Credit insurance for European SMEs

Transcription

1 Credit insurance for European SMEs A guide to assessing the need to manage liquidity risk Enterprise Guides Directorate-General for Enterprise European Commission

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3 This document was prepared by the Access to finance unit of the European Commission s Directorate-General for Enterprise. For further information, contact: European Commission Directorate-General for Enterprise Access to finance unit B-1049 Brussels Fax: (32-2) : entr-finance-sme@cec.eu.int A great deal of additional information on the European Union is available on the internet. It can be accessed through the Europa server (

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5 Table of contents LIST OF FIGURES AND TABLES...IV SUMMARY... V 1 INTRODUCTION THE RATIONALE OF CREDIT INSURANCE THE PRODUCT CREDIT INSURANCE DIFFERENTIATION FROM OTHER INSTRUMENTS THE CREDIT INSURANCE INDUSTRY THE CREDIT INSURANCE MARKET CREDIT INSURANCE OFFERED FOR SMES CREDIT INSURANCE FOR SMES CONCLUSIONS ADVANTAGES FOR SMES DISADVANTAGES FOR SMES CONCLUSIONS BIBLIOGRAPHY ANNEX SME ORGANISATION S SURVEY III

6 List of Figures and Tables Figure 1: Average payment period for SMEs sales invoices in Figure 2: Credit Insurance Relationship...5 Figure 3: Basic Components of a Credit Insurance Relationship...6 Figure 4: Alternative instruments to cope with the liquidity transfer or non-payment risk inherent in a trade credit transaction...10 Figure 5: Major Companies Estimated Share in World Credit Insurance Premiums and Ownership Structure...11 Figure 6: Leading Companies Premium Income from Credit Insurance Figure 7: Credit Insurance World Market 1998 (Premiums)...12 Figure 8: Credit Insurance Penetration Rates, Europe Figure 9: Domestic Share of Credit Insurance Premiums (1996, in %)...14 Table 1 European Business Insolvencies *...3 Box 1: Questionnaire: Perception of Credit Insurance...17 Box 2: Example of a Credit Insurance for SMEs...19 IV

7 Summary The purpose of this guide is to raise awareness of one aspect of SME s financial management that is often overlooked the risk of liquidity constraints caused by customer failure. Providing trade credit is common practice for SMEs, whether as an element of their marketing approach or because they are forced to do so by larger enterprises. On average, European SMEs have to wait for 50 days to get paid. 50 days during which they lack the liquidity associated with the trade credit transaction and bear the risk of not being paid at all. The recent increase in business failures in Europe clearly underlines the risk inherent in trade credits Financial difficulties are ranked highest among the causes of business failures, thus the counterparty s insolvency might be ruinous for the SME providing trade credit. Managing counterparty risk is therefore essential for SMEs. The basic findings are: 1. By granting trade credit, companies provide liquidity for their customers and take the risk of not getting paid. Credit insurance is one possible option to cover this risk and to avoid severe liquidity constraints, which might otherwise put the SME s existence at risk. 2. Credit insurance is one of several instruments for managing short-term liquidity risks in business-to-business activities and for improving a company s risk management. It is not a substitute for long-term loan finance and generally not suitable for business to consumer activities. 3. With an 83 % share of the total market volume, the European market forms the largest regional market segment of a concentrated world credit insurance market. 4. For SMEs with a number of low-level transactions or with small business partners about whom little information is available, the costs of monitoring risks, analysing customers and drawing up insurance contracts are hard to justify. In the case of an SME doing business with similar companies, the monitoring costs will constitute a fixed cost, resulting in a tendency for SMEs serving larger customers to enjoy more favourable insurance conditions. 5. The standard insurance contract covers the trade credit risk of all the company s buyers for standard premiums of around % of the turnover. This may absorb a significant fraction of an SME s profit margin. After a period of mergers and acquisitions in the insurance industry and an increasing number of insolvencies, the premiums are tending to rise and the insurers risk assessment (rating) procedures are becoming progressively stricter. Therefore credit insurance does not seem to be the next best option when, because of economic pressure, other financial V

8 sources become unavailable. Rather it is an option for profitable, well-managed SMEs. 6. Given that usually the total outstanding turnover is covered by the insurance (and is therefore the basis for calculating the premium), from the SME s point of view the potential benefits of insurance rise with the concentration of turnover among (and dependence on) a limited number of clients. 7. Given a set-up period of 6 to 9 months and the potential monitoring costs, credit insurance is more an instrument for SMEs doing business with their customers on a regular basis in a long-term relationship. This is especially true for exporting SMEs, for example for those exporting to countries with an unknown or insufficiently transparent legal framework and those with significant problems of late payments. 8. Product and process innovations, implementing simplified and standardised contracts, and using Internet-based solutions to speed up information exchange and to decrease costs are increasing the appropriateness of credit insurance for SMEs. However, the principle of insuring a bundle of single contracts with different customers sets a natural border for cost cuts and reducing complexity. The opinions published by the industry association and received via a survey from SME organisations indicate that costs and complexity are calling into question the adequacy of credit insurance for SMEs. 9. The central recommendation of this paper is that SMEs must be aware of the risks involved in giving trade credit. Not to cover the risk might prove costly for the SME and ultimately cause insolvency. A sound assessment of the costs and benefits of the different instruments for managing this risk is appropriate. The SME should weigh carefully all alternatives (credit insurance, risk management by the SME itself, factoring, buying information from agencies, using collecting agencies, bank guarantees), being aware of the risk in the event of a customer s default. VI

