Using Credit Insurance to Lower Bad Debt Reserves

Many companies self-insure against bad debt losses. Accounts receivable is often the only tangible asset on the balance sheet not insured. Companies often have substantial bad debt reserves in recognition of the fact that sooner or later one (or more) of their customers will file for bankruptcy protection, or default in some other way on payment.

One alternative is to purchase credit insurance that covers the entire accounts receivable portfolio. Once a credit insurance policy is in place, a company may be able to reduce its bad debt reserve significantly. In effect, a credit insurance policy can "cap" a company's exposure to unexpected and catastrophic credit losses. Credit insurance eliminates risks by transferring them to the insurer.

Even with a credit insurance policy in place, it is difficult to determine how much of the company's bad debt reserves can be "drained." Some of the limiting factors include these issues:

• Coverage will be denied to some customers.
• The company may elect only to purchase coverage for a certain portion of its accounts receivable. (For example, it is not uncommon for companies to insure only their foreign accounts receivable.)
• Some customers will not qualify for the dollar amount of amount of coverage requested.
• Insurance policies typically include an exclusion for losses below a certain dollar amount - so not all accounts and not all losses will be covered.
• Amounts outstanding prior to the effective date of the policy are not covered.
• The fact that the debt must be undisputed to qualify for coverage.
• Policies come with an annual deductible and a per loss co-payment or deductible - each of which must be factored in when determining the appropriate bad debt reserve.

All of these factors make it difficult to know exactly how much the bad debt reserve can be reduced. What is clear is that some adjustment to the reserve must be made once a credit insurance policy is in place --- so credit insurance can be used to lower (but not eliminate) bad debt reserves.

Source: Michael Dennis, author of "Credit and Collection Handbook" available at the NACM Bookstore.