Trade Credit Insurance: Better to Have Than to Have Not

In order to close a sale of its products, almost all companies need to provide their customers with commercial credit facilities. This implies that they will deliver the goods, issue an invoice and allow the client to pay that invoice at a later stage, often 30-90 days. This way, the client can sell those goods, make a profit and thus generate the cash to pay the invoice.  

As clear as it is, that there is almost never trade without credit, it should be just as clear that there is also no credit without risk. As companies grow, the total value of this trade credit, reflected in Accounts Receivables (A/Rs) on the balance sheet, quickly represents the single largest item among current assets. However, it is surprising how few companies really dedicate the necessary resources to the management of this significant risk, not to mention how few in Mexico are actually using Trade Credit Insurance to protect this asset against the risk of nonpayment. In this brief article, I will show how  Trade Credit Insurance is an efficient, quite affordable and multipurpose instrument to do just that.

Trade Credit Insurance protects the account receivables of a company against nonpayment caused by insolvency or protracted default. Insolvency means a company goes into bankruptcy or (the equivalent of the US’) Chapter 11, while a protracted default means a company recognizes it has an obligation to pay, but does not have the money to do so. In Mexico, there is a variant called “de-facto insolvency,” a situation where a company does not even bother to go through an insolvency process, but just disappears, which is also covered. This way, this important asset is protected against unforeseen risk events that can seriously affect the company’s cash flow and financial stability. Companies can run into financial difficulties for many reasons, but unexpected loss of cash flow from account receivables ranks among the Top 3.

By teaming up with a large trade credit insurance company with global reach, companies gain access to this insurer’s vast resources regarding their clients, both in Mexico and around the world. A key element in the structuring of a policy is obtaining “insured limits” from the insurer for each of the clients. Insurers tend to have much better access to information about these client’s creditworthiness and function as a great source of advice about to whom to sell on credit terms, for how much, or maybe not at all.  

But there are reasons other than “not losing sleep over your A/Rs” that make this insurance coverage interesting for companies. Under the policy, companies must comply with reporting some basic information to the insurer, such as how much they sell on credit to which client, inform when the invoice has not been paid and what actions it has taken to obtain payment. Strange as it may sound, many companies mention that this improvement of structure in its risk management is another major advantage of having this insurance, as it complements existing procedures, adds discipline and significantly increases the amount of information available on its customer portfolio. Also, companies tend to see their sales increase, as it can start selling on credit to prospects based on creditworthiness information provided by the insurer, whereas before, sales were not completed due to the lack of this information, especially when it concerns trying to open new (international) markets.

Having trade credit insurance in place can also help monetizing A/Rs more efficiently through bank financing. When a company can transfer the rights under the insurance policy to its lender, this reduces the risk the lender is taking on, which should translate to more or cheaper financing, as the bank’s reserve requirements are reduced because of this protection it obtained. Last, but not least, trade credit insurance is a much more liquid and efficient form of protecting account receivables than the more traditional instruments like guarantees and mortgages, and much cheaper than letters of credit.

So how does this protection operate in practice? First, the partnership between insured and insurer focuses on maximizing sales while, at the same time, preventing the nonpayment of a receivable. Not only does the insurer perform an analysis of the existing credit portfolio at the beginning, but throughout the lifetime of the policy, the quality of the receivables is monitored, using all information sources available to the insurer. For example, the insurer may obtain negative information on a customer from other insureds, therefore being a step ahead and in a position to advise a company to be careful. But nobody has a crystal ball, so inevitably delays in payment of receivables may occur. If so, the insured and the insurer team up to reduce the potential loss amount, by finding the best way to obtain payment of the past-due invoice. This can happen for example by jointly pressing for payment, using debt collection agencies or sometimes allowing additional insured sales in exchange for a payment plan, while at the same time sharing the expenses related to these actions. And if all these actions do not prevent a loss because of nonpayment, the insurer provides liquidity to the insured through the payment of a claim, after which necessary actions to recover the loss, ranging from reporting the debtor to the Credit Bureau or legal actions, will continue..

Teaming up with a trade credit insurer brings numerous advantages to a company, from being protected against nonpayment of receivables to access to the insurer’s global information sources about the creditworthiness of its customers. How much this coverage costs is impossible to answer, as it depends on many variables, including insurable sales volumes, products and sectors, export or domestic (or both) sales, concentrations in the customer portfolio, the amount of the deductible and/or percentage of co-insurance (usually 10%). The premium is calculated as a fraction of a percentage point over insured sales. But remember, the most expensive insurance is the insurance one does not have when a significant loss occurs.

Written by Karel van Laack, President of Holland House Mexico.