9 1 Introduction At the Lisbon European Council 1 the Heads of State and Government set out a ten-year strategy for success, a common vision for economic and social development for the Union. At the heart of the Lisbon strategy is the aim of strengthening economic growth to achieve full employment and social cohesion adding a culture of economic dynamism to the culture of economic stability. The strategy calls for parallel action across a range of interconnected areas in order to develop a virtuous cycle of growth, jobs, innovation and greater social cohesion. To this end, in April 2000 the Commission adopted a Communication and a proposal for a multiannual programme setting out how its enterprise policy could meet the challenges of globalisation and the new knowledge-driven economy. The multiannual programme for enterprise and entrepreneurship, and in particular for small and mediumsized enterprises (SMEs) was adopted by the Council on 20 December The programme is a framework plan of activities that aim inter alia at improving the financial environment for business, especially SMEs. The Stockholm Council 3 continued to emphasise other essential factors in reaching the Lisbon goals, including a stable macroeconomic framework, structural economic reforms, and regulatory simplification for small and medium-sized enterprises (SMEs). This paper is a part of a long-term strategy by the European Commission to address different aspects of access to finance by enterprises. It is linked to the changes in the banking sector in Europe, including increasing competition and consolidation and builds on previous papers on access to finance (see, for example, SEC(2001)1667). Today, bank lending is the most important source of SME finance in Europe. Changes in the banking sector and the economic downturn have made banks more reluctant to lend to risky SMEs. Therefore SMEs must consider alternative ways for funding their business and for managing the liquidity to run their enterprises. The purpose of this paper is to provide SMEs with information on one specific and often overlooked financial aspect the risk of liquidity constraints caused by customer failure. While some background information on the industry is given in chapter 3, the focus is more on practical aspects, explaining the need to cater for this risk, the possible solution provided by credit insurance and its pros and cons. In business-to-business transactions it is widely applied practice to deliver goods or services and agree to receive payment at a certain time after delivery. SMEs may give trade 1 Lisbon European Council, presidency conclusions, /819/EC, OJ L 333, Stockholm European Council, presidency conclusions,

10 Introduction credit to recognise the reputation of a customer, it might be part of their business strategy to capture new business, part of their pricing policy or simply reflect industry norms. Their size, however, often puts them in an asymmetric bargaining position vis-à-vis their customers so that the decisions to grant credit and on what terms to offer are often driven by customer expectations or customer pressure (Wilson/Summers 2002: 3). Given the recent restructuring of the banking sector, SMEs access to finance problems have increased. The shortage and cost of finance is ranked fourth on SMEs list of constraints for expansion (Grant Thornton 2002). According to a recent survey, the average payment period for SMEs sales invoices in the European Union is 50 days (Figure 1) with a large difference between Member States, ranging from 26 days in Finland up to 83 days in Greece. Figure 1: Average payment period for SMEs sales invoices in 2001 Average payment period for sales invoices (days) Finland Denmark Austria Germany Sweden United Kingdom Netherlands Luxembourg Belgium Ireland France Portugal Spain Italy Greece EU Average Source: 2002 Grant Thornton European Business Survey Consequently, SMEs transfer liquidity to their customers for nearly two months. Every year, the European Union s enterprises lose around jobs due to late payments. 4 In addition, EUR 23.6 billion worth of receivables is lost through insolvency cases. Directive 2000/35/EC of the European Parliament and of the Council on combating late payment in commercial transactions, which entered into force in 2002, established a legal background to support SMEs in this regard. The Directive gives a benchmark of 30 days as a payment 4 For more information on late payments and the European directive and its background see: 2

11 Introduction period, which mainly refers to payment delays. SMEs will benefit from a statutory right to interest 30 days after the date of the invoice. With transactions on a trade credit basis, SMEs not only lock their liquidity into a specific customer relationship but also take the risk of not being paid. In business surveys, financial difficulties are the highest ranked causes of business failures (P & P 2002: 53, 81). Financial losses caused by the insolvency of a debtor can be a major cause of liquidity constraints and even bankruptcy. The significance of this threat is seen in the increase in business failures in Europe (Table 1). Therefore, doing business on a trade credit basis cannot just be part of the marketing or liquidity management. The SME must be aware of the risks involved, so a sort of risk assessment or risk management is needed. Table 1 European Business Insolvencies, * Country % change 01/02 Austria Belgium Denmark Finland France Germany Great Britain Greece Ireland Italy Luxembourg Netherlands Portugal Spain Sweden EU * Private person s failure excluded, national figures with limited cross-national comparability, e. g. there is no formal insolvency procedure for micro enterprises in Greece and Spain, explaining the rather low absolute values Source: Creditreform

