Credit insurance is a risk mitigation tool, not a means of payment,
and covers a buyer’s failure to meet its debt obligation on time due to
protracted default (slow pay) or insolvency. In the event of a claim,
the insured provides the insurer with all documentation of the transaction
and, once validated by the insurer, receives payment less any agreed retention
(such as coinsurance and/or deductible and negotiated fees).
Credit insurance is widely used by companies selling on open account
terms since it provides security against non-payment and 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 the world of trade there are methods available to mitigate credit
risks. As indicated in the chart below each risk mitigation strategy has
its strengths and issues.
Alternative
Benefit
Issues
Captive Insurance / Self Insure
Definition
Bad debt reserve. No transfer of risk from balance sheet.
• May be cost effective over the long
term
• No exclusions
• Flexibility to respond to issues
• Can create liquidity problems, especially
for unforeseen risks.
• May reveal operating weaknesses
• Requires significant monitoring and strong internal credit risk and auditing
controls.
• No alternative “bad cop” to soften difficult discussions with clients
that are slow to pay.
• May not be as well tuned in to the credit worthiness of clients.
Collateral
Definition
Transfer of risk from balance sheet using cash (pre-payments), LC’s, other
assets (i.e., liens). Type of collateral depends on transaction.
• Provides mechanism for quick recovery
• Most letters of credit are unconditional obligations
• May be difficult to obtain for the
company may be unable/unwilling to provide
• Requires some administration to maintain security position. (For example,
filing UCC statements, monitoring escrow accounts, and/or proper execution
of L/C documents).
• May damage the relationship with the client if you have to move against
the asset
Surety Bond
Definition
Bond issued by insurance company that guarantees performance. Primarily
used in the construction industry.
• Provides mechanism for recovery
• Relies on third party for payment
•Seldom contain covenants or triggers that restrict credit in the event
of a change in the financial condition
• Most surety bonds are conditional obligations
whereby the insurer has the right to examine the claim, so it is difficult
to assess the probability of rejection.
• The loss of surety coverage due to economic conditions may curtail the
company’s business activities.
• Currently, insurers have requested higher premiums, non-renewal for lower
credit quality clients, or request for collateral.
Credit Derivative
Definition
Securities bought or sold to protect against adverse change in credit factors
• Does not require proof of loss to obtain
recovery
• Clearly defined triggers for recovery
• Liquid trading market allowing creditor to take action prior to default
• Can accommodate sizeable exposures for up to 5 years
• Limited to companies that have issued
bonds
• Incur counterparty risk
• More expensive when compared to other forms of credit protection
• Triggered by defined event so no recovery based on extended receivable
aging
Credit Insurance
Definition
An insurance policy that covers the losses that are the result of receivables
being unpaid.
• Designed for single buyers or entire
A/R portfolio
• Covers late payment as well as bankruptcy
• Cost effective. Often, a US exporter’s cost of processing documents for
their export L/C’s are higher than costs associated with credit insurance
policies
• Accommodates both Sizeable and smaller exposures; rated and unrated companies;
delivered product and trading operations.
• As credit quality deteriorates, coverage
may be cancelled (depending on carrier)
• Coverage is conditional
• Policy Term is one year; most policies now have “evergreen” provisions
• Party seeking protection bears the cost so the buyer may not know coverage
is being purchased.
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
Insurable Risks
Insurable Perils (dangers, hazards)
Insolvency/Non Payment (due to either
commercial or political events)
Confiscation
Expropriation
Nationalization
Deprivation
Forced Abandonment
Business Interruption
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 cover, 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
