Warranty and indemnity insurance: Will euphoria give way to disillusionment?
Business in warranty and indemnity policies (W&I) may be booming, but it is complex and volatile. New analyses have shown that loss ratios are higher than many players in this challenging market think.
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Global demand for W&I policies has more than tripled since 2011, with total premiums and available insurance capacity rising with it. Tempted by the, at first sight very attractive, prospects, more and more providers have been crowding into the market in the last few years. Now prices are coming under increasing pressure, with extensions of cover on offer at the same time.
W&I policies are a new product introduced around 10 years ago on a broad scale to cover warranties and risks in connection with company takeovers. Private-equity companies are often behind mergers and acquisitions (M&A), and W&I insurances play an important part in their business models. A quick look at the benefits of the product tells us why.
Benefits of covering a transaction
By taking out a W&I policy, the seller of a company limits its liability for the financial, tax and legal risks arising out of the sale. This is a crucial issue for private-equity companies because without W&I insurance they cannot gain immediate access to the greater part of the sales proceeds, which have to be left as security on a trustee account for years. The buyer of a company in turn benefits from greater protection for its investment, generally in the form of high sums insured and policy terms of several years. Every W&I policy is unique – tailored to a specific case, highly complex and involving considerable underwriting work.
How the market has developed
For many years after it came into existence in the USA, the market for W&I insurance was a niche in which, worldwide, only a small number of insurers and reinsurers were active. Today, the picture looks very different. The main driver has been soaring demand. It has quadrupled since 2011 (cf. figure), and in the same period global market capacity has quintupled to around US$1.5bn.
Worldwide premium volume currently stands at approximately US$1.2bn. What is particularly interesting is the fact that, whilst the number of M&A transactions has shown an increasing trend in recent years, the total value of the transactions has fluctuated within a relatively narrow corridor (cf. figure) – i.e. it is the number of smaller transactions that has risen most.
Beware of the soft market tendencies
Despite the rising demand, providers of W&I products are certainly not operating in a sellers’ market. On the contrary, high single premiums, the growth in the market and losses that, until a few years ago, appeared to be low have made W&I business look so attractive that more and more providers have been trying to get into the market. Competition is becoming fiercer, with very unpalatable consequences, including premiums falling across the board, increasingly broadly formulated conditions and, in some cases, underwriting processes that do not do justice to the complexity of the risk.
The trend towards a soft market is being strengthened even more by the number of “buyer-side policies” written, which has been increasing for months. These policies cover buyers against financial loss resulting from the acquisition of a company. If the policyholder suffers a loss, it claims compensation directly from the insurer. This arrangement is likely to be especially hazardous if the risk assessment for underwriting is further simplified and the buyer’s due diligence is in future no longer submitted to risk managers or not submitted in full. Another critical point is that, due to the development of the market, insurers are finding it increasingly difficult to find qualified staff for the challenging risk assessment work involved.
Extensive loss database provides substantiated market insights
Notwithstanding this, more companies are still moving into this business segment. Many of them may have cause to regret their decision in a few years’ time because on more detailed analysis, the reality of W&I business looks much less rosy. This is borne out by Munich Re’s extensive loss database on the W&I market.
Due to the long treaty periods and the complexity of M&A transactions, losses are generally only reported once the first audit cycle has taken place, i.e. at the earliest 6 to 18 months after the sale or purchase of a company. Our database provides a reliable picture of the loss history for the entire market, especially for older transactions, and permits substantiated forecasting of future developments.
Our analysis shows that, following the favourable loss experience throughout the market in the years up to 2009, the combined ratios had already risen significantly by 2011. What is more, projections based on realistic assumptions for the years after that indicate combined ratios very close to 100% (cf. figure), barely sufficient to enable insurers to exceed operational break-even. Even minor fluctuations in losses or a further worsening of market conditions could put many insurers into the red in this business.
Optimism despite the high volatility
Nevertheless, the enormous potential of the market is cause for optimism. W&I insurances are currently being purchased for less than 10% of global M&A transactions. If that percentage increases significantly, the resultant higher total premium volume will, over time, reduce the high volatility of the losses. There is also hope that the market will learn from past losses – which is where our loss database comes into its own.
We make the statistics it provides and the expertise and worldwide market knowledge it gives us available exclusively to our clients so that we can work with them to improve risk management. Munich Re is thus able to provide its insurance partners with systematic support in their W&I activities, paving the way for profitable business – even in such a difficult environment.
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