12 Introduction This is what this guide is about. Credit insurance 5 is one means to handle the risks involved in trade credit. Business credit insurance, also known as accounts receivable insurance, bad debt insurance or credit risk insurance, is a potential financial management tool to eliminate the risk resulting from insolvency or non-payment by SMEs customers. Despite the fact that credit insurance has existed for decades, many companies are still unaware of the product, although a wide variety of new and improved programmes can be customised to SMEs needs. Chapter 2 provides an overview of the basic principles of a credit insurance contract and the main alternatives. Chapter 3 describes the credit insurance industry, the supply side. The concluding Chapter 4 outlines the views of SMEs, the demand side, to give pros and cons to be weighed in deciding whether credit insurance is an appropriate tool for an SME assessing its business risks. 5 This study concentrates on domestic trade, not export and export credit insurance and on short term business. 4

13 2 The Rationale of Credit Insurance 2.1 The Product : Credit Insurance During the average payment period of sales invoices (see chapter 1), Europe s SMEs transfer liquidity to their customers for nearly two months. For the debtors, the credits provide a considerable source of liquidity - for example, on average 23 % of the balance sheet total of French companies or 12 % for German companies (Sauvé/Scheuer 1999: 102ff.) For the creditor SMEs this common business practice implies taking the trade credit risk of not receiving payment and thereby causing severe liquidity constraints. This risk is the focus of a credit insurance contract Basic Principle of a Credit Insurance Contract A credit insurance covers the risk of non-payment ( default ) by customer enterprises ( buyer ) that a supplier of goods or services ( seller ) bears when selling on a deferred payment basis ( trade credit ). Figure 2: Credit Insurance Relationship Credit Insurance Company (1) Trade Credit Buyer Seller (SME) Payment solid lines: primary contractual relationship between the actors dashed lines: other relationship Figure 2 depicts the basic relationship underlying a credit insurance contract. (1) The seller sells goods or services to the buyer (an enterprise not consumers), due for payment after a specified period (trade credit). After an appraisal of the risk involved in transactions with a specific buyer (2), and against premium payment (3), the credit insurance company covers the risk of non-payment (4), the default risk and may depending on the specific contractual arrangement with the seller try to collect the debts from the buyer. The general principle allows for a wide range of specific contractual agreements between the seller and the insurance company. The outline of the product credit 5

14 The Rationale of Credit Insurance insurance and the premiums to be paid depend a variety of factors specific to the country, the seller and his needs and the buyer. Figure 3 provides a (non-exhaustive) list of the basic factors at play. Figure 3: Basic Components of a Credit Insurance Relationship Trade Credit Default Services seller s size protracted default risk assessment time horizon (payment due) insolvency credit management seller s sector collection domestic/ international recovering of loss buyer risk (sector, size, track record, ) Nature of Trade Credits to be Covered The size of the seller not only influences the risk, and therefore the insurance premiums, but nowadays also the type of insurance offered by most insurance companies. Enterprises under a certain turnover threshold can normally buy a standard contract, which is relatively easy to implement and handle (see Box 2), whereas larger enterprises can choose among different elements to establish tailor-made contracts, fitting their different needs. At least for the latter, the maturity of the trade credit is another distinctive feature of the insurance product offered. The standard distinction in credit insurance is between short-term contracts (where the period covered in the contracts varies from a maximum of 180 days up to two years, the focus of this study) and long-term contracts (3-5 years). The latter are normally designed to cover capital goods deals and work contracts. And finally, on the seller s side, the sector will influence the insurance company s risk assessment. 6 On the buyer s side, the standard distinction between domestic credit insurance and export credit insurance refers to the origin of the buyer, although export credit is not the explicit focus of this study (for an overview: OECD 2001). Finally the insurer will assess the buyer s default risk, influenced for example by his sector, size or track record, to check if and for what premium he will accept the risk. 6 In case no other sources are mentioned, figures given in the text are based on expert interviews conducted for this study. 6

