It has been a little over a year since my previous article about transaction insurance in South Korea, so I thought it was a good time for an update especially since 2018 and the first half of 2019 experienced continued growth in warranty & indemnity insurance use and the first placement of tax liability insurance policies.
Warranty & Indemnity Insurance
As a quick refresher, warranty & indemnity insurance (W&I) allows a buyer and seller in an M&A transaction to transfer actual or alleged warranty breach risk to an insurance company for a fixed premium. It is an increasingly cost-effective alternative to the traditional means of addressing warranty and indemnity transaction risks such as escrows, purchase price adjustments, hold-backs, guarantees, or walking from the transaction.
W&I Insurance Policies
# Estimated based on various sources, includes domestic and outbound transactions
I introduced W&I to Korea’s M&A sector back in 2007 but, despite much educating of private equity and strategic M&A professionals and their advisors, the first policies were not placed until 2013. All three policies that year were for acquisitions made abroad by Korean strategic investors who used W&I to add comfort to transactions in unfamiliar jurisdictions.
2014 saw the first W&I policy issued for a domestic Korean transaction involving a local seller, buyer, and target. Two additional “Korea centric” policies were purchased that year; all three were arranged primarily to provide a clean exit for the seller. The W&I environment in Korea was looking favorable for 2015, however, no W&I policies materialized that year.
W&I started to gain acceptance in 2016 when “first-mover” concerns were finally overcome and five policies were placed for a variety of strategic reasons (see Strategic Benefits chart below). Most policies covered small deals, but the year ended with Korea’s first mega-policy being placed that provided insurance limits in excess of US$200 million.
In 2017, the reluctant early adopters became fast followers as seven policies were put into effect. Advisors’ knowledge had increased, repeat buyers emerged, and sellers took advantage of structuring W&I “sell-buy flips” (see below) into their exits.
Momentum gained pace in 2018 with a record fourteen W&I policies closed and W&I underwriting inquiries surging. 2018’s growth was reflective of Korea’s M&A trends: larger number of closed transactions, increased deal size, sellers’ interest in securing clean exits, and strategic investors pursuing outbound acquisitions. Also of note in 2018 was insurers agreeing to provide broader U.S.-style coverage enhancements on Korean placed policies. These enhancements were driven by Korea’s most experienced insurance brokers who leveraged their global knowledge and wide deal experience.
The first half of 2019 experienced steady W&I use with eight policies closed and numerous currently being underwritten. Despite an overall slowdown in Korea M&A activity so far this year, 2019 is on pace to meet or beat 2018’s record number of W&I policies which is a good sign that W&I has finally become a regular consideration for Korean M&A transactions.
ARIA has advised on approximately US$15 billion of Korean domestic and outbound M&A transaction value over the last 36 months and have seen W&I policies used on transactions with deal values anywhere between US$30 million and US$3.5 billion. Policies with limits of US$200 million or more are not uncommon and the total available per transaction capacity for a W&I policy in the Korean insurance market is currently in excess of US$400 million. The drivers behind the purchase of these policies covered the full range of strategic benefits offered by W&I policies as outlined below.
|Warranty & Indemnity Insurance
Facilitates the transaction by bridging seller / buyer warranty and indemnity expectation gapsEases SPA negotiations, streamlines mark-ups, and reduces related expensesTransfers warranty breach risk to a creditworthy insurer for a low pre-determined costBest practice risk managementEnables board / investment committee approvalsMaintains good PR as claims are usually settled by confidential out-of-court settlement
|Secure a clean “nil-recourse” exit allowing for prompt distribution of funds which is key for PE fund, RE fund, and family business sales
|Buyer can differentiate bid by accepting a lower warranty cap and shorter duration from the seller and then supplementing with W&I
|Avoid or limit seller escrow and contingent liabilities freeing up capital on the balance sheet
|Added comfort when acquiring in unfamiliar jurisdictions or industries or with unknown sellers
|Seller can maximize valuation and attract bidders by offering an enhanced warranty package to bidders: higher warranty cap, longer durations, etc.
|Claim on insurance rather than on retained management and/or founder during earnout or ongoing joint venture partner
The Sell-Buy Flip
ARIA has pioneered the use of the sell-buy flip strategy for Korean transactions. This term refers to a W&I policy that is initiated early in the M&A sale process by the seller, that is flipped or transitioned to the bidder(s) later in the sale process for final negotiation and placement. The sell-buy flip gives comfort to the seller that W&I is available for the transaction and that the insurance underwriting process will not slow the sale process as the policy will have been largely underwritten prior to the flip.
