Efficient Risk Allocation in the Use of Warranty and Indemnity Insurance in M&A Transactions

Pernille Garde & Rikke Louise Høy Falsner

Student thesis: Master thesis

Abstract

In mergers and acquisitions the buyer will often require the seller to deposit a portion of the purchase price in a third party escrow account in order to satisfy post-closing claims. The buyer will want to secure protection against seller's insolvency and unwillingness to provide indemnification for potential losses. This form of security has historically been widely used in Danish mergers and acquisitions but the financial implications of an escrow can be substantial for the seller. When the seller has to deposit a portion of the purchase price in a closed account for a period of time, it will incur an opportunity cost for the seller. To avoid a hold-up in the release of the purchase price insurance markets have designed an insurance product allowing for the total purchase price to be released to seller when the transaction is completed. Over the recent years this insurance product has become increasingly popular due to decrease in price and broader coverage. Warranty & indemnity insurance is designed to cover the liability incurred by the seller in mergers and acquisition transactions. The product provides financial protection for unknown issues in the event of a breach of warranty and can be taken out by a seller or buyer. Both the buyer and the seller can benefit from this solution if used optimally, however involving a third party could complicate and prolong the process. The negotiations with the insurance company can be difficult and it is rare that the insurance company will take on all risks which the parties should be conscious of when negotiating. This thesis will examine if there are situations where the use of warranty and indemnity insurance could optimize the risk allocation between the buyer and the seller. The parties incentives to collaborate will be analyzed in a game theoretical perspective and financial models will be used to investigate the economic implications of escrow and warranty and indemnity insurance. Depending on transaction specific factors there might be cases where one form of security will enhance the value for the parties more than the other. On the basis of this analysis it will be discussed how the share purchase agreement and insurance contract should be designed in transactions where it could be relevant to utilize warranty and indemnity insurance. In order maximize the risk allocation to the insurance company there are certain parameters which the parties should take into consideration when negotiating the share purchase agreement.

EducationsMSc in Commercial Law, (Graduate Programme) Final Thesis
LanguageDanish
Publication date2016
Number of pages119