15 The Rationale of Credit Insurance The Default Risk Subject to Credit Insurance The primary risk covered by the insurance is the default risk. The SME can principally cover two different default risks inherent in trade credit transactions: Firstly, the risk that a valid debt remains unpaid for a specified period after the due date for payment, the so-called protracted default. This period varies between different credit insurance companies, but generally involves between 6 and 9 months after the date due for payment. Secondly, and this is the traditional and standard subject of a credit insurance contract, the risk of a buyer s insolvency can be covered. The political risks of fundamental disturbances arising from legal or political frameworks are subject to additional insurance contracts and not the subject of this study Scope and Price of Services Offered by a Credit Insurance Depending on the trade credit and nature of default risk, the SME can use the services of a credit insurance company. Except for some niche offers, the SME will not be able to cover its trade credit transaction on a self-selected, case-by-case basis. In general, all or most of the company s trade credit transaction must be covered by the insurance contract. The basic types of policies are called "multiple market policies", providing cover against insolvency and time-extended non-payment, in respect of all buyers in selected markets and "whole turnover policies", where cover relates to all credit transactions conducted with all buyers in all markets. The premium for a typical whole turnover policy is between 0.3 % and 0.7 % of the company s turnover, influenced by the enterprise's track record, business sector, trading partners and the specific policy-details (cf. Dowding 2000: 21). Thus, the insurance premiums will absorb a considerable fraction of the SME s profit margin 7 or increase its loss in an economic downturn. In the words of the industry: Credit insurance is an expensive form of insurance cover, and there are many reasons for this. Many policies have a strong element of credit management tied with the financial protection and this increases the premium cost. At the same time, the nature of the risk means that it is a high risk area. Hence the risk premium ratio for credit insurance is different than for property insurance (Dowding 2000: 22). Credit insurance policies normally cover the invoice value with a % excess. In other words, in the event of loss, 80 % up to 90 % of the insured debt is covered the balance being for the policyholder s own account. It is general practice to give the policyholder a limit below which he is free to transact business with one buyer without further reference to the insurer. This so-called "limit of discretion" equals a maximum 7 For example, for German SMEs, the empirical profit margin since the mid 90s is around 2.5 % of the company s turnover (Plattner 2001). For a detailed analysis on SME profitability and finance cf. Riveaud-Danset

16 The Rationale of Credit Insurance amount outstanding in respect of any particular debtor. For credit transactions that exceed the discretionary limit, the policyholder is obliged to obtain the prior consent of the credit insurer. Typically, there are numerous credit limits on various buyers for one policy. As mentioned above, before underwriting, the insurance company must accept every single buyer. Therefore the insurers rely on a risk assessment process, a rating of the different buyers. They collect information, such as financial data about buyers or about the specific sector, product or general economic conditions. This research is usually part of the core business of credit insurers, leading to wide-ranging databases on the creditworthiness of buyers. To reduce costs, especially in standard SME contracts, some companies offer to accept information from professional information agencies, bought by the seller itself. Risk monitoring of the buyers is an ongoing process during the lifetime of the insurance policy. Insurers offer this regularly updated information to their clients as a service to improve sellers credit management. It is usual to provide for a maximum extension of the contractual period for the payment of an insured debt. This period is provided to allow for reasonable flexibility in the commercial relations between the policyholder and his clients. The credit insurer must previously approve any extension beyond that specified date. The maximum extension period generally varies from 30 to 90 days also depending on the original credit term. In the event that an insured debt remains unpaid after this period, the policyholder is required immediately to notify the credit insurer. In the case of a protracted default covered by the insurance policy, from that point onwards the debt in question becomes the subject of a "co-operative collection procedure". Against the payment of a collecting fee and normally a share in the sum recovered, the insurance company or (usually) a subsidiary tries to collect the money from the debtor. In the case of a protracted default, the SME will receive payment for the amount covered after the 6 9 months past due date originally agreed upon or on average within 30 days after an approved insolvency. In the case of insolvency, the insurer will recover the insured amount. 8

17 The Rationale of Credit Insurance 2.2 Differentiation from other instruments To handle the risk and the liquidity element involved with trade credit, SMEs may use a range of instruments that are partial substitutes for credit insurance. The most relevant alternatives are: a) Bank Guarantee (Letter of Credit) A traditional means to cover a failure, to be initiated by the buyer. Bank guarantees fulfil individual contractual obligations, providing for the payment of the amount claimed, dependent only upon the presentation of supporting documents. Their biggest merit lies in their simplicity, since they can be executed on the simple request of the beneficiary. b) Factoring This involves a process whereby a specialised firm assumes responsibility for the administration and collection of the account receivable for its clients. It is based on an agreement through which the "factor" has the right to act on behalf of his client, performing the administrative management of all the relevant invoices and undertaking all recovery operations. It works by selling customers debts against instant payment at a discount or against an agreed fee plus interest (cf. GLE 2003). c) Professional Collecting Agencies The service offered by the insurance company in case of a protracted default is supplied by a variety of professional competitors. Enterprises can employ these specialised agencies to urge late payers to fulfil the contractual requirement, normally on the basis of payment on success plus a fee. d) Non- (Self-) Insurance In this case the company manages and takes the risk by itself, which should not be confused with neglecting the risk of customer default. Non-insurance describes the decision (after having compared the cost of alternatives) to set up its own credit management using, for example, information from credit agencies. Compared to the above, credit insurance can be distinguished a) from bank guarantees, firstly by the fact that bank guarantees cover only individual transactions and not the whole turnover as in standard credit insurance. The second difference is that it is the buyer s task to provide the guarantees, increasing his transaction costs and restricting his overall credit limit, whereas credit insurance increases the seller s external transaction costs; b) from factoring, firstly by the clear distinction of roles, in the sense that the creditinsurance-guarantor does not act towards the defaulting party in the name of and on behalf of the beneficiary, but merely covers the seller without interfering in the 9

