Insurance Due Diligence – Ignore it at your Peril!

The very mention of insurance is generally enough to glaze the eyes of the listener!  As number 37 on a check-list of 25, it has a very low priority in most transactions.  However, as this article demonstrates, it has a vital part to play and is critical to the success of most commercial transactions – especially where a bank is involved.
 
To be effective, insurance due diligence (IDD) must look back - on past risk exposures, coverage and claims experience; look at the present - at insurance in force and compliance with any obligations imposed on the client; and look to the future - to assess if there are any foreseeable factors that might affect the availability or price of insurance which, in turn, might skew the viability of the transaction.  This should be done with an eye to the requirements of the various contract documents that control insurance – the loan agreement, leases and construction contracts – as well as considering best practice. 
 
Before considering the IDD process, it is important to consider the role that insurance can play in facilitating a deal that might otherwise collapse.  The requirement for these insurances often stems from the legal due diligence.  It is therefore important that the insurance advisers and the lawyers work closely together.  A simple insurance solution might be all that is needed to get a stalled deal on track again.
 
The sale and purchase agreement will impose certain warranties and indemnities upon the vendor – if indeed they are in a position to assume them.  This is not always the case with a bank or trustee.  It is also sometimes of concern that the party giving the indemnity has adequate financial substance to meet any substantial claim.  Warranty and Indemnity insurance may provide solution that the bank needs to be happy that adequate funds would be available in the event of problems.  The same goes for tax advice and other deal-critical issues for which indemnity insurance may be available.
 
This is a very specialist area which needs to be considered at an early stage in the process.  It usually takes several weeks to obtain firm quotations, during which time the underwriters will be undertaking their own due diligence.  Although substantial limits of indemnity – in excess of £100m – are available in the market, these take time to organise, both within the UK and overseas.  It is certainly advisable to employ a broker with established experience in this field – of which there are not many.
 
More frequently encountered is a group of policies known as legal indemnities.  These are designed to provide protection in the event that an identified legal issue damages the financial viability of an investment.  Of these, defective title and restrictive covenant policies are most often uncovered.  They may have been arranged by a previous owner, in which case the cover may need to be updated, or arranged just in response to a problem that is discovered during the transaction. 
 
The policies have a common basis of cover – to indemnify against damages that a court might award, meet the legal costs of defence and the subsequent impact on the value of a property.  Following a series of high profile cases against developers, there is an increasing demand for rights of light insurance where the cover also extends to meet the costs of demolition or adaptation of the offending property and the subsequent loss of market value.  Loss of rental income may also be covered.  Finally, especially in relation to planning issues, it is possible to insure against the costs and consequences of a judicial review demanded by an objector to a scheme. 
 
A starting point in undertaking IDD is the bank’s requirements under the loan agreement.  These often require changes to the existing insurance or, in extreme cases, even the arrangement of replacement or additional cover that is compliant.  If the client is a bank, confirming that all the requirements have been met is a fundament element of the IDD project.
 
Also critical to any DD role is accurate documentation.  Unfortunately, this is often not available – at least at the start of the process.  Copies of the actual policy documents - with full schedules and up-to-date endorsements, together with the reinstatement valuations and accurate rent schedules – should be vetted.  It is all too common to be given an assurance that the insurance is compliant – only to discover later that it is not. 
 
Looking backwards involves an analysis of past claims experience.  This can identify trends that might influence a decision to proceed with the deal, or at least the price.  It also involves looking at past premium levels to gain satisfaction that there has not been some recent adjustment to improve the attractiveness of the deal.  Are there any outstanding premiums that might have to be paid by the purchaser post completion?  If the deal is a corporate rather than asset based one, the purchaser may have to take over the existing insurance and the arrangements for placing it.  Of course, it might be possible to change brokers mid-term, even if the insurers have to be retained.
 
The cover provided by public and employers liability insurance - for damages and legal costs resulting from claims for personal injury and property damage - is on a claims occurring basis.  The policy in force when the incident happened is the one that responds, rather than the one in force when the claim is notified.  It is therefore important to establish, via insurance archaeology, a clear record of past insurance to ensure that any claim arising from an historic incident can be referred to the relevant insurers.  Liability claims can be considerable and adequate cover is essential, even if it has to be arranged on a retroactive basis. 
 
There may be outstanding risk improvement measures required by the insurers that should be identified.  Otherwise, they may undermine the viability of the deal.  It should also be established that there is no known reason why the current insurance could not be maintained by the vendor.  It might be that the insurers have already notified their intention not to renew a policy.  That might make life difficult for the purchaser.
 
Why is insurance so often left until the last stages of the transaction when it causes delays, rather than being given the attention that it deserves?  Even if the IDD is done at an early stage, insurance issues that require rectification are still left until the last minute - sometimes until it is too late.
 
Insurance should be taken seriously and recognised as a critical element of any successful commercial transaction.  Detailed and expert consideration during the due diligence process will lead to a more secure outcome, helping to avoid some of the problems that so often follow the completion of a dream deal that turns into a nightmare.
 

Bill Gloyn is Chairman of the British Property Federation insurance committee; Treasurer and Past President of the City Property Association and a member of the RICS insurance forum steering group.  He recently led the JLT team advising on the acquisition of an interest in the Meadowhall Shopping Centre.
 
Mr Gloyn can be contacted by phone on +44 (0)20 7528 4646 or alternatively via email at Bill_Gloyn@JLTGROUP.COM