‘major classes’ means:

• property and business interruption

• general liability, including products and

professional indemnity risks

• management liabilities, including directors’ and

officers’ liability, pension trustee liability, fiduciary,

employment practices liability and crime

• cyber/breach of privacy

• workers’ compensation/employers’ liability

• auto/motor

b) Schedule of current premiums, including details of adjustment conditions

c) Details of any significant changes in the past five to ten years, e.g. in self-insured retentions or indemnity limits

d) Names, titles and contact numbers of insurance brokers

e) Details of any self-insurance arrangements, including captives, alternative risk-financing programmes, parental guarantees, or co-insurance or co-participation clauses

f) Details of significant policy exclusions, e.g. terrorism, asbestos and mould

g) Details of any batch provisions on product liability policies

h) Details of any long-term agreements in force

i) Details of any loss-handling or broker agreements and cancellation conditions.

Insurance history a) A schedule of all past insurance companies, branch addresses, policy numbers and effective periods for:

• liability insurances – dating back to the original incorporation of the company. Where possible, also obtain copies of the policy wordings

• other classes – dating back five years

b) Details of any retrospective rating programmes that remain open.

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Insurance underwriting information

Property

• Schedule of premises, including postcodes

• Reinstatement value of buildings and

contents (per premises)

• Maximum and average stock holding

• Sums insured for rent and miscellaneous items

Business interruption

• Basis of cover, e.g. gross profit or

additional cost of working

• Sum insured

• Indemnity period

• Customer, supplier and inter-company dependencies

Liability

• Payroll, allocated between clerical and manual workers

• Number of employees

• Turnover, including a geographical split

Motor Vehicle numbers – commercials and private cars.

Other As appropriate

Claims a) Claims listings/loss runs, including numerical summaries of paid and outstanding claims for each of the major classes over the last five years. For liability classes with a high frequency of claims, a ‘triangulation’ should be available

b) Specific description of all major losses

c) Record of claims that are not otherwise recorded because of deductibles

d) Declaration of any known circumstances that may give rise to a claim in the future

e) Details of any major uninsured losses such as environmental impairment, cyber, product recall or employment practices liability.

Loss control a) Insurance survey reports, including details of any outstanding risk improvement recommendations and site responses to these recommendations

b) Details of all loss control/prevention programmes and records relating to the success of those programmes, including:

• property loss control work and professional valuations

• health and safety

• product quality control and recall procedures

• disaster/contingency plans

c) Copies of all health and safety manuals and logs, fines and citations.

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Notes

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Notes

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