18 The Rationale of Credit Insurance seller-customer relationship. Secondly, factoring provides instant reimbursement of cash to the seller. The liquidity aspect is the main focus of this business, whereas the risk-covering aspect is subject to subsequent agreements; c) from collecting agencies, by the missing insurance aspect. Only in the case of a protracted default can the seller choose on a case-by-case basis if he will use this service, without any guarantee of cover in the case of insolvency; d) from self-insurance, by the fact that, against payment of the premium, (part of) the risk is covered externally and, depending on the contract, additional services are bought. Figure 4 summarises the basic economic consequences of a trade credit transaction, the temporary risk transfer from seller to buyer and the non-payment risk for the seller, and the alternative instruments discussed to cope with these different consequences. Figure 4: Alternative instruments to cope with the liquidity transfer or non-payment risk inherent in a trade credit transaction factoring temporary liquidity transfer Seller collecting agency credit insurance nonpayment risk bank guarantee Buyer 10

19 3 The Credit Insurance Industry 3.1 The Credit Insurance Market Market Structure by Credit Insurance Companies The world credit insurance market is highly concentrated. After a wave of mergers and acquisitions throughout the last decade (cf. Dowding 2002: 1ff.) there are only three big companies left, all based in Europe. According to an estimate published by the International Credit Insurance Association (ICIA) (Dowding 2002), the three companies, Coface, Gerling NCM and Euler & Hermes (merged in 2002) together have 84 % of world premiums (Figure 5). While the two biggest credit insurers, Euler & Hermes and Gerling NCM, are mainly owned by large insurance companies, in 2002 Coface came under the control (98%) of Natexis, a French bank. Figure 5: Major Companies Estimated Share in World Credit Insurance Premiums and Ownership Structure Allianz Natexis Banques Populaires 17% 98% Coface SwissRe 8.27% Euler & Hermes 59.3% AGF 64.86% 42% 44.1% 25% Gerling NCM 49.0% SwissRe Gerling-Konzern Versicherungs- Beteiligungs-AG Source: Ownership Structure: Companies Publication, Market Share: Dowding 2002: 1 There are neither independent nor recent figures available concerning the volume of the credit insurance market. The most recent industry estimates available range from a total market volume (premiums) of 4bn to 6.8bn in the year 2000 (Dowding 2002: 1). Figure 6 depicts the reported premium incomes of the leading companies in 2000 and 2001 respectively, indicating an overall increase of 10 %. A closer inspection of the underlying market trends (cf. section 3.1.3) reveals that this is likely to be due to increased premiums rather than an increase in new contracts. For a detailed analysis of the total market volume, 11

20 The Credit Insurance Industry the most recent available industry study (Raturi/Schmolck 2000), delivering data for 1998 and an older independent study (Wilson/Summers 1998 with data for 1996) have been used as basic statistical sources. Figure 6: Leading Companies Premium Income from Credit Insurance Million Euros , Coface Gerling NCM Hermes Euler Source: Companies Annual Reports for Market Structure by Region Measured by premiums, Europe is the world s largest credit insurance market. About 83 % of the 3.8bn premiums in 1998 were raised in Western Europe (Figure 7). Within Europe, the premiums collected in Germany, France and the UK cover more than 60 % of the market. Figure 7: Credit Insurance World Market 1998 (Premiums) North America 13% Australia 1% Japan 2% Other 1% World United Kingdom 14% other 16% Western Europe France 17% Western Europe 83% Source: Raturi/Schmolck 2000 Spain 8% Netherlands 7% Italy 7% Germany 31% Figure 8 shows the so-called penetration rate of credit insurance in the EU and selected candidate countries, that is the premiums as a percentage of GDP. Another way of 12

