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Business Risks

Warranty and indemnity (W&I) covers make merger and acquisition (M&A) projects safer. But do they also benefit insurers?

In a merger and acquisition transaction, a seller provides representations and warranties regarding a target’s basic legal, financial and tax situation.. These are generally supplemented by warranties regarding the target’s operational risks (for example, its major clients and suppliers, public subsidies, compliance). Private equity firms in particular use W&I insurance to cover their transactions. The market is booming. Monika Milberg, Head of Financial Lines Treaty, talks about the opportunities and risks for insurers.

02.06.2016

Topics Online: Ms. Milberg, W&I business is thriving. Many insurers want to benefit from the rising demand for this type of cover and are looking to enter this niche. What is Munich Re doing to position itself in this segment, and what course is it pursuing?

We are very active in the field of W&I, and we offer our clients expertise and substantial capacity. However, we do not share the general euphoria without caution. Our intention is to raise risk awareness for this business. There are a number of reasons for this.  W&I business is a highly complex field. Standard covers are virtually non-existent – each and every policy needs to be customised. Accordingly, the requirements for underwriting and the participating law firms are very complex. These requirements can hardly be met from one day to the next, which is why W&I is far from being a "me too" business for all. On the contrary: It takes wide-ranging expertise to reliably assess and profitably insure the risks that these high-limit project insurance covers involve. 

Are you saying that W&I business will not pay off for many players in the long run?

The first signs of this are already evident. The analyses show that claims frequency has been recently increasing significantly. And policies with above-average limits of indemnity are proving to be particularly susceptible. We are expecting a number of major losses in this range in the near future. In short, W&I business is not necessarily highly profitable. Due to the significant exposure accumulation, this business is by its nature extremely risky, not only for primary insurers but also for reinsurers. We therefore anticipate that sooner or later the market will consolidate.

What does this imply for your clients, what are your plans?

We are currently investing in the creation of a global W&I claims database that will allow us to analyse the risks and mechanisms even more closely. W&I Insurance is purchased during or as a consequence to the “due diligence” process. Consequently, it is a very discreet line of business. Therefore, the reinsurer can only steer his accumulation via “managed” capacity allocation at the time of the reinsurance-contract inception. We share our established know-how and global market expertise exclusively with our existing W&I clients in order to strengthen their competitive position. In other words, we are committed to our clients unconditionally. We are also firmly convinced that W&I will not become a standard business for all providers. This is why we also caution against excessive euphoria and an unprepared entrance to the market.

What the latter might lead to can be seen from the increasing frequency of W&I claims. Is there an explanation for this new trend?

W&I insurance is a fairly young product that was introduced about ten years ago. In its pioneering stage, market coverage was therefore minimal. Claims under these early policies were rare, and profit margins were all the more attractive. The terms and conditions were very narrowly defined, premiums were high, and the underwriting process was lengthy. But in recent months, the market has expanded significantly owing to additional policy wordings, lower premiums, less burdensome underwriting processes, and the popularity of buy-side policies. Furthermore, most policies run for seven years. As a result, the portfolio is expanding as the market grows – and the actual frequency of claims is becoming more visible. A preliminary assessment has shown that every seventh policy concluded between 2011 and 2014 has been affected by a claim. 

Will these unexpectedly high claims figures lead to more caution and reservation? How do you assess further development?

We are currently experiencing a paradoxical situation. The private equity sector is thriving globally and causing the demand for W&I covers to grow. This is reflected in rising demand, which should result in a scarcity of supply and higher premiums. But that is not happening. Looking for profitable niche business,  more providers are rapidly making their way into the market, and they are undercutting each other with the premiums they charge and the terms and conditions they offer. This is lowering risk-bearing capacity overall, and is gradually turning a profitable market into a soft one. We think this is an alarming trend, and we need to address it with even greater professionalism. We support our clients with know-how and a global market overview. 

Warranties and indemnities

W&I policies are customised products for securing warranties for mergers and acquisitions. They are used in particular by private equity companies for selling a portfolio company. Sellers can significantly limit their liability for warranties in this way. They can immediately use a large portion of the proceeds without having to leave money in an escrow account for years. Buyers, in turn, benefit from significant investment protection, for instance through higher limits of indemnity or longer policy terms.

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