Trade Credit Insurance

Companies routinely insure their physical assets – their buildings, equipment and inventory. They would not contemplate operating without this protection. Ironically, however, one of their largest assets – their accounts receivable – is often not insured. Yet if it makes sense to insure a building against loss, surely it makes equal sense to insure this large and volatile asset as well.

Credit insurance covers the risk of a company’s customer not paying because of its insolvency or because of a political event that prevents the buyer from honouring its payment obligation. Credit insurance has developed over the past 80 years, based on government-initiated programs in the United Kingdom and Europe, to encourage exports after World War 1. In Europe, trade credit premiums now exceed US$4.5 billion.

Companies exploring the many advantages of credit insurance will quickly recognize that their demonstrated good credit management becomes the cornerstone upon which the insurance relies. Buying credit insurance to reduce or replace the credit management team is seldom a valid reason to buy the coverage. Conversely, for companies without a highly-developed credit team, credit insurance is an unbeatable way to reinforce the necessary decision-making process for evaluating customer risk. The many insurance companies now offering coverage in North America tend to be global in scope with enormous information systems upon which they rely for their credit assessment purposes.

The rapid growth of trade credit insurance in North America is not surprising. Exploring the advantages of this risk mitigation tool is fundamental to the notion of “good stewardship.” While a company may decide against taking advantage of transferring its receivable risk via a trade credit policy, this decision should be made on an informed basis.

PERILS INSURED

The perils insured against in a trade credit policy are determined by the nature of the transaction being covered and by the countries in which the buyers reside. In those instances where country risk is not a concern, the policy will protect against:

COMMERCIAL RISK

Insolvency of the Buyer (the customer)

A court-recognized act of insolvency has occurred. (Insurers list the events that are accepted as indicators of insolvency in the policy.)

Protracted Default

The policy coverage is triggered at a certain point of delinquency (e.g. 90 days past due), irrespective of whether there has been a formal act of insolvency.

In addition to covering the actual goods shipped, it is possible to extend the above coverage to include pre-shipped goods – especially when such goods are designed specifically for the buyer and may not easily be re-directed for sale elsewhere. Some insurers will permit the inclusion of binding contracts coverage in a policy. This allows for the insured, in a restricted set of circumstances, to continue supplying a buyer on an insured basis for a predetermined period of time, even though the insurer has withdrawn a credit limit.

Where country risk is a consideration, the policy will be expanded to protect against political risk.

POLITICAL RISK

These risks arise when political or economic events in a country, typically as a result of government action, frustrate payment for service provided or goods sold or prevent the performance of a contract. The availability of political risk coverage depends upon the risk perception of the country concerned; coverage wordings differ between insurance companies. Insurers constantly update country risk analysis to reflect any pertinent changes. Typical political risk coverage protects against:

Import Embargo

Coverage for loss caused by the cancellation of a valid import license or the imposition of legislation that prevents the importation of goods into the buyer’s country.

Export Embargo

Protects against action taken in the supplier’s country that prevents the exportation of goods before shipment has been made.

Currency Inconvertibility or Transfer

A buyer in a foreign country may wish to pay for the goods or services rendered but, because of a foreign exchange shortage, may not be able to make the payment in the contract because of restrictions imposed by the government. To respond, the insurance company would require proof that the buyer has made a deposit of the appropriate amount and has applied for the foreign exchange.

Public Buyer Default

This coverage protects against the risk of non-performance of contract or non-payment of debt by a Public Sector organization.

Confiscation/Nationalization

Coverage is provided against the possibility that political action in a foreign country results in the loss of assets because of an inability to lay claim to them or return them to the owner’s country. A company making investments overseas would likely wish to expand the coverage through the purchase of specific investment insurance to protect against nationalization and the risk of not being able to repatriate dividends.

Non-Honouring of a Letter of Credit Separate from the risk that the buyer will not pay, this coverage is provided against the economic and political risks associated with the commercial banks involved.

Unfair Calling of a Bond

Coverage is provided against the capricious or politically-inspired call of on-demand bonds that may have been issued in support of a bid or contract performance.

ADVANTAGES OF TRADE CREDIT INSURANCE

In addition to benefiting from bad debt protection, the insured benefits from the genuine partnership with the insurance company and immediately shares in the aforementioned buyer information systems that are administered globally. In addition, the insured is now empowered to take advantage of a competitive advantage: the insured may be able to offer open or longer credit terms, for example, or a higher credit limit because of the transfer of risk to the insurance company. Furthermore, having been enhanced by credit insurance, the insured’s receivables will be viewed in an entirely different light by their lenders. This might lead to increased margining – especially of the export receivables – and quite possibly a reduction in borrowing costs.

The above advantages clearly help to offset the cost of the insurance.

POLICY STRUCTURE AND ADMINISTRATION

The design of a credit insurance policy should accurately reflect the insured company’s appetite for risk and degree of credit sophistication. It is possible to design a policy without a deduc-tible, but most policies risk-share by means of a deduc-tible and co-insurance. Indemnification is usually around 85% of the loss amount, although 100% indemnification is at times achievable.

Policy administration is slight and differs between insurance companies. Some form of reporting of past dues is required; also, the insured is required to maintain its credit procedures as outlined in the application for insurance.

EXPLORING CREDIT INSURANCE

Several credit insurance companies will deal directly with insureds and all of the companies will work with insurance brokers in designing a trade credit program. When electing to deal directly with the insurers, companies somehow need to gain a frame of reference as to how the insurer’s product offering stacks up against what is available elsewhere – from the perspective of both coverage and price.

If dealing with an insurance broker, make sure to question their experience with the product. You likely would not want to have your appendix removed by a dentist; the same kind of logic should apply when considering risk mitigation of your company’s trade receivables.