21 The Credit Insurance Industry expressing the market penetration would be to calculate the volume of trade covered by credit insurance. An average EU penetration rate of around 0.03 % and (as a rule of thumb) a premium of approximately 0.5 % of turnover results in a turnover covered of around 6 % of GDP a credit insurance market share comparable to that of factoring (cf. GLE 2003). The graph shows the Czech Republic in the lead among the candidate countries. Figure 8: Credit Insurance Penetration Rates, Europe 1998 Credit Insurance Premiums/GDP in % Greece 1 Hungary Poland Finland 1 Italy Ireland 1 Portugal Denmark Czech Republic Austria Sweden France Germany Spain United Kingdom Netherlands Belgium 1 1 Figures for 1996; Source: Raturi/Schmolck 2000 and Wilson/Summers 1998 Figure 9 shows the importance of the domestic credit insurance business in relation to export insurance. In spite of the greater public awareness of export insurance, the graph indicates that domestic business clearly dominates in the majority of the Member States for which data is available. Moreover, whereas the importance of the credit insurance business in Belgium reported in Figure 8 stems from the prevalence of export credit insurance, in the other countries where credit insurance has a substantial impact (measured by the penetration rates), domestic business is clearly dominant. In the countries with lower penetration rates, the picture is somewhat mixed. Whereas in Ireland, Denmark, Austria and Sweden credit insurance is hardly accepted as an instrument to cover domestic trade credit risk, in Greece, Finland, Italy and Portugal, domestic business captures the larger share of the market. 13

22 The Credit Insurance Industry Figure 9: Domestic Share of Credit Insurance Premiums (1996, in %) Sweden Denmark Belgium Ireland Austria Greece Portugal Italy United Kingdom Finland France Netherlands Germany Spain EU Average Source: Wilson/Summers Increase in Business Failures and Premiums: Recent Developments in the Credit Insurance Industry The world-wide economic downturn, illustrated by the first increase in bankruptcies for years and an expected further growth (cf. Table 1), has had at least a twofold impact on the industry. On the one hand, as a consequence of the increase in insolvencies, insurers are reassessing their risk policy, looking more closely at which enterprise risk they will accept. Increasingly insurers will not cover new buyers risk or will even stop covering the risk of previously accepted buyers. Insurers are therefore renegotiating contractual agreements more frequently to change the conditions in their favour. Some sectors, namely construction and trade, are treated with special care and reluctance. To put it in the words of the industry: The group then initiated more selective assessment of risks of all sizes (Coface Annual Report 2001: 12). The twofold impact of the downturn is illustrated by another example: In order to reestablish the balance between the level of premium rates and that of risks covered, greater selectivity regarding new business and rates increase programmes were introduced at all the group s subsidiaries early in the second half of 2001 (Euler Annual Report 2001: 38f.). The industry was and is able to increase their margin. This is done firstly by reducing the cover rate. Secondly the insurers increase their premiums, not least because enterprises awareness of the risk involved in their business rose (cf. Dowding 2002: 50). Insurance representatives are said to have successfully raised premiums %. This supports the conclusion that at least a major part of the increase in companies premium income reported in Figure 6 might not be due to an increased market volume, driven by a wider insurance coverage, but to increasing premiums for a given exposure. 14

23 The Credit Insurance Industry To diversify their risk, large insurance companies at least are increasingly spreading their activities. All facets of the business could be linked with separate business activities. Insurance companies are, for example, offering structured finance products or rating tools, based on their risk databases, and are establishing or acquiring debt collection or factoring companies. A potential area for future action, increasing the demand for credit insurance, is the inclusion of credit insurance into structured finance products such as asset-backed securities (ABS) transactions. By implementing credit insurance the risk of SME receivables might, on the one hand, be reduced, thus making them tradable, while on the other hand the implementation into a structured finance deal creates room to manage the risk covered by the insurance and thereby for reducing the premiums. However, due to high set up costs for ABS deals, this is obviously more an option for the larger (in size) medium-sized enterprises. Finally, the overall impact of the downturn on the industry should not be neglected. The need to reassess risk policy obviously reveals errors of risk judgment in the past, undermining the insurers reputation. Another lesson is that it is important to note that credit information and credit insurance providers are not resolving the problems of market instability. While diminishing the risks of other companies failures, they themselves could be exposed to the excessive demands arising from their obligation to insureds if their counter-parties massively fail to respect contractual obligations in the event of a generalized economic crisis (UNCTAD 2002: 144). 3.2 Credit Insurance offered for SMEs Appropriateness and Use of Credit Insurance by SMEs Enterprise size is not the primary indicator of whether credit insurance is in principle available for SMEs. Legal status, financial capacity, past and recent market behaviour, seriousness and viability as far as their client's contractant is concerned are the main issues raised by insurance companies whenever they have to deal with their clients. In practice, however, at least the kind of product differentiation already mentioned in chapter 2 exists. Additionally, as underlined by a survey of European business organisations conducted for this study (Box 1 and Annex), credit insurance is not generally seen as a promising potential instrument for SMEs. The question then is, why is this the case and what are the reasons for this? Firstly, the size of the premium seems to discourage SMEs. In section 2.1.1, we described credit insurance as a product whose final design depends on a variety of factors, making it highly specific to the transaction covered. In other words, credit insurance is not a homogeneous product but the various contract(s) between one seller and one buyer. The insurer regularly covers the portfolio risk of a bundle of different contracts. A standard 15

