Credit Insurance

Credit insurance is a risk mitigation tool. It covers a buyer’s failure to meet its debt obligation including protracted default or insolvency. In the event of a claim, the insured party must provide the insurer with all documentation of the transaction.  Once the claim is validated by the insurer, the creditor receives payment less any agreed retention (such as co-insurance and/or deductible and negotiated fees).

Credit insurance is used by companies selling on open account terms since it provides security against non-payment, and it is recognized by most banks as security for receivables included in a borrowing base. In addition, credit insurance is a valuable tool for monitoring credit risk, with both the insurer and the insured working together to identify, and reduce, potential default risks and prevent claims.

1. Political and Commercial Risk

Credit insurance policies cover Commercial Risk or Commercial and Political Risks. Domestic policies, those covering only shipments originating and delivered in the same country, cover Commercial Risk – buyer protracted default (slow pay) and/or insolvency. Export policies, covering shipments originating in one country and delivered to a buyer in another country, cover both Commercial Risk and Political Risk. In brief, a Political Risk is defined as an action, taken by a government, which prevents payment for the goods shipped and/or prevents retrieval of the goods by the insured. It is important to keep in mind both criteria for a Political Risk event because if they are not both present, then a claim filed by the insured would have to be a Commercial Risk claim.

One common mistake is to assume that a currency devaluation is a Political Risk event. Keeping in mind the definition, currency devaluation is a government action but, does it prevent payment? No, devaluation may simply make payment much more expensive and may, in fact, cause a buyer to default on payment to the insured. If this should happen, then the insured would file a Commercial Risk claim with the insurer.  In most comprehensive insurance policies, those insured want to protect against both commercial and political risks. Insured companies will normally insure between 80 % and 90% of the commercial (credit) risk and 85% to 100% of the political risk in a transaction.

The total risk not covered by the insurer is called retention, since the insured “retains” responsibility for some amount of the risk. Retention is composed of the coinsurance – expressed as a percentage – and deductible (sometimes called primary loss or first loss) – expressed as an absolute dollar amount.  Insurers are willing to take on payment risk in partnership with insureds. Therefore, insurers want insureds to retain some financial stake in all covered open account sales – encouraging insureds to work with reputable buyers and providing incentive to pursue collection aggressively. Since the insured has some measure of control over commercial risk, sharing the risk between the insured and the insurer is prudent. On the other hand, political risk events are outside the control of the insured; therefore, insurers are more willing to take on a greater level of responsibility for political risk.

2. Options Available to Manage Credit Risk (Alternatives, Benefits, Issues)

In international trade, there are tools and methods available to mitigate credit risks. As indicated in the chart below, each risk mitigation strategy has its strengths and issues.

3. Credit Insurance Terms/Phrases 

Policy Face Amount: The maximum amount the insurer will pay out in claims for losses covered under the policy.

Discretionary Credit Limit (DCL): The DCL gives the insured the authority to extend credit to new buyers without seeking the approval of the insurer based on the insured’s established credit procedures and/or other qualifying criteria specified in the policy.

Policy Period Deductible: In the event of a claim filing, the amount retained by the insured before the insurer begins to make payment.
 

Insured Percentage of Coverage: The insurer is essentially shares the risk with the insured, up to a certain percentage on each claim. In the case of a claim, the insurer agrees to pay the indicated percentage of the loss, after subtracting out the deductible

Premium Rate: This rate, multiplied by the sales volume, calculates the premium.

Minimum Premium: This amount is indexed to the insured’s estimated annual sales figure, multiplied by the premium rate and represents the base premium due to the insurer for the policy year.

Premium: The premium payment required at the inception date of a policy.

4. Risk Categories

5. Other Guarantees Linked with an Exported Product

A credit insurer provides other types of insurance:

• Insurance for corporations having subsidiaries abroad. For companies trading internationally, a credit insurance policy can be endorsed to cover shipments from foreign subsidiaries as though the shipments originated at the head office. Such an endorsement generally includes wording requiring that, in the event of a claim filing, the receivable must be assigned by the subsidiary to the parent so that it may then be assigned to the insured, under the terms of the policy.

• Manufacturing risk guarantee or work in progress. This coverage provides the insured with protection against losses incurred when goods are produced but not shipped due to the insolvency of the buyer or due to a Political Risk event that prevents shipment. It is important to note that this type of coverage is beyond the scope of the traditional credit insurance policy since it provides coverage even though no receivable has yet been created.

• Bid bonds or performance bonds or advance payments, or retention bonds or guarantees. These instruments protect the exporter against any unfair first demand call on those bonds.

• Goods exposed in a foreign fear can be guaranteed against the political or catastrophic risk for a maximum of 6 months.

• Goods in a consignment stock could be insured for a period of 12 months.

• Export insurance could be extended as well to the exporter abroad on his behalf. The guarantee is applicable on the final buyer risk.

• Protection of the investment abroad. A corporate can insure its new production unit in a foreign country against the political cause of loss: expropriation, war, non-transfer.

• Other coverage such as, supplier default, breach of contracts, trade fair insurance etc.

6. How to Purchase Credit Insurance

There are several ways one can purchase credit insurance:

• direct from an insurance company through a licensed agent, or
• from a global insurance brokerage company or a regional specialist credit insurance brokerage company. 

There are several steps to buying credit insurance:

• completing of a credit insurance application that lists the names and addresses of top buyers and the required credit limits.
• providing a copy of your credit procedures, accounts receivable aging, loss history
• policy administration may include reporting to the insurance carrier your exposures/sales for the buyers at the end of each calendar month, and/or notification to the insurance company 

Date:
August 2005

Contributors:
David G. Clark, Vice President, Euler Hermes ACI, http://www.eulerhermes.com/group/en/index.html
Paul Beretz, Pacific Business Solutions