Impact of the Corona Pandemic on the M&A Insurance Market

1. Introduction

The good news upfront: In the opinion of many market participants, the M&A market will recover rather soon from the disturbances caused by the Covid-19 outbreak, which was declared a pandemic by the WHO on 11 March 2020. However, the Corona Pandemic’s mid and long-term consequences for the M&A and M&A insurance market but are expected to be significant. Even prior to the Corona Pandemic outbreak, experts predicted a downturn in the European M&A market and an increasing number of insolvency proceedings due to the general economic developments. These trends have been fueled by the Corona induced shutdown.

2. Immediate Impact on Deal Flow

Beginning of March 2020, the governmental measures for the containment of the Corona Pandemic in basically all European countries have led to a temporary shutdown of the European economy. Due to the complex uncertainties regarding the mid and long-term consequences for the business of (potential) target entities and thus their valuation, many M&A processes were immediately put on hold. Correspondingly, the W&I market froze. Howden M&A reports that as of 23 March 2020, the number of live projects dropped from 183 to 60, with further of these projects being placed on hold over the following weeks. Other players in the market report similar developments.

With the governmental restrictions now being gradually released and the economy – at least in Europe – returning somewhat back to “normal”, M&A activities and correspondingly the W&I market have slowly picked up since the end of May.

3. Increase of distressed transactions

The shutdown has caused severe liquidity issues for many companies. To stabilize the economy, financial aid programs and further measures have been implemented on a national level to bridge liquidity shortages and insolvency risks. Germany for example has passed legislation that allows for a temporary suspension of the obligation to file for insolvency proceedings. On a European level, a recovery plan is currently under discussion. However, in many cases, these measures will not be sufficient to avoid insolvency. The number of transactions in which either the seller or the target is (almost) insolvent will therefore increase dramatically as soon as the governmental support programs expire.

Typically, the insolvency of a company is the result of mismanagement, in particular due to the management’s failure to identify and handle operational risks. In transactions with such target companies, the likelihood of a warranty breach and lack of sufficient disclosure is rather high. Also, in low performing assets, the buyer tends to take a closer look at the warranties and potential damage claims to evaluate whether there is a way to mitigate some of the losses of his investment by recovering the damages either from the seller or the insurer. This was one of the main reasons why insurers have been reluctant to underwrite W&I risks involving distressed assets in the pasts.

If the (threatening) insolvency of an asset is caused only by external factors induced by the Corona Pandemic, however, the typically elevated risk for claims does not apply if the business model is sustainable, management is sound and liquidity matters are dealt with professionally. Insurers are therefore more likely to consider respective transactions and put a focus on assessing the reasons for the insolvency in their underwriting exercise.¹

4. More demand for use of synthetic warranties

Corresponding to the expected increase in distressed M&A transactions, the demand for synthetic warranties will increase. Synthetic warranties are technically not given by the seller or the management. They are merely “synthetically” agreed between the buyer as insured and the insurer under the W&I policy. The advantage for the seller – not only in distressed transactions – is that he basically entirely excludes liability for the statements contained in the warranties under most jurisdictions, except for fraudulent behavior.

As long as the seller or selling insolvency administrator ensures a thorough disclosure process, synthetic solutions appear to be feasible on a large scale. However, underwriting processes will very thoroughly consider the particularities of the transaction. The scope of the warranties will still be matched individually against the disclosure and corresponding due diligence exercise. In many cases, the scope of the warranties will remain below the standard buyers are used from “normal” transactions. This is due to the limitations on disclosure and due diligence in speedy distressed transactions.²

5. Corona Exclusions in W&I policies

As a first reaction to the complex uncertainties triggered by the shutdown, some insurers have included blanked Corona exclusions in their policies, excluding basically any and all damages resulting from risks relating to the Corona Pandemic.

From a buyer’s perspective, such broad exclusions are very unfavorable. It is rather difficult to factually determine whether and to what extent damages have actually been caused by the Corona Pandemic. One could even argue that in the current circumstances, it had an impact on most damages to some extent.

Quickly, the market has managed to reconcile the buyer’s interest in a meaningful scope of coverage and the insurer’s interest for risk mitigation: instead of requesting general exclusions, insurers now include specific questions on the impact of the Corona Pandemic on the target’s business in their underwriting questionnaires and reflect risks identified in the underwriting process in their coverage position with regard to the specific warranties affected by these circumstances.

6. Underwriting

In addition to questions on how the Corona Pandemic has generally influenced the target’s business (in particular matters of business continuity and resilience, financial forecasts, use of government support) in their underwriting questionnaires, particular risk areas such as supply chain management, potential material contract disputes and employment matters are being reviewed more thoroughly.

Further, insurers have put even more emphasis on other aspects of the target’s general risk profile, such as insurance arrangements and general compliance matters than prior to the Corona Pandemic. So far, we have not seen a significant reduction on the scope of coverage under the W&I policy.

7. Contingency Risks

Already before the outbreak, market participants expected more demand for known risk cover. This included in particular tax liability insurance, specific risk environmental insurance and contingent legal risk and litigation insurance.

The Corona Pandemic will likely increase the demand for specific insolvency related contingent liability risks in distressed M&A transactions. Details for such risks vary significantly over the different jurisdictions in Europe. One area of application are pre-pack solution risks were the execution of the transaction depends on the consent of a third party and such consent has to be given if statutory defined criteria for the transaction are met. Further, e.g. in Germany, there are risks that a transaction consummated prior to the filing of insolvency proceedings is later appealed by the insolvency administrator of the seller if the terms of the transaction were to the detriment of the seller’s creditors. So far, only few insurers offer solutions for these risks. Further market participants will likely follow.

8. Increase of W&I claims

Due to the increasing number of underwritten W&I policies and the improved level of professionality on the insurer’s as well as on the insured’s part, the number of claim notifications and claims paid out has increased significantly over the past years. As every economic downturn leads to an increased number of legal disputes, this can also be expected for M&A insurance claims in the (post) Corona Pandemic period.

Although the market has seen some significant claims that were settled or paid out in the last years, claims handling still appears to be an area were the lack of experience of the acting market participants – including insurers, brokers and insureds and in each case their advisors – leads to numerous avoidable misunderstandings that impede an amicable and satisfactory solution for all parties involved.

9. Pricing

Whereas many market participants have reported a decrease in premiums for W&I insurances due to the highly competitive market in the last months, most expect a stabilization of premiums and even mid-term price increases as a result of an increase in claims.

10. Scope of Coverage in W&I Insurances

In our experience, the insurer’s general intention to offer back-to-back coverage on warranties agreed in a transaction between the parties has not been influenced by the Corona Pandemic. Further, the market still strives to implement and develop customer friendly enhancements such as materiality, knowledge or “US Style” Due Diligence Report or VDR scrapes.³ Although more reluctantly than before, some insurers still offer new breach cover options, covering warranty breaches that occur and are identified between signing and closing.

11. Summary

The W&I market has found solutions for the Corona Pandemic related challenges at a remarkable speed. Both underwriting process and terms of W&I policies have adapted to the increased level of uncertainty with regard to operational risks without a noticeable setback in available scope of coverage. However, satisfactory solutions require the effort of all players involved. A thorough disclosure and underwriting process remains crucial. Insurances for known risk will become more important and the focus of innovation in the market. The number of claims will undoubtedly increase – handling them well will likely be a significant competitive advantage for insurers in a highly competitive market.