Warranty and indemnity insurance explained: Insurance, claims and tax liabilities

Briefcase

One of the key aspects of any business transaction is the negotiation and agreement of appropriate warranty and indemnity protection for a buyer. Following this, vendors must go through a lengthy disclosure process to highlight to the buyer any items or issues which the vendor is not able to warrant or indemnify.

Although warranty and indemnity claims are rare (due to the length and depth of the warranty negotiation and disclosure processes) many vendors can be left feeling exposed to possible future warranty or indemnity claims, which could lead to them being sued for some or all of their sale proceeds.

What is a warranty and indemnity claim?

Warranties and Indemnities are used when a business is sold primarily to provide the buyer with protection and to ensure that there is full transparency in what they are buying. Although the two are closely related, they have differences. A warranty is a factual statement made by the seller at the time of sale. An indemnity, however is a promise made by the seller to the buyer to make right any losses upon occurrence of a particular future event.

The warranties and indemnities a seller will provide will largely be shaped by the findings of any due diligence exercise, as well as certain ‘boiler plate’ warranties any buyer typically asks for. Indemnities tend to be given when a specific historic event has occurred which may lead to a future liability in the hands of the new owner such as, an ongoing legal claim, the outcome of which is unknown at the point of completion.

Warranties are given, essentially as confirmation that information provided during due diligence is factually correct. An example of which might be ‘no debtors have been outstanding for longer than 90 days’. If this statement was not factually correct, the seller would need to disclose against this statement, providing additional details to the buyer. Alternatively, the seller risks having a possible warranty claim bought against them, provided the buyer can prove they have incurred a loss as a result of the non-disclosure.

The process of agreeing the wording of warranties and indemnities and the seller then disclosing against them can become very complex and with most deals there will a number of issues which may be unresolved shortly before completion. In particular cases where specific warranties or indemnities are required by the buyer in order to complete the transaction, it is certainly worth the seller considering warranty and indemnity protection to limit the risk of a claim being made against them.

Warranty and indemnity protection insurance

One solution which we have noticed being used more frequently is warranty and indemnity protection insurance. This method of risk mitigation is particularly useful in a transaction where some or all of the vendors are not involved in the day to day running of the business and are therefore relying on key management to adequately disclose against warranties.

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Alternatively, such protection may be used where the buyer requires a significant amount of retention or deferral of consideration until it has satisfied itself that the risk level is acceptable once they have stepped into the business (a retention period typically lasts for 12-24 months).

There have been some significant changes in the last 12 months which have made this type of protection a much more attractive option for vendors;

  • Reduced premiums across UK based transactions, which are now typically 1% of the policy limit, compared with around 1.5% of the policy limit across Europe.
  • Lower attachment points (the excess payable under the policy) are typically between 0.5% and 1% across Europe however in some cases this can be as low as zero compared to a non-negotiable excess of 1% 12 months ago.
  • There has also been a rise in nil vendor recourse meaning that vendors can now typically walk away from a transaction with a maximum potential warranty and indemnity liability of £1 (excluding claims in relation to fraud). Previously, it was expected the vendors would retain some ‘skin in the game’ and potentially be liable for significantly more of their sale proceeds. Insurers need to be satisfied that the transaction has been carried out on an arm’s length basis and that a comprehensive disclosure process and due diligence exercise has been followed.
  • Real estate transactions are viewed as much lower risk than operational businesses, with premiums as low as 0.5%-0.6% of the policy limit and nil excess as standard.
  • This vendor risk mitigation option is now available over a much broader range of jurisdictions with increased uptake in the UK, Central and Eastern Europe, the Middle East and South Africa.

Tax liability insurance

A further transaction insurance product we have seen used effectively recently is to protect against a possible tax liability as a consequence of a transaction. Occasionally, due to specific circumstances around the transaction, advance assurance from HMRC for capital treatment of proceeds can be inconclusive. This means that proceeds may not be eligible to be taxed at the 10% Entrepreneurs rate, therefore giving the vendor a dilemma as to whether to proceed with the transaction (and potentially suffer significantly higher income tax rates on the proceeds) or to postpone the deal for all parties.

A solution to this is offered by way of tax liability insurance. The insurer will wish to have sight of all of the transaction documentation as well as the advance assurance application and copies of all correspondence with HMRC in order to assess the risk exposure and quantify the premium. This can be an expensive option compared to the much more preferable Entrepreneurs relief rate of tax but significantly cheaper than risking being taxed at higher level income tax rates.

This article was written by Stephen Reed Partner and Sebastian Humberston from our Strategic Corporate Finance team. For more information or to ask Sebastian a question fill in the form below.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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