Managing real estate and property transaction risk
December 2018 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
December 2018 Issue
FW speaks with Chris Hewitt at CLS Risk Solutions Ltd about managing real estate and property transaction risk.
FW: How would you characterise real estate and property transactions in the UK and Europe over the last 12 months or so? What activity levels are you seeing in this space, and what factors seem to be driving deals?
Hewitt: The referendum result in 2016 had a significant impact on the UK commercial property market. Many deals were delayed or halted while people absorbed the ramifications. However, confidence has returned and in the last 12 months there has been a more positive deal flow, with some significant transactions completed. That said, in the last three months, there are clear signs of transactions slowing, due to the difficulty the UK government is having in offering investors a clear position on a Brexit deal. Until this uncertainty is lifted, it seems that many are ‘sitting on their hands’, if there is no pressure to trade assets. Brexit has had minimal impact in Europe. In the last 12 months, activity levels have remained buoyant across European countries where there is positive economic growth. However, in countries where there is economic stress, there has been a reduction in activity while investors take stock of future prospects for the property asset class.
FW: Is there a strong appetite among players to seek insurance solutions when executing real estate and property transactions?
Hewitt: The interest in utilising warranty and indemnity insurance (W&I) in both the UK and Europe has steadily increased over the years. This is a result of greater awareness of the product, coupled with the broadening of cover being offered to clients by the insurance market. Additionally, the market has become more adept at addressing the challenges posed by clients and responding in a more efficient and timely manner. Many now consider W&I to be a standard element of their M&A strategy when considering a deal.
FW: In your experience, how is insurance being used to address warranty and indemnity (W&I) issues arising from real estate and property transactions?
Hewitt: When clients are looking at a potential target, the warranty pack that the seller is willing to offer is becoming more limited. Sellers cap their exposure to as low as £1 or €1. Shorter warranty periods are now commonplace, putting the buyer in a challenging position with regard to a time period in order to detect and report problems that it may discover in the target. Clawbacks are also harder to achieve, if at all. Consequently, in order to manage the potential exposures that buyers now have to accept, insurers are providing solutions which step into the warranty void left by sellers. Equally, buyers that are chasing attractive assets in a competitive bid situation are keen to present themselves as the preferred bidder. Buyers, wishing to minimise the sell-side exposure, which they might otherwise demand, can utilise buy-side W&I insurance to offset their risk. As buyers become more familiar with the policy, the opportunity to work more closely with the insurer has increased. Both parties become comfortable with the due diligence processes and working practices of each other, enabling more creative solutions to be structured.
FW: Could you provide an insight into the different types of warranties that tend to arise in connection with these transactions, such as title to property, title to shares, general warranties, tax warranties, environmental warranties and contingent issues?
Hewitt: The warranties given in the sale and purchase agreement (SPA) play a pivotal role in a transaction. Correctly structured and through the full disclosure and due diligence process, they set out the position of the target company. These warranties determine the liabilities for each side. The W&I policy is structured to assume those liabilities, thereby transferring them to the insurer. The extent to how much of those liabilities is transferred is determined by the policy. This is the stage where early engagement with an insurer can significantly assist in the structuring of warranties, enabling the insured party to achieve a more beneficial outcome. In property transactions, liabilities are typically categorised under title to property, title to shares, general warranties, tax warranties, environmental warranties and contingent issues. Title to property warranties focus on risks relating to the title of the properties themselves. These include ownership risks, risks emanating from enforcement rights and restrictive covenants, issues surrounding the transfer of leases and issues relating to the enforcement of all obligations under specific leases. These risks are dealt with through legal due diligence or data due diligence gathered on the properties. Title to shares warranties are focused on the seller as the legal and beneficial owner of the shares. This extends to confirmation that all notices and accurate procedures regarding the sale shares have been followed and complied with, confirmation that none of the sale shares have any encumbrances on or over them and confirmation that no third-party has the right to call for the issue of any shares or loan capital other than those listed within the SPA. These issues are dealt with via corporate structure, legal analysis, confirmations from the seller and comprehensive due diligence. Common general warranties are the broadest range as they encompass all warranties made that would not be better placed under any of the other classifications. Generally these warranties relate to capacity to conduct business and incorporation, a confirmation of an absence of legal proceedings being brought against a company, a confirmation that the signing of an SPA or equivalent sale document will create valid legal and binding obligations to the seller with regard to these terms, financial warranties regarding the nature of the accounts, including management accounts, and share and loan capital, and employment and pensions agreement warranties. Tax warranties are restricted solely to tax issues. They typically include risks stemming from corporation tax issues, confirmation of an absence of disputes with a tax authority, stamp duty land tax risks, confirmation that the company has maintained possession and records of all tax information required under statute, confirmation that the transaction has been dealt with at an arm’s length basis and real estate transfer tax risks. These are the most complicated warranties to assess from an insurer’s perspective. The property in question determines the environmental warranties provided. The most common environmental warranties relate to confirmation that no investigations or environmental audits have occurred or are ongoing, confirmation that no hazardous substances, contaminated land or environmental encumbrances are present, confirmation that an environmental permit has been obtained, and confirmation that the company has materially complied with all applicable environmental laws and agreements for which they are required. Again, environmental due diligence carried out on the site and answers from the seller will determine insurability. Contingent issues, disclosed issues or ‘known risks’ cover within a W&I policy, is a departure from the norm in the market. To wrap such risks within a W&I policy is new. Often these specific known risks stall or collapse deals. The ability to consider such risk, and provide complete or partial cover, enables the completion of the deal. Provided the insurer is able to undertake full diligence and qualify the risk, and on the premise it is insurable, there is a high probability that a solution can be structured.
