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Euler Hermes ACi

Companies would be wise to protect themselves against commercial and political risksbeyond their control.

Financial executives must continuously balance the cost of doing business with the risk of doing business. Each time a dollar of revenue is produced, all costs incurred by generating that dollar are thoroughly analyzed in an effort to maximize the profit margin. The hundreds of billions of dollars in losses associated with bad debt charge-offs in 2002, however, brought new attention to managing trade receivables.

Accounts receivable, which typically represent more than 40 percent of a company’s assets, are a vital component of a healthy business. If a major customer is unable to pay its invoices, or if several customers are unable, there will be a negative impact on cash flow, earnings and capital. In a worst-case scenario, this could literally put a company out of business. These risks, therefore, require thorough analysis.

In the face of today’s changing domestic and global economic climate, recognizing and managing future risks has become a priority for business leaders. Losses attributed to nonpayment of a trade debt or bankruptcy can and do occur regularly. Default rates vary by industry and country from year to year, and no industry or company is immune to trade credit risk. Indeed, the Euler Hermes Global Index of Business Failures predicts a 51 percent increase in U.S. business insolvencies in 2007.

Financial executives should weigh the cost-benefit of several options in an effort to mitigate trade credit risk. Each one should be investigated carefully to determine the best fit for a specific company. Some of the more common methods are self-insurance, factoring and trade credit insurance.

Self-Insurance

Many companies choose to self-insure in the form of bad-debt reserves. This fund is available to offset the deficit should any of their customers become unable to pay, but it also impacts other areas of cost, including:

• Investments in credit management resources;
• Investments in systems;
• Investments in information acquisitions, analysis and management;
• Impact on sales given risk tolerance; and
• Impact on capital allocation of the balance sheet.

Factoring

A factor is a company that typically purchases other companies’ accounts receivable at a reduced amount of the face value of the invoices. These discounts may range from 1 to 10 percent, based upon a variety of reasons. This gives a company immediate access to cash in exchange for a percentage of the receivables’ value, plus a fee. Many factors will also offer invoicing, collections and other bookkeeping activities for companies looking to outsource the entire accounts receivable function. Some factors will assume the risk of nonpayment of the invoices they purchase, while others will not. Other cost impacts when working with factors include:

• Considerable margin erosion;
• Loss of control of customer relationships; and
• Line availability.

Trade Credit Insurance

Trade credit insurance is a business insurance product that indemnifies a seller against losses from nonpayment of a commercial trade debt. With trade credit insurance in place, the seller/policyholder can be assured that nondisputed accounts receivable will be paid by either the debtor or the trade credit insurer within the terms and conditions of the policy.

Trade credit insurance is a financial tool to hedge against both commercial and political risks that are beyond a company’s control. Balance sheet strength is ensured, cash flows are protected and loan servicing and repayments are enhanced. A trade credit insurance policy also allows companies to feel secure in extending more credit to current customers, or to pursue new, larger customers that would have otherwise seemed too risky.

The protection provided by trade credit insurance allows a company to increase sales to grow its business with existing customers. Insured companies can sell on open account terms, whereas they may be restrictive or only sell on a secured basis without such protection. For exporters, in particular, this can be a major competitive advantage.

The Case for Trade Credit Insurance
Companies invest in trade credit insurance for a variety of reasons, including:

• Sales expansion – if receivables are insured, a company can safely sell more to existing customers, or go after new customers that may have been too risky without insurance;
• Expansion into new international markets;
• Better financing terms – in many cases, a bank will lend more capital against insured receivables and may also reduce the cost of funds;
• Reduction of bad-debt reserves – This frees up cash for the company. Also trade credit insurance premiums are tax deductible, but bad-debt reserves are not; and
• Indemnification from customer non-payment.

While indemnification is the reason most companies cite for purchasing trade credit insurance, the most common driver is to increase sales and profits.

As an example, a wholesale company’s credit department had granted a credit line of $100,000 to a customer. It then purchased a trade credit insurance policy, and the insurer approved a limit of $150,000 on that same customer. With a 15 percent margin and an average DSO of 45 days, the wholesaler was able to increase its sales for an incremental annual gross profit of $60,000 on that one account alone.

Trade credit insurance can also improve a company’s relationship with its lender. In some cases, the bank actually requires trade credit insurance to qualify for an asset-based loan. For example, a $25 million scrap metal dealer had extreme concentration in its accounts receivable because it only had eight active accounts. The smallest of these customers had A/R balances in the low six-figure range, and the largest was into the low seven-figure range. The company’s bank was concerned about this concentration and required trade credit insurance in order to include the A/R as collateral. The scrap metal dealer purchased a trade credit insurance policy that specifically named all of its buyers, providing the bank the comfort level it needed.

In fact, the bank increased the advance rate from 80 to 85 percent. The net result was that the scrap metal dealer was able to obtain an additional $400,000 in working capital, thanks to its trade credit insurance coverage. The cost of the policy was $25,000, so the return on this investment was excellent, and the scrap dealer was able to use the additional cash to continue to fund the growth of the company.

