Risk Aspects to Consider While Doing Deals in Asia Pacific
While buyers have long considered their financial, legal and commercial risks in the course of M&A transactions, there is increasing awareness in Asia of how insurance can be used to transfer “transaction liability” risks from either the buyer or the seller to the insurance market. In addition, the importance of understanding, prior to signing, how ongoing operational risks can be mitigated by insurance has led to the increased use of insurance due diligence.
Transaction Liability Risks The most prominent transaction liability risk transfer tool is Warranty & Indemnity (W&I) Insurance (sometimes referred to as Reps & Warranties Insurance), which has been in use in Europe and North America since the late 1990s. In the last five years, it has become a staple of the majority of deals in Australasia where private equity is involved and is increasingly being considered on private equity and strategic deals in Asia.
W&I Insurance covers breaches of seller warranties under a Sale & Purchase Agreement (SPA). A seller can use it to backstop or replace their obligations to indemnify a buyer for a warranty breach; a buyer may use it to supplement, back-up or even replace a seller’s obligations. As the breadth of warranties and the related indemnification regime can be major points of deliberation during the negotiation of an SPA, this product is increasingly being used by parties to a transaction to reduce or completely transfer their risk.
While the strategic uses of this product have been understood for some time in Western markets, there is a growing recognition in Asia that insurance capital can help get deals done by offering downside protection to either side in a transaction.
This awareness has been facilitated by a recognition of the strategic uses of the cover which include:
- A seller wanting to have a clean exit and no trailing risk of having to meet a warranty claim;
- Replacement of escrow accounts and distribution of sale proceeds/reinvestment of capital;
- A buyer having collection concerns in the event of a breach-distressed sellers, group of disparate sellers;
- Passive sellers being asked to give warranties where they have not been involved in the day-to-day running of the business
- A buyer entering a new market, wanting to have greater downside protection.
As a result of this increased understanding of how insurance can be used to transfer deal risks, policies have been placed for transactions in Japan, Korea, Greater China, Malaysia, Vietnam and Indonesia as well as Hong Kong and Singapore. Insurers have appetite to underwrite these risks in most countries in Asia, bar those that are subject to sanctions by the United States.
Other examples of “transaction liability” risks where insurance capital can be used to reduce risk include litigation cap insurance (where the potential risk of litigation against a target company can be capped with insurance), successor liability insurance (on asset deals where the newco may be found to be the party that should indemnify third parties for injury/damage arising from historic events) and tax liability insurance.
Ongoing Operational Risks For Target Companies In the past, checking on the insurance for a target has often been seen as something that can be dealt with as a “tick box” item in the course of due diligence (dd), with the legal advisers being asked to provide a summary of the coverage purchased for a target company. However, having the knowledge that there is cover in place is barely useful, if there is no understanding of whether that cover is appropriate and adequate for the risk profile of the business being purchased. It is quite possible that the target may have inadequate cover, or cover that leaves it self-insured. Law firms are not in the business of identifying insurable risks or advising on how these risks are best transferred to the insurance market.
In effect, many purchasers “don’t know what they don’t know” when it comes to this area of risk, so a proper insurance due diligence exercise can supplement any initial work undertaken by the legal dd advisers.
Examples of issues that arise in Asian or Asian outbound deals include:
Lack of sufficient cover for cash flow following damage to property: In many instances, a factory or warehouse in Asia can be rebuilt relatively quickly. However, even if it can be rebuilt in a 6-12 month period, the business may suffer a cash crunch if it cannot deliver products and its customers defect to the competition. Moreover, even when the property is reinstated, it may not be possible to win back customers quickly or easily. We repeatedly find that businesses underestimate this risk (and interdependency risks between different parts of their business and risk of loss due to damage to third-party suppliers and customers). They may have a rudimentary understanding of the risk, but little or no awareness of the risk transfer (i.e., insurance) options available to them, which include cover for loss of profits and ongoing fixed costs, as well as additional expenses that may be incurred.
Natural catastrophe risks: These have been highlighted by the earthquake and tsunami in Japan and the Thai floods in 2011. Increasingly, companies are looking to identify their exposure to “Nat Cat” risks in these and other countries in Asia, e.g., Taiwan (earthquake, windstorm), Philippines (earthquake, windstorm), and Indonesia (earthquake). In some instances, the availability of cover may be restricted or there may be co-insurance clauses applicable, such as being asked to self-insure 20% of earthquake losses in Taiwan. It would be better to be aware of these prior to signing, along with the possible risk transfer solutions that may be available to mitigate such risks.
Insurance cost increase: Buyers in carve out situations not recognizing early on that the stand-alone businesses insurance costs may be significantly higher than they were as part of a larger seller group. The difference between the two costs can be a material number that the buyer may wish to reflect in the transaction price and budgets for the ongoing business.
- Outgoing M&A deals from Asia to North America/ Europe/Australasia: The incidence of insured (or insurable) litigation is far greater than in Asia as are the premium and self-insured deductible costs that a target may face. For instance, in the US there are numerous examples of employment practices liability type claims – harassment, racial and sexual discrimination law suits – which can run into the millions of dollars. Identifying whether there is insurance in place to cover such losses (or the lack thereof) can help a buyer understand its need to negotiate on these items during the M&A process, as well as the availability and cost of insurance solutions that may be available.
Aon M&A Solutions