M&A risks in focus: W&I masterclass with Devonshire MGA founder

Warranty and indemnity is a complex line of insurance that does not favour pricing models, explains James Dodd, founder of Devonshire Underwriting, a new MGA specialising in W&I, speaking on the Voice of Insurance podcast.

Warranty and indemnity (W&I) is a highly niche and relatively new class of business that some people may have heard about over the last decade, but unless they are involved in mergers and acquisitions (M&A), few people will have had the chance to get to know it intimately.

The latest episode of the Voice of Insurance podcast provides a masterclass on W&I business – sometimes referred to as Reps and Warranties – from an underwriter and entrepreneur who has set up a managing general agent (MGA) within the past year that focuses on this specialist business.

Coming from a legal background, before getting into insurance as an underwriter for seven years, James Dodd was drawn by an entrepreneurial streak to launch a specialist MGA, Devonshire Underwriting, which launched in April this year.

In short, Dodd explains, W&I is there to cover the risk of losses that may arise from a breach of warranty, or claims under a tax indemnity, usually in the context of a merger or acquisition, typically under a share purchase agreement.

In practice, this eventually may occur some period after a deal has completed, if the buyer receives an unexpected tax bill – not part of the expected tax liabilities disclosed by the seller – providing the acquirer a welcome level of additional security behind the contracts that have been signed.

“As my wife says, ‘We insure promises,’” Dodd says, with benefits for buyers and sellers. Brokers tend to be the distribution channel for this business, Dodd notes, with the request and a stack of supporting information, coming to the MGA once a deal is in the offing.

“It means the seller retains minimal or no liability, and so it gets the money in and has the freedom to go spend it on whatever it has that earmarked for. For private equity houses, it allows them to wind up the funds and then return money to investors, because ongoing liabilities have been limited, and covering the unknowns in a transaction,” Dodd says.

“We would always expect the buyer to be undertaking due diligence on the deal from a legal, financial and tax perspective, risks identified in there wouldn’t be covered by W and I. It’s the things that haven’t been identified are rather two products, tax and contingency, which are for the more identified risks,” he adds.

Underwriting questions can represent another set of expertise, reviewing a transaction for risks that the lawyers and tax advisors may not have considered, Dodd explains. The risks that may be picked up within the due diligence (DD) process can also be covered by the MGA, he underlines, with tax and contingency, together with W&I representing three products in all.

“If something’s identified in a DD report that normally wouldn’t be covered under the W&I, but we can then say to clients, we can explore potentially covering this under a tax or contingency product,” he says.

Policies tend to be long duration – typically three years, Dodd explains. Tax and fundamental warranties tend to have a seven year lifespan, which is the longer tail period for which claims may come through, he reveals.

“We have seen that the earlier a claim comes in, the more likely it is to be paid, just from past experience,” Dodd says.

Earlier claims tend to be bigger but also clearer cut, Dodd acknowledges, with more complexity tending to arise over time, especially in establishing the quantum of the loss, and because both sides tend to be well advised through their lawyers, accountants and tax advisors.

“If it’s very simple breach and the quantum can be identified very quickly, then that could be a matter of weeks. In our experience, for the types of policies that Devonshire writes, you would normally expect six to 12 months for a claim to be settled, but in very complex cases it’s not unheard of for that to be 24 months,” he says.

This is not business that lends itself to the risk modelling seen within other classes of business. As host Mark Geoghegan pointed out, “getting your head around that risk” is a challenge, due to the mix of human behaviours involved, plus the complexity of dealing with detail tax codes across multiple jurisdictions, which are also given to changes over time.

Underwriters need to know what to look for, he acknowledges. W&I “is not the type of product” for which there are models into which an underwriter can feed some inputs, for the model to spit out a price output.

“A lot of what we do is based on experience and feel, if you’d like,” Dodd says.

“Every M&A transaction is different. You’ve got different buyers, sellers, targets will be different. Being able to model that and price it by putting it into a computer doesn’t really work. There are so many variables that play, and a lot of it is driven by past experience with a particular industry or sector,” he adds.

Dodd comes from a legal background, but an array of skills are needed to underwrite W&I business. Many underwriters in this market have trained as lawyers, accountants or tax specialists. Putting together a puzzle using these perspectives is the key to success, he suggests.

“A lot of what we do is like putting the jigsaw together,” Dodd says. “We have to look at the various pieces. That could be the legal analysis on the target, as well as the financial and tax analyses, put those together, but then step back and look at the target as a whole, to fully assess where the risks are in this business.”