What Is W&I Insurance (Representations and Warranties Insurance)? Risks Covered in M&A and the Seller's Liability

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

In the share purchase agreement (SPA) for an M&A deal, negotiations over the representations and warranties clause sometimes stall in the final stages. The buyer wants to broaden the scope of the representations and warranties, raise the indemnity cap and secure a long survival period. The seller, on the other hand, does not want to carry liability long after receiving the purchase price for the shares. When the two sides' positions stay parallel, someone may propose: "Could we reach agreement by using representations and warranties insurance?"

Representations and warranties insurance (Warranty and Indemnity Insurance, or W&I insurance) is not a mechanism that removes the contractual conflict itself. It is a mechanism that transfers certain economic losses arising from breaches of representations and warranties to a third party, the insurer. What can be transferred is limited to the risk of financial recovery if a breach occurs. Conducting due diligence (DD), drafting the representations and warranties in the contract, preparing disclosure materials, designing exclusions and limitations, and considering the scope of the seller's liability cannot be skipped even when insurance is used.

Risks Transferred by W&I Insurance and the Liability That Remains in the Contract

There are two types of W&I insurance: buy-side policies, under which the buyer is the insured, and sell-side policies, under which the seller is the insured. Which party arranges the policy and pays the premium is decided by agreement between the parties, separately from who the insured is. Under a buy-side policy, the buyer claims directly against the insurer for losses arising from a breach of representations and warranties. Under a sell-side policy, the buyer claims indemnity from the seller, and the seller claims under the policy to cover that indemnity. The mechanism of buy-side policies is also described in Marsh's explanation of W&I insurance (Japanese).

What the insurance covers is loss caused by a breach of representations and warranties. In practice, breaches of representations and warranties are distinguished from breaches of covenants, and for matters already known, the parties consider whether to address them through a special indemnity. Ordinary W&I insurance covers unknown breaches of representations and warranties, judged against the persons whose knowledge counts and the reference date defined in the policy. Some buy-side policies are designed to cover breaches resulting from the seller's fraud that the buyer did not know about. Under a sell-side policy, by contrast, the seller's own fraud is excluded. In addition, breaches of covenants, such as those concerning the conduct of business before and after closing, are not covered by ordinary W&I insurance and are therefore addressed through the indemnity provisions of the SPA and the like. Some policies are designed to specifically cover tax covenants and the like, so it is important not to decide insurability based solely on the label "covenant."

Matters already known are in principle excluded from ordinary W&I insurance. Whose knowledge counts and as of what point in time is set according to the policy wording and the disclosures made. Specific risks already identified at signing, such as pending litigation discovered in DD, are often addressed as a special indemnity in the SPA and are not included in the scope of ordinary W&I insurance. For certain risks it may be possible to consider a separate specific-risk policy, but whether it can be underwritten is decided case by case. What insurance underwrites are breaches that could not be identified despite thorough investigation; risks identified in the investigation and written into the contract are handled on the SPA side through representations and warranties or special indemnities.

Preparation and the Underwriting Process

Obtaining W&I insurance requires advance preparation and time for the insurer's underwriting review. When submitting DD materials and DD reports to the insurer, you need to confirm the authority to disclose them under the contracts with advisors and secure confidentiality with the insurer and the broker before undergoing underwriting (Small and Medium Enterprise Agency, SME M&A Guidelines, 3rd edition (Japanese), p. 53). Through these materials, the insurer independently assesses the risks of the target company.

During underwriting, the draft SPA is also shared with the insurer. Because the scope of the representations and warranties is affected by whether the insurer can underwrite them, discussions with the insurer proceed in parallel with the negotiations between seller and buyer. The insurer may ask additional questions about areas not investigated or the wording of the representations and warranties, and answering these Q&As also becomes part of the negotiation process.

The time required and the premium vary depending on the target company's industry and the size of the deal. They are confirmed for each deal, taking into account the progress of DD and the insurer's underwriting policy. If the SPA negotiation schedule and the underwriting schedule do not mesh, the insurance terms may not be settled until just before closing, so it is realistic to start considering insurance at an early stage of the SPA negotiations.

The Scope of DD and the Conditions for Coverage and Exclusions

W&I insurance can cover many representations and warranties, but some matters are by nature unsuitable for insurance. Fines and penalties are subject to restrictions under law and policy terms, and matters relating to anti-social forces may also be excluded. Check separately whether there has been a violation and the scope of loss the insurance covers. Unknown breaches of tax representations and warranties may be covered, while known tax liabilities, environmental contamination and the like are generally excluded. For insurance covering specific tax or environmental risks, check whether separate underwriting is possible, referring also to product information such as Mitsui Sumitomo Insurance & Financial Services' explanation of W&I insurance (Japanese). The treatment of tax and environmental representations and warranties differs by product and deal, and they are not necessarily uniformly excluded.

