MOLITOR – Sealing the deal: mastering warranty and indemnity (W&I) insurance under Luxembourg law

Article written by MOLITOR as part of their sponsorship of ACA Insurance Day 2024.

W&I insurance has become an essential risk management tool in mergers and acquisitions (M&A), providing protection to buyers and sellers against breaches of representations and warranties.

Major transactions inevitably carry risks, some of which remain uncertain or unforeseen even after closing, despite thorough audits and due diligence. In M&A deals, sellers typically provide representations that the information disclosed during the buyer’s review process is accurate and complete, helping the buyer assess the target’s value. These representations are often supported by an indemnification mechanism, obliging the seller to compensate the buyer if, post-closing, unforeseen circumstances lead to increased liabilities or a reduction in the value of the target’s assets.

The cost of W&I insurance is typically negotiated between the buyer and the seller. In some cases, particularly during competitive bidding, the seller might agree to share or fully cover the premium. W&I insurance doesn’t replace the seller’s indemnification obligations but acts as an additional layer of protection, similar to tools like surety bonds or professional payment guarantees.

While the use of W&I insurance is well established in international transactions, its adoption in Luxembourg is increasing, driven by the jurisdiction’s role as a hub for investment funds, private equity, and cross-border deals.

Legal framework and key features

Under Luxembourg law, W&I insurance is governed by general contract and insurance law principles, primarily under the Civil Code, the amended law of 7 December 2015 on the insurance sector, and the amended law of 27 July 1997 on the insurance contract. A W&I policy is a specific type of insurance contract designed to indemnify the insured party for financial losses arising from a breach of representations and warranties in an M&A agreement.

Key features of W&I insurance include:

• Coverage scope: Policies typically cover unknown breaches of warranties made by the seller in a sale and purchase agreement (SPA). The buyer may purchase a W&I policy to cover losses arising as a result of a seller’s breach (intentional or not), while the seller might use it to insure against a buyer’s claims arising as a result of a breach by  the seller of its representations and warranties given in good faith.
• Insured party: Policies can be taken out by the buyer (buy-side policy) or the seller (sell-side policy), with buy-side policies being more common in Luxembourg transactions.
• Policy period: The duration of coverage generally aligns with the warranty periods in the SPA, often extending beyond the standard limitation periods for contractual claims.
• Claims and exclusions: Claims under a W&I policy must meet the loss thresholds (retentions/deductibles) specified in the policy.  Known risks, including issues identified during due diligence and forward-looking warranties are commonly excluded.

Regulatory considerations in Luxembourg

Luxembourg’s regulatory framework for insurance policies is aligned with EU insurance regulations, including Solvency II. W&I policies are typically underwritten by international insurers authorised to operate in Luxembourg. It is crucial for the policyholders to ensure that their insurer is properly licensed or passported into Luxembourg under the EU freedom to provide services regime.

Furthermore, Luxembourg law recognises the principle of subrogation, meaning that an insurer who indemnifies a buyer may step into the buyer’s shoes and seek recourse against the seller. This can have strategic implications in M&A negotiations.

Practical considerations

• Due diligence and underwriting process: Underwriters conduct thorough due diligence on the transaction before issuing a W&I policy. Buyers should ensure comprehensive disclosure to maximise coverage.
• Negotiation of coverage: Buyers and sellers should carefully negotiate the scope of warranties covered, exclusions, and the policy’s interaction with the indemnification provisions in the SPA.
• Warranties: The enforceability of specific warranties under Luxembourg law should be assessed when structuring a W&I policy.

W&I insurance has a growing significance in Luxembourg M&A transactions, offering financial protection and facilitating smoother deal execution. Luxembourg law offers significant flexibility in drafting W&I policies, making careful structuring and negotiation essential to achieve optimal coverage. Businesses engaging in M&A transactions in Luxembourg should seek legal and insurance expertise to navigate the complexities of W&I insurance effectively.