FW: What challenges face insurers serving this market? How difficult is to establish an all-encompassing policy in this space, for example?
Hewitt: The key challenges faced by insurers when looking at insuring the warranties within an SPA are the broad spectrum of risks that the warranties encompass, and being able to respond in a timely manner with a coverage package within the time frame of the transaction. In order for an insurer to cover all warranties, they must have a diverse appetite for risk. That requires specialist teams in each sector to underwrite the risks and have adequate insurance capacity to deploy for each risk sector. It also requires the insurer to assume such risks with differing periods of time that they are insured for. Consequently, when there is a transaction which encompasses all these risk factors, insurance brokers are often having to discuss the risk with multiple insurers, as there was no one insurer able to offer a single policy to cover all risks. Historically, due to the broad spectrum of risks that warranties within SPA cover, it is common for a buyer to end up with a number of individual insurance policies, in order to cover, where possible, all warranties within an SPA. Each policy would have been placed with different insurers. They would all require individual meetings and different information, adding additional time and potential delays to the process. This has the added inherent issue of potential shortfalls in coverage between different policies. Additionally, in respect of title to property and title to shares, the insured requires the cover to be in place for “the period of the Insured’s ownership of the property/shares”. This is, consequently, an undetermined period of time which presents a challenge for many insurers, as they require predetermined end dates for all the policies they issue. Therefore, those insurers willing to offer such cover are scarcer compared to insurers with a finite period. In respect of environmental warranties, typically look to have a policy period of between 10 and 15 years. Tax is seven years and general warranties usually two years. But buyers may want more. Contingent risks – known events – policies would look to be open until the finality of the issue. All these elements mean structuring policies is very challenging. When there are complex issues that require different solutions, the result has been individual policies tackling individual issues with different insurers.
FW: To what extent can players feel confident that a particular policy provides adequate coverage for their transaction? How should they go about assessing the merits of insurance on offer?
Hewitt: In order to ensure comprehensive cover that responds to risks, appointing an experienced specialist insurance broker in the field of W&I insurance is critically important. Equally, early engagement with insurers is also critical. As with any transaction, if an insurer has been consulted early in the process, it is familiar with the deal background. Understanding the needs of the insurance buyer is key to an insurer, to enable it to craft a policy to meet those needs. This insight enables the insurer to move swiftly at the closing stages, ensuring minimal delays and, where able, to match the warranties with insurance. A single policy issued from a single source, that wraps all the insurable risks within a transaction, must be the most desirable option. This means that there is only one conversation going on between the deal team, their lawyers, the insurance broker and insurer. This minimises significant duplication of information, conversations and delays. It means that a policy is seamless and clear on the coverage provided. As the deal progresses, if there are numerous different insurers offering individual policies for specific risks, a conversation with each is required. As a deal draws to a conclusion, multiple insurers create delays at a critical stage. A good W&I policy should mirror the warranties in the SPA. By that I mean that the cover for each warranty should be complete. Inevitably, there will be instances where the insurer is unable to match the warranty with cover, but these should be minimal. If there is early engagement with insurers, acceptable warranty language can be discussed at that stage, thereby establishing some ground rules when the insurance buyer is negotiating a deal. They are then aware of the insured bounds and consequently have the choice as to how far they wish to step outside of insurable risk.
FW: In your opinion, how can insurance providers improve the policies they arrange to ensure they encapsulate risks, mitigate coverage gaps and, ultimately, eliminate uncertainty for the insured? How do you expect insurance solutions for real estate and property transactions to evolve in the months ahead?
Hewitt: W&I insurance policies have evolved significantly over the last five years. As a relatively new insurance product, gaining traction in the early 2000s, those early adopters were operating with minimal actuarial statistical data when determining pricing and coverage. Consequently, pricing and coverage was difficult. Inevitably, this meant that the underwriters were very conservative. With the passage of time, actuarial data claims experience and deal knowledge – the ability to assess, qualify and quantify risk with greater certainty – has increased significantly, enabling higher quality of underwriting. The ability to analyse data with technology is providing insurers with better risk insight, enabling them to price the product more accurately. Additionally, coverage has expanded through underwriting knowledge and experience. Insurers are now better equipped to meet the challenges and requirements of insureds. There are continuous steps being made by insurers to offer more comprehensive policies to tackle the risks. Consequently, the coverage now being offered by the market is more comprehensive than ever. However, the lack of markets offering a single policy is not ideal for insureds. Yes, there are insurers able to offer solutions for individual elements, but this creates uncertainty regarding the completeness of the insurance provided. Only, with a single policy can such uncertainty be eliminated.
Chris Hewitt has 30 years’ underwriting and broking experience in the financial lines area. More specifically, he has 15 years’ experience in transactional (warranty and indemnity) liability. With his broad experience of transactional liability risks across the spectrum of small and large transactions, covering both traditional and complex deals, he brings creative thinking and solutions to transactions. He has been instrumental in the development of product innovations which have differentiate CLS in the marketplace. He can be contacted on +44 (0)20 3409 9536 or by email: email@example.com.
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