24 The Credit Insurance Industry case or a standard risk does not exist, so for each seller the insurer must assess the risk of the specific portfolio of contracts. Initially, this case-specific variety obviously results in costs for insurers and sellers as well, creating economies of scale for larger sellers insuring higher sales volumes with each respective customer. A fact addressed by the industry s association: The reason for the lack of success in making credit insurance attractive to smaller companies has been the perceived expense of credit insurance, combined with its complicated nature and jargon, and the fact that it is just not seen as a must-have class of insurance (Dowding 2002: 20) as well as by our survey respondents. In consequence the additional insurance costs are hard to justify. This is especially true in the case of SMEs doing only a few or low-level transactions or having small business partners, about whom information is usually limited and facing a high volatility in their existence, especially younger enterprises. A careful, unbiased estimation of costs and benefits of credit insurance in comparison with the alternatives should therefore be a prerequisite before giving trade credit to customers. However, here there is a trade-off between the SME s and the insurance company s interest: Whereas the company might be interested in covering selected risks, especially of opaque, new or big clients, the insurers, using the advantages of a portfolio, regularly offer only multiple market or whole turnover policies. From the SME s point of view, old customer s turnover also provides the basis for the fee calculation. Additionally, the increasing difficulties European SMEs face in gaining access to bank loans, at a time when banks are reassessing their risk policy, coincide with insurance companies raising their premiums and imposing a stronger restriction on the risks accepted (cf. section 3.1.3). So the credit insurance instrument becomes more expensive and harder to get at a time when alternatives are rare and when (bigger) buyers, facing similar credit constraints, might make more use of trade credit and might urge smaller companies to provide this sort of finance. Secondly, SMEs are less if at all aware of this particular insurance means. The degree of information available in a medium or a small enterprise is clearly limited. In some cases, even a traditional lack of "insurance conscience" that sometimes characterises family-owned and run enterprises might explain the existing de facto reluctance to join an unknown scheme. 16

25 The Credit Insurance Industry Box 1: Questionnaire: Perception of Credit Insurance A questionnaire (see Annex for further details) was sent to various European-level associations, concerning the following points. Questions a) To what extent is credit insurance known and used by SMEs? b) Is credit insurance of interest to and potentially useful for SMEs? c) Do you think that insurance premiums are too expensive for SMEs? d) Do you think that small companies (those with fewer than 50 employees) can use credit insurance? e) If credit insurance is little known/used, why is this? f) What measures would you propose to remedy this situation? The first four questions were followed by multiple choice answer possibilities. The last two were open, with a free text answer space. Out of a dozen reactions (only four associations did not send their views), the following conclusions could be drawn. Answers a) Credit insurance is little known to SMEs. (Nobody opted for the "unknown" choice and only one association believes that credit insurance is well known). b) Credit insurance, on the other hand, is considered to be of little use to SMEs. (Three associations, however, rank credit insurance at a "very useful level, whereas none believes it to be "not useful at all".) c) The majority of the respondents qualify credit insurance as "too expensive". (Three associations share the view that it is "reasonably priced", while none considers it "cheap".) d) The majority of the respondents think that small companies can use credit insurance. (Four associations are of the opposite view.) e) The main reasons offered as to why credit insurance is little known/used may be summarised as following: lack of relative tradition and corresponding habits; high rates charged (almost general complaint); lack of corresponding "promotion" by the banking sector; credit insurance companies' lack of interest in SMEs; lack of SMEs' confidence in insurance in general; low creditworthiness of SMEs' customers; preference for own research and investigation; preference for other means (ex. advance payments); administrative complexity; legislation too rigid. f) The following measures to remedy the situation are proposed: extension of SMEs' credit limits by financial bodies; reduction of banks' and insurance companies' bureaucracy; lower rates; lower minimum credit amounts; special treatment of SMEs by insurance companies; structure change of insurance companies; information on a permanent basis; meetings and discussion on common problems; education of professional advisers; marketing promotion by governments via SME services; tax advantages. 17