The Philosophy of Trade Credit Insurance

As important as it is to know what trade credit insurance is, it is equally important to know what it is not. Trade credit insurance is not a substitute for prudent, thoughtful credit management, and sound credit management practices must be in place before a trade credit insurance policy is bound. Additionally, trade credit insurance does not cover fraud. However, the coverage does attach to disputed invoices, but only if the dispute is resolved in favor of the insured.

The process of insuring accounts receivable is based upon an understanding of a company’s trade sector, risk philosophy, business strategy, financial health, funding requirements and internal credit management expertise. The ultimate goal is not simply to indemnify losses incurred from a trade debt default, but to help the insured avoid catastrophic losses and grow its business profitably. The key is having the right information to make informed credit decisions and, therefore, avoid or minimize losses.

A trade credit insurance policy does not replace a company’s credit practices; rather, it supplements and enhances the job of a credit professional. The best credit insurers will invest heavily in the development of proprietary credit and financial information and also will employ risk analysts, as well as industry- and country-based underwriters in many geographic locations in order to have a close physical presence to its customers’ buyers. The better credit insurers will also analyze payment information about its policyholders’ buyers to identify early signs of financial trouble.

These risk analysts research and evaluate information about individual buyers and use that information to extend, deny or hold down credit limit requests to the policyholders. Having access to this private information allows companies to make more informed decisions about how much credit to extend to which buyers. More importantly, it enables companies to avoid losses through the close monitoring of their customers.

How Does a Policy Work?

Unlike other types of business insurance, once a company purchases trade credit insurance, the policy does not get filed away until next year’s renewal; rather, the relationship becomes dynamic.

A trade credit insurance policy can change often over the course of the policy period, and the credit manager plays an active role in that process. The better-established credit insurers are “limits underwriters,” meaning that the policyholder’s more significant buyers will be analyzed individually and each assigned a credit limit for coverage. This is where the type and amount of information the insurer collects on a buyer plays a key role in monitoring, because credit limits are assigned based on the information available about that particular buyer.

Throughout the life of the policy, the policyholder may request additional coverage on a specific buyer as needed. The insurer will then investigate the risk of increasing the coverage and will either approve it or decline with a written explanation. Similarly, policyholders may request coverage on a new buyer with which they’d like to do business.

It is the trade credit insurer’s responsibility to proactively monitor its customers’ buyers throughout the year to ensure their continued creditworthiness. This is accomplished by gathering information about buyers from a variety of sources, including visits to the buyer’s place of business, public records, data supplied by other policyholders that sell to the same buyer, receipt of financial statements and so on. When signs indicate a company is experiencing financial difficulty, the insurer notifies all appropriate policyholders of the increased risk and establishes an action plan to mitigate and avoid loss.

The ultimate goal of a trade credit insurance policy is not just to pay claims as they arise, but to help policyholders avoid foreseeable losses. If an unforeseeable loss should occur, the indemnification aspect of the trade credit insurance policy comes into play. In these cases, policyholders file a claim with supporting documentation, and the insurer pays the policyholder the claim benefit, typically within 60 days from the date of the loss. For a company’s less significant buyers, a trade credit insurer will often cover these accounts under a blanket, or self-underwritten type of cover, known as a “discretionary credit limit.”

The insurer does not individually underwrite all buyers that fall under the discretionary credit limit; rather, it is the policyholder’s responsibility to establish minimal acceptable credit criteria and be aware of any warning signs that these buyers’ creditworthiness is deteriorating. If one of these accounts should become unable to pay and the event was not foreseeable, the insurer will pay a claim up to the predetermined amount established within the policy parameters and qualified by the credit professional.

Trade Credit Insurance for Everyone?

Trade credit insurance can be a smart investment for many companies, but it may not apply to retailers or companies that sell exclusively to governments, since it only covers business-to-business accounts receivable.

For the most part, however, any business that conducts business-to-business trade transactions is essentially investing in a trade credit insurance program. It is the sum of the costs associated with their risk philosophy, sales avoided, systems, credit/financial information, accounts receivable management, collection and insolvency management, etc. All are real costs that should be weighed against the cost of outsourcing these functions to a competent credit insurer and the resulting benefits the company would derive.

In the face of the Federal Reserve’s repeated raising of interest rates in 2005–2006, soaring energy prices, geopolitical events, natural disasters and challenges in key industry sectors (automotive, airline, etc.), the global economic climate requires more vigilance than ever from our business leaders.

A trade credit insurance policy, if used properly, provides a valuable extension to a company’s credit management practices – a second pair of objective eyes when approving buyers, as well as an early warning system in the event things decline so that exposure can be effectively managed. And, ultimately, should an unexpected loss occur, the trade credit insurance policy provides indemnification, thus protecting the policyholder’s revenue and bottom line. By maintaining a strong relationship between the insurer and the credit management department, trade credit insurance may be the wisest investment a company can make to ensure its profits, cash flow and capital are protected.