This structure effectively bakes W&I into the sale process to expedite deal execution, reduce SPA negotiations, enhance bidder valuations, and be used to deliver a clean nil-recourse exit to the seller. Regarding that last point, it is critical that a sell-buy flip policy be accompanied by proper wording in the SPA that establishes the W&I policy as the sole recourse available to the buyer. The buyer receives security via an insurance policy with a financially secure and highly regulated insurer whose reputation is contingent upon paying claims. In practice, the premium for a sell-buy flip can be borne by the buyer, seller, or shared between them, it is a commercial decision.
The Key Players
AIG remains the clear leader in Korea’s W&I market as they were the first insurer to have their policy approved by regulators (in 2009) and then adapted their global experience for Korea’s M&A sector. Hyundai Marine & Fire and Ace/Chubb obtained W&I policy approvals in 2016 and 2017 respectively, and each have had moderate success. Dongbu is the most recent insurer to offer W&I in Korea and additional competition is not far off as several insurers and reinsurers are currently evaluating how best to enter Korea’s W&I market.
Insurance brokers of all shapes and sizes are trying to get in on the action by flogging W&I around Seoul like it was a business auto policy. There is a danger in this since any rumors of one poorly structured W&I insurance policy or one deal that is delayed by insurance will quickly spread among Korea’s M&A professionals and tarnish W&I’s reputation. It is crucial to recognize that W&I is a highly complex insurance contract that requires extensive negotiation for each unique transaction and, therefore, it is imperative for your broker to have a deep team that has real M&A legal credentials as well as extensive experience in designing and negotiating W&I policies.
The Million(s) Dollar Question – Are Claims Paid?
We cannot have a proper insurance article without addressing the age-old insurance question: will insurers pay claims? The answer is yes. AIG’s 2019 Claims Intelligence report “Taxing Times for M&A Insurance” noted that AIG experienced a 20% claim notification frequency on the W&I policies they issued between 2011 and 2017. Regarding claim severity, the proportion of claims that have a value of US$10 million or more has almost doubled year on year from 8% to 15% and the average size of these significant claims was US$19 million. Globally, the most common breach claims emanate from financial statements (19%), tax (18%), and compliance with laws (15%). Claims are also being reported in a more timely fashion as 74% of all claim notifications were made within the first 18 months after policy inception. Clearly, insurers are experiencing a greater number of claims and paying out large W&I settlements with one in the Asia Pacific region exceeding US$100 million. Closer to home, Korea is not immune to W&I claims as the first one was settled in 2018.
Tax Liability Insurance
Tax liability insurance is another type of M&A transaction insurance that is gaining traction in Korea with the first policy written in 2018 and the largest written in 2019. Tax insurance enables a taxpayer to reduce or remove a potential financial loss relating to a tax position where the legal accounting conclusions underlying the tax position may be challenged by the relevant tax authority. Coverage is designed to address taxes due and related penalties, interest, and defense costs.
- There are many strategic uses of W&I that offer a variety of benefits for sellers and buyers.
- After a slow start, W&I use for Korea domestic and outbound M&A transactions is taking-off.
- It is critical to utilize an insurance broker who has a deep team with M&A legal credentials and extensive experience in negotiating W&I policy wording, recommending related SPA language, and settling claims.
- Other M&A transaction insurance solutions like tax liability insurance can ring fence “known issues” and facilitate deal closure.
For more information, please contact:
Asia Risk & Insurance Advisors
M: +82-10-2267-2788E: [email protected]