26 The Credit Insurance Industry Thirdly, even when SMEs are aware of the existence of credit insurance, the selfinsurance instrument is their first choice. A common reaction is "I know my clients and I know how to protect myself". This assertion may lead companies (not only SMEs) to decide to act as their own risk carrier. In this case, knowledge of a trading partner s ongoing financial standing, business morality and potential errors in judgement are critical to the profitability and, in certain circumstances, even the continued financial viability of this risk-carrying, self-insured company. This problem is more severe for SMEs that develop additional trade with new clients likely to pose unknown credit risks. Finally, teams of legal and financial professionals, usually working in a large company, are scarce or non-existent in the framework of SMEs. And even in cases where they exist, these professionals have to face the everyday "trivial" problems and difficulties and are hardly equipped to deal with the details of a credit insurance contract. For additional information, insurance companies in France, Germany, Greece and the United Kingdom have been consulted on their business policy. The companies based in the more mature markets (F, D, UK, cf. Figure 8) calculate that they reach a considerable fraction of the companies eligible for insurance. The share of those already insured are cited as being roughly between % of the target population. In the case of Greece, the country with the lowest penetration rate, this fraction is estimated to be about 2 3 %. The companies do not cite as their target population the very small entities linked to the entrepreneur's personality or entrepreneurial ability (examples given were small grocery stores, hairdressers with just one or two apprentices helping the owner/entrepreneur, oneperson shops etc.). They are rather looking for larger ones, companies with at least a management structure able to cope with basic financial management Credit Insurance Designed for SMEs Being aware of the problems of cost-efficiency and complexity, until recently insurance companies have been more oriented towards large enterprises. For practical reasons referred to above (smaller number of potential clients, bigger turnover and financial capacity, larger amounts of money involved, traditional tendencies, better granularity of risk), their offer of services was targeted at established large companies. From the credit insurers point of view, it has been more profitable to handle large (and some medium-sized) enterprises than to cater for essentially small business units. Hence, the typical credit insurer will have the core of his portfolio (measured in terms of number of policies) associated with large and medium-sized enterprises. Recently insurers have followed a twofold strategy in trying to reach SMEs. Firstly, reducing complexity through standardisation and, secondly, reducing transaction costs for these standardised products through e-business applications. As already mentioned, over the past years, practically all credit insurers have marketed standardised policies involving low administrative and policy management costs that are designed for small 18

27 The Credit Insurance Industry enterprises (see for example the case illustrated in Box 2). Typical aspects of these policies are reduced reporting obligations and a simplified premium calculation. Box 2: Example of a Credit Insurance for SMEs For whom? - For enterprises (seller) with a turnover up to EUR 2.5 Mio. - No cover for SMEs with clients mostly in construction sector Risk covered? Buyer s risk in most European countries Simplifications? - Annual premium calculation based on last annual turnover (no monthly account reporting necessary) - Standardised premium calculation for domestic and export business - Standardised flat rate for buyer s risk assessment of EUR 250 for up to 10 buyers Optional extras? - Possibility to cover protracted default (payment 6 months past due) against additional premium - Possibility to employ, against charge, group own collecting agency To cut costs and increase the speed of the decision-making process, the majority of suppliers introduced Internet-based applications to exchange information with their clients. In future, SMEs should be able to buy their insurance on-line and receive instant or at least rapid information about their credit limits with specific buyers. Today the systems are mainly used either to manage existing trade credit lines or to apply for rating information used for a firm s credit management (e. g. through Euler s EOLIS system or Gerling s Serv@Net). However, in connection with the increasing track record in their rating applications, a decision engine -generated acceptance of new buyers seems possible. The acceptance of s outcomes for Coface s setting of the credit limit in existing policies is a primary example of this. Moreover, there are new niche suppliers in the market offering insurance for smaller firms, using the advantage of lower electronic transaction costs and thereby increasing the supply for SMEs. These product and process innovations will contribute to an improved supply of credit insurance services for SMEs. However, even within the industry there is some doubt as to how far the necessary standardisation process can go. The inherent borderline is the definition of the product itself, not insuring the homogeneous standard case but the bundle of specific contracts between one seller and his customers. 19

28 4 Credit Insurance for SMEs Conclusions A summary of the arguments given above follows in form of a list of pros and cons, intended to ease the decision process necessary at the business level itself. 4.1 Advantages for SMEs The advantages that should be taken into consideration by any SME, before it decides if it is appropriate or not to get involved in credit insurance, could be summarised as follows: 1. First and foremost, credit insurance by definition guarantees the payment of the agreed credit itself and prevents potentially devastating losses. Subject to the specific contract's terms, it is considered customary for an insurance company to cover an amount equivalent to % of the final unpaid part of the value insured. This guarantee could encourage any SME to proceed to a transaction, not only with a new and inevitably unknown client but with old customers as well, since nothing can ensure that even the latter will not face insolvency. A problem that has become more severe recently is the increasing number of business failures in Europe (see Table 1). This may enhance SMEs awareness of the risk involved in trade credit transactions and may urge them to re-evaluate the quality of their clients even more since a probable loss is bigger in relative terms for an SME than for a large company. It should, however, be underlined that the ability of the credit insurer to underwrite the risks in question (i. e. the default by and insolvency of the various buyers) rests upon the availability of specialised information. This includes up-to-date, reliable and comprehensive financial data about the buyers, information about the various markets and industrial sectors as well as about general economic, monetary and fiscal developments in the markets of the buyers. (Credit information on buyers is partly obtained from sources such as professional information agencies. In addition to using such sources, most credit insurers maintain their own very comprehensive system of data on buyers.) 2. Due to newly developed standardised products for smaller clients, insurance companies can guarantee the payment of even small amounts, reducing insurance costs and complexity for SMEs. 3. Another important asset for an SME with credit insurance is the greater facility it has for rapid and easier bank financing. Presenting a contract, almost total payment 20