What is paid as insurance proceeds may include, in addition to covered losses and costs, reasonable costs incurred in defending or settling claims for indemnity. However, the insurer's prior consent may be required before defense costs are incurred, and the coverage is limited to the matters underwritten by the insurance. Even if representations and warranties are set out in the SPA, areas not sufficiently investigated in DD may be excluded from coverage. Narrowing the scope of DD helps contain investigation costs, but it also narrows the scope of insurance coverage. The DD process is explained in The Purpose, Process and Required Documents of Legal Due Diligence.

W&I insurance generally has a retention (deductible) and a policy limit, and if the loss does not reach the retention, no insurance proceeds are paid. Matters concerning forward-looking statements, specific exclusions, the scope of persons whose knowledge counts and the reference date are set by each insurer's policy wording and individual terms. There are no uniform amounts or periods, so in considering specific coverage, check the latest policy wording and confirm the individual underwriting terms through a broker.

Designing SPA Provisions When Insurance Is Used

Even when W&I insurance is used, the representations and warranties clause in the SPA itself remains. Because the basis for paying insurance proceeds is the seller's breach of representations and warranties, the seller's representations and warranties are also set out expressly in the SPA. Whether the accuracy of the representations and warranties is made a condition precedent to closing, and how that standard is set, are determined in the SPA negotiations. Indemnity for breaches of covenants that cannot be insured is maintained as an indemnity provision in the SPA. The structure of the contract as a whole can be reviewed in SPA (Share Purchase Agreement) Indemnities, Price Adjustments and Closing.

Under a buy-side policy, the buyer can claim directly against the insurer, but merely obtaining insurance does not automatically release the seller. Whether claims against the seller are excluded, and whether claims are to be made first against the insurer or the seller, are set out in both the SPA and the insurance policy. Sellers sometimes seek a non-recourse design that limits liability for breaches of representations and warranties to the amount of the insurance proceeds and excludes direct claims against the seller. However, insurance has exclusions and retentions, and policy limits apply even to fundamental representations and warranties, so the buyer may argue for leaving room to claim against the seller for portions not covered by insurance and for serious breaches.

When adopting a non-recourse design, check that the insurer's waiver of subrogation against the seller is consistent with the limitation of liability provisions on the SPA side. Some waivers of subrogation retain exceptions such as the seller's fraud, so confirm their scope in the actual policy. Even where the buyer receives insurance proceeds, liability may remain on the seller. Where a sell-side policy is used, the buyer first claims indemnity from the seller and the seller then claims under the policy, so the SPA provisions take a form close to an ordinary contract.

Criteria for Deciding Whether W&I Insurance Is Suitable

W&I insurance is not an all-purpose tool to be introduced uniformly in every M&A deal. When considering it, check how well it fits the deal from the following perspectives:

• The burden of the premium and underwriting costs relative to the deal size
• Consistency between the SPA negotiation schedule and the insurer's underwriting period
• Alignment between the progress of DD and the scope of representations and warranties for which coverage is sought
• The nature of known material risks (whether they should be handled by special indemnity or price adjustment)
• The purpose of using insurance (smoothing agreement, or avoiding substantive negotiation)

Material risks discovered in DD are likely to be excluded as known matters, and even if insurance is arranged, they need to be addressed separately through representations and warranties, special indemnities and price adjustments in the SPA. This analysis also relates to the setup, discussed in Comparing M&A Legal Support Providers, that handles everything from legal due diligence through SPA negotiation in an integrated way. From the perspective of indemnity liability for breaches of representations and warranties, the concepts of knowledge qualifiers and materiality qualifiers discussed in Risks Founders Tend to Overlook in SPA Representations and Warranties also need to be considered, whether or not insurance is obtained.

When considering insurance, prepare a list organizing the areas already investigated in DD and those not investigated, the current draft of the representations and warranties and indemnity provisions in the SPA, and a list of known risks identified in DD. Having these three items ready lets you get an early view of insurability when consulting the insurer and the broker. The scope of our work on SPA negotiations involving insurance and legal due diligence is summarized under M&A Support. How representations and warranties and indemnity provisions fit within the contract is explained in An Overview of the Main Provisions of an SPA (Share Purchase Agreement).

Frequently asked questions

If we use representations and warranties insurance (W&I insurance), does the seller's indemnity liability disappear?

No. Representations and warranties insurance is a mechanism that transfers losses arising from breaches of representations and warranties to an insurer, and losses relating to known matters, breaches of covenants, and matters falling under the policy's exemptions and exclusions are outside its coverage, so the representations and warranties and indemnity provisions in the SPA, and special indemnities for known risks, remain necessary.

What is the difference between a buy-side policy and a sell-side policy?

Under a buy-side policy, the buyer is the policyholder and the insured, and claims directly against the insurer for losses arising from breaches of representations and warranties. Under a sell-side policy, the buyer first claims indemnity from the seller, and the seller claims insurance proceeds from the insurer to cover that indemnity. Which type is used also changes how the representations and warranties and indemnity provisions of the SPA are drafted.

Can representations and warranties insurance be used even if the DD was insufficient?

Insurers ask for the results of the DD and the submission of DD reports during underwriting. Areas that were not investigated do not automatically become covered unless they are expressly stated as representations and warranties, so if the scope of the DD is narrow, the scope of representations and warranties that can be insured may also be narrow.