“Trade credit insurance covers manufacturers, traders and service provides against the risk of non-payment by their domestic or export buyers for goods or services delivered on credit terms. The insurance covers the buyer’s failure to pay the contractual debt as a result of actual insolvency or to pay within a pre-defined period calculated from the due date (known as protracted default)…. The insurance policy pays out a percentage of the outstanding contractual debt, usually ranging 75 to 95% of the invoice amount. In the absence of trade credit insurance many trade transactions would have to be done on a pre-paid or cash basis, or not at all. Trade credit insurance is an essential credit management tool and is used to control risk, obtain vital buyer information and monitor exposure. It provides protection from financial losses and leverage for better financing terms from banks”.
This definition is provided by the International Credit Insurance & Surety Association (ICISA), the first association founded by the credit insurance industry. ICISA was established in 1928 and its members are responsible for more than 95% of the worldwide credit insurance volume within the private market.
The demand for credit insurance results from the standard procedure of selling goods and services on credit. The outstanding sums arising from related sales amount to approximately 30% of an average company’s total assets. Corporations’ face a significant risk of financial difficulties due to delayed payment or even nonpayment of their outstanding trade receivables. In fact, one of four insolvencies in the European Union (EU) is caused by the late payments of buyers. By way of example, in 2006, 37,900 bankrupt companies in Germany had total outstanding receivables of EU 26.7 billion, a sum equal to 1.3% of the Gross Domestic Product (GDP). According a study by the business information specialist Bürgel Wirtschaftsinformationen GmbH & Co. KG, approximately 15% of the bankruptcies in Germany were initiated by a domino effect and follow-up insolvencies in 2013.
By implementing a credit insurance policy, companies can transfer both their commercial and noncommercial risks concerning business transactions partly or completely to designated financial institutions (so-called credit insurance companies). Such credit- or production risks may trigger losses, but such risks can be indemnified by credit insurers in exchange for credit insurance premiums. In this case, compensation for losses will be repaid within a determined amount, if the insured company is not paid by his foreign or domestic customer for its delivery of goods or services without its own fault.
Credit insurance can be used for international and domestic trade. In an international environment, however, business transactions are affected by more widespread risks. While domestic transactions are jeopardized through the creditworthiness of the buyer (commercial/ credit risk), international business transactions are also compromised by political risks, meaning that a foreign buyer might be able and willing to pay his debts, but might be stopped from doing so for political reasons. Therefore, credit insurance enables companies to safely expand credit terms to foreign debtors, thereby supporting business transactions that could not otherwise be realized. On the one hand, credit insurance can cover short-term transactions, allowing payment terms of below one year; on the other hand, credit insurance can also cover medium- or long-term projects, allowing for trade transactions with durations between one and fifteen years. Short-term transactions are regularly covered on the basis of whole turnover, including the entire portfolio of the seller’s trade receivables. By contrast, medium- and long-term transactions are typically insured on an individual basis, protecting trades of capital goods or services with payment periods extending over several years.
Functionality and types of credit insurance:
Credit insurance policies usually cover the entire trade receivables portfolio of an insured company. While the insurer might exclude or reduce credit limits for specific buyers with a deficient creditworthiness, the insured company is normally not allowed to select the individual customers it wants to cover. However, the premium rate of the credit insurance policy reveals the general creditworthiness of the entire buyer portfolio. Most of the credit insurance policies need to be renewed annually, and have premium rates in place, which are related to the insurable turnover of the policyholder. While the premium rate is agreed upon commencement of the policy and calculated on the expected insurable turnover, the insured has to declare its turnover on a regular basis (monthly/quarterly/annually). The effective premiums are invoiced accordingly. Aside from premiums based on turnover, there are policies available, particularly in the German credit insurance market, which calculate premiums on the basis of the insured’s outstanding balances. Nevertheless, in recent years the usage of this premium method has declined. Other policies, mainly used in the US, are determined on the basis of given credit limits.
All credit insurance policies include policyholder retentions, implying that the policyholder needs to bear a certain percentage of a loss on his own account. The percentage is usually fixed between 10 and 20 percent, depending on the quality of the insured’s trade receivables portfolio. In consequence, policy retentions are an incentive for the policyholders to manage their credit risks professionally.
Nevertheless, a credit insurer always has to realize that he will not be able to do any business, if the policyholder is not able to complete sales due to credit limits for the insurable trade receivables portfolio not being granted. At the same time, the insured company also needs to realize that all granted credit limits can always represent a potential loss for the credit insurer, as long as insured and supplied goods or services are not paid for by the designated buyers. In order to resolve this hazardous situation, both parties need to collaborate towards reaching the three main objectives of credit insurance:
- Prevention: Specialized credit underwriters will evaluate each customer of the insured regarding his creditworthiness and his financial capability to pay his debts. Both indicators are monitored constantly. Every credit limit is then determined as the highest balance permitted to be outstanding at any one time for each individual buyer. The best solution for the credit insurer and the insured is to find and agree upon credit limit amounts that enable the insured to achieve the desired sales with its customers. If the credit insurer provides fewer limits than required, this has a direct influence on the insured’s negotiation position towards its customers.
- Indemnity: The credit insurer compensates losses of the insured in case of non-payment by its clients, if both parties have agreed upon a valid credit limit for the specific buyer before the delivery of goods or services.
- Recovery: After the compensation of a loss, the credit insurer will try to recover payments through collaboration with the insured, in order to collect outstanding payments from the buyer. For instance, legal steps can be initiated to certify that the buyer pays the outstanding invoices. Another opportunity might be a consensual payment plan, meaning that the buyer agrees to pay back his debts over a certain period of time.
Taking all of the aforementioned objectives of credit insurance into consideration, this instrument offers policyholders several benefits mitigating the permanent risks of non-payment or late payment by their buyers. Credit insurance shifts these risks to the credit insurers, which are able to shoulder them by using their financial strength, diversification and credit assessment knowhow. The main result of this risk transfer is that the insured company receives balance sheet protection against unforeseen losses, financial strains or even insolvency. Furthermore, the earnings volatility can be reduced and access to better financing and credit conditions from banks can be improved, as many banks require credit insurance as a kind of security. In addition, policyholders can take advantage of the risk expertise of the credit insurer by gaining access to specialized advice. As part of this, the business’ credit management can be supported or possibly outsourced, in order to save costs. Finally, credit insurance strengthens policyholders in the negotiation process with their buyers, since they are allowed to offer expanded credit terms, instead of demanding securities or cash advances. Extended credit terms are now especially used in many industries, as buyers improve their working capital by expanding their terms of payments with their suppliers.
While most credit insurance policies cover the entire trade receivables portfolio of an insured company, the credit insurance market has developed more specific and adapted policies over the years, thereby expanding its product offerings with the intention of meeting the sophisticated needs of its customer base. Firstly, some credit insurers offer named-buyer contracts, meaning that in contrast to whole turnover policies, only a certain number of named buyers are covered. Secondly, some insurers provide single risk policies, implying that only one debtor is insured. Furthermore, there are excess-of-loss credit insurance policies available, covering large losses, which exceed a pre-determined deductible. On the whole, within excess-of-loss policies the insured company decides the credit limits on its own, following the instructions of a defined credit risk manual, which is audited and agreed upon by the credit insurer. For this reason, excess-of-loss policies comprise an aggregate first loss amount, below which the credit insurer has no obligations to pay any indemnification for incurred losses. The amount is usually fixed at the average loss ratio over the last five years, entailing that the insured company is only protected against catastrophic losses.
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