Warranty insurance in a pandemic: Where is the market heading?
COVID-19 has already had an immediate and profound impact on M&A activity, both in New Zealand and globally. However, its impact on the warranty insurance market is yet to be fully determined. Below, we have summarised some of the issues relating to warranty insurance that we expect to see emerge over the coming months.
Warranty insurance policies will remain valuable and will continue to be used
Warranty insurance is firmly entrenched in the New Zealand (and global) M&A markets. We don’t expect that to change as a result of COVID-19. The benefits associated with warranty insurance, and the reasons for its popularity (including cleaner seller exits, enhanced buyer protections over what a seller may offer, quicker negotiation of transaction terms, and the recourse for a buyer to a dependable insurer in the event of a warranty breach), are unlikely to be significantly impacted by COVID-19.
There is, however, likely to be a decrease in the use of the product in the short term, simply due to a dip in the number of deals occurring while New Zealand and the world navigates the unfolding health and economic crisis.
Many insurers have signalled that they will be including specific COVID-19 exclusions in new policies for the foreseeable future. While this is a predictable reaction from the insurers, it has caused some market participants (and some advisors) to rush to question the value of warranty insurance at the present time. This is particularly the case when it can be expected that many warranty breaches will have at least an indirect connection to COVID-19.
Our view is that a properly negotiated warranty insurance policy will continue to have value, even where loss related to COVID-19 is excluded. This is because:
- The warranty schedules in most sale agreements are broad and there could potentially be a variety of circumstances where there are future warranty breaches that have no link to COVID-19.
- Most warranty insurance policies are drafted to exclude loss “to the extent that” it arises due to a particular circumstance or situation. Therefore, even if COVID-19 is a factor that leads to a particular warranty being breached, it may not be the only factor and a partial claim may still be possible.
- The insurer would still need to be able to prove that a warranty breach is related to COVID-19 before the COVID-19 exclusion could be relied upon. Given the newness of the issue, this is yet to be tested.
- Insurers remain keen to write warranty insurance policies and realise that adopting an approach that is too heavy-handed could be bad for future business.
- In some situations, for example, where the assets of a distressed business are being bought, a warranty insurance policy may be the only protection a buyer can obtain for warranty breaches.
It also needs to be remembered that warranty insurance was only ever intended to cover loss related to unknown issues associated with a target business. As a known issue, it is reasonable to expect transaction parties to adopt other approaches to dealing with the risks associated with COVID-19, including purchase price adjustments, retention/escrow arrangements, earn-outs and specific indemnities. We expect to see transaction parties using these types of approaches more frequently in the months ahead.
Buyers may have an opportunity to use warranty insurance where they buy some distressed business assets but insurers will be selective about what they underwrite
The current market conditions will inevitably see an increase in formal insolvency processes (such as receiverships and liquidations), and lenders working closely with the owners of distressed businesses to sell business assets to pay down debt. On the flip side, we are already seeing some businesses with significant capital reserves expressing interest in acquiring good quality assets from distressed sellers, should suitable opportunities present themselves.
Buyers of distressed assets often struggle to obtain effective warranty protection. If a formal insolvency process has commenced, the party managing that process will generally refuse to provide warranties. Even where there is no formal insolvency process, warranties offered by a distressed seller, with an already compromised credit position, are likely to be of little practical benefit.
Warranty insurance may provide an opportunity for buyers to get better warranty protection and we anticipate that some insurers may potentially consider offering ‘synthetic’ warranty protection for some transactions.
However, it can be expected that insurers will be selective regarding the transactions they agree to underwrite, with that decision being driven by the specific circumstances surrounding the distress, the quality of information available about the target and the robustness of the buyer’s due diligence exercise. Both of these exercises may be more challenging where a formal insolvency process has commenced and the shareholders of the target business are no longer in control. Our view is that deals involving businesses and assets that are in distress because of the COVID-19 crisis but which are otherwise sound businesses are likely to be considered as insurable by most insurers.
Robust due diligence will remain the key to obtaining good coverage under a warranty insurance policy
A comprehensive due diligence exercise has always been essential for obtaining good coverage under a warranty insurance policy. This will not change, but insurers may demand more in-depth due diligence in the months ahead.
In recent years there has been a move toward more targeted legal due diligence exercises and ‘red flag’ reporting which focusses on material identified issues only. Often the red flags style reports have been prepared with the knowledge that warranty insurance is being sought for warranty breaches.
We consider that red flags due diligence reports will continue to make sense in the post COVID-19 landscape and expect that insurers will continue to accept this type of reporting if it is scoped appropriately. However, for issues that could potentially be impacted by COVID-19 (for example, key customer and supply contracts, employment, insurance, financial accounts, and transaction pricing), insurers may require that those reports include more in-depth analysis than they have in the past.
It will remain important for the scope of any due diligence exercise to broadly align with the warranty coverage under the sale agreement. Even before COVID-19, it was becoming increasingly common to see insurers refusing to cover warranties that were excluded from the scope of the insured’s due diligence exercise. We expect that trend to continue, with insurers either excluding or partially excluding warranties dealing with matters that have not been sufficiently diligenced.
The materiality thresholds the due diligence reports use to identify material issues may also become subject to more scrutiny than they have been in the past. If a due diligence report uses a quantitative materiality threshold that is significantly higher than the requested policy de minimis or only applies a qualitative materiality threshold, the insurer will want comfort that there are no coverage gaps (i.e. issues that the policy would respond to that were not considered as part of the due diligence process due to the higher materiality thresholds applied). If comfort cannot be provided, this may impact on the de minimis the insurer is prepared to offer.
The process for selecting a warranty insurer may change
In the past, the process for selecting a warranty insurer has generally revolved around two key metrics: pricing, and the extent of coverage a particular insurer is willing to offer. While these two factors will remain important, we expect that other metrics will also become increasingly important in the current environment, including the insurer’s credit rating, and the insurer’s history with respect to the settlement of claims.
This could see a move away from some of the newer entrants into the warranty insurance market and back to the larger insurers with established track records of settling claims.
More claims under warranty insurance policies can be expected, and this could lead to increases in premiums
The past few years have seen strong competition for desirable business assets, which has led to high purchase prices and vendor friendly sale agreements. However, even before COVID-19, it was becoming apparent that some buyers felt they had overpaid for the business assets they had obtained. As a result, we had already seen an increase in the number of warranty claims brought under sale agreements, with buyers looking to recoup value. COVID-19 will make some good purchases look like bad purchases (and some bad purchases look even worse), so we expect this trend to continue for the foreseeable future as some businesses look to warranty claims as a means of mitigating losses.
Warranty insurance has been widely used in New Zealand over the past few years, so it is inevitable that many of these types of claims will be made against insurers rather than against transaction parties. This, in turn, may lead to an increase in premiums, as insurers seek to recover amounts paid out on claims.