Companies turning to Trade Credit Insurance in an unpredictable and debt-laden world

Transcription

1 Companies turning to Trade Credit Insurance in an unpredictable and debt-laden world

2 Companies turning to Trade Credit Insurance in an unpredictable and debt-laden world On the heels of a period of financial uncertainty, many businesses are looking at alternatives for managing and mitigating the credit risks associated with their customer portfolios. The failure of a major customer, or several smaller customers, to pay can severely impact the financial health of an organization and, in the most severe cases, even put a company into bankruptcy. However, several methods may help mitigate trade credit risk. Some of the more common tactics include using letters of credit, factoring, self-insurance in the form of bad debt reserves, and purchasing trade credit insurance. Each has advantages and disadvantages, and organizations should assess their particular situation to determine what approach is most suitable for their needs. What many will find is that trade credit insurance provides one of the best and most cost-effective solutions, especially when expanding globally. What many will find is that trade credit insurance provides one of the best and most cost-effective solution, especially when expanding globally. U.S. businesses are increasingly looking outside the United States for growth and profitability. Often these opportunities are lucrative, but not without risk. This became even more apparent during the recent economic downturn. The global nature of the Great Recession resulted in an increase in business failures worldwide. In 2008 for example, the U.S. alone experienced a 33 percent increase in year-over-year bankruptcy filings and then another 34 percent increase in The importance of protecting accounts receivable from bankruptcy, protracted default and political risks, not only for new customers but also existing ones were some of the major lessons learned from the recession. Understanding this is particularly important for businesses when entering new global markets. Historically, the United States has not been a sizeable market for trade credit insurance products. Since the U.S. is a large country, equivalent in size to all of Europe, with common laws, language and currency, many businesses perceived domestic expansion as relatively easy and risk free. On the other hand, in Europe, a continent of many countries with different laws, languages, and pre-euro, different currencies, growth almost always meant selling outside one s home country, where the risks of doing business are multiplied. Many believe it is this reason that trade credit insurance is a much more mature industry in Europe than in the United States. For example, some estimate that Europe alone accounts for nearly half of the $8 billion worldwide trade credit insurance marketplace. While the market for trade credit insurance is a growing market in the United States, the increased risks associated with cross-border transactions significantly increase the demand for such products. 1 United States Courts, Bankruptcy Filings Down in Fiscal Year 2011 (November 2011) Bankruptcy_Filings_Down_in_Fiscal_Year_2011. aspx In recent years the United States trade credit insurance market has experienced a substantial increase in demand for trade credit insurance. This is evidenced by the estimates received by the global insurance brokers that there was nearly $700 million in annual premiums generated in 2012 for the short term trade credit business with another approximately $150 million for medium term structured trade credit business. This estimate does not include premium and fee figures from the Export-Import Bank of the United States (Eximbank), the official Export Credit Agency of the United States. Eximbank plays a critical role in the trade credit insurance market. Their mandate is to offer coverage to underserved markets, such as small businesses or companies selling into higher risk countries, where the private sector insurers do not have the appetite or capacity to cover. While premium and fee income figures are not readily available, Eximbank s insured exposure has increased substantially over the past five years. For instance, in 2008 Eximbank had $14 billion in exposure which increased to approximately $35 billion in Eximbank Annual Report 2008 and

3 Some believe the increase is due to the globalization of the world economy, while others attribute it to the impact of the recession still being fresh in the minds of many businesses. Whatever the reason, U.S. businesses are looking for ways to mitigate trade credit risk. What is trade credit insurance? U.S. exports to emerging markets have gained momentum over the past decade. Foreign trade will continue to be responsible for a surge in U.S. company revenues as companies will seek growth from emerging markets to offset soft demand from industrialized nations. However, as with any growth opportunity there is potential for increased risk. The risk of exporting is amplified when the laws, customs, communications and reputations of customers, or potential customers, are not fully understood. 3 Open account terms of payment are typical in the United States and are becoming more common for international sales as well. Historically, domestic U.S. companies would require letters of credit, cash in advance or other secured terms for international transactions. While this is beneficial to the US exporter, as virtually all credit risk had been eliminated, trading under secured terms has the potential to put a company at a competitive disadvantage since their competitors, namely European competitors, often offer open account terms. Obtaining open account terms from a supplier is basic working capital management since open account purchase is akin to an interest free short term loan. While the benefits seem one-sided, since the buyer gets the product, holds title and is not required to pay for a period of 60 to 90 days, the fact is that many suppliers or would be suppliers are not in a position to change this status quo given the competitive landscape. Trade receivables often account for up to 40 percent or more of a company s total assets and are many times one of the largest assets on the balance sheet. They are also the only assets with a direct correlation to the income statement. Trade credit insurance is a risk management product designed to indemnify companies for trade receivable losses due to commercial risks such as insolvency (i.e., bankruptcy) and protracted default, which is the failure of a company to pay within six months of the due date. If a company is trading internationally, trade credit insurance also covers the political risks associated with a sale such as currency inconvertibility, war and civil disturbance as well as confiscation, nationalization and expropriation of a buyer. There are several types of trade credit insurance programs. The size and scope of a business will determine what program is most suitable. The types of trade credit insurance policies include: Whole-turnover Policy There is no selectivity available for this type of policy and the insured is required to cover their entire portfolio of customers. The only flexibility offered is the ability to choose to insure all domestic sales, all export sales or both. There are two types of underwriting philosophies when underwriting a whole turnover account: 3 Peter M. Jones, The World Bank, Trade Credit Insurance (February 2010) siteresources.worldbank.org/ FINANCIALSECTOR/Resources/Primer15_ TradeCreditInsurance_Final.pdf - Excess-of-loss or non-cancellable underwriting philosophy Designed for larger companies that have an established credit risk management department and are looking for protection against unexpected and catastrophic losses. Buyer and country limits are non-cancellable and these policies are typically structured with a moderate to large first loss deductible. 3

4 - Ground Up or cancellable philosophy The underwriter makes all credit decisions for the organization usually designed for the SME segment of the market and for companies who do not employ a full time credit management team. These insurers almost act as an outsource of the credit management department. When taking all of the costs and fees associated with letters of credit, trade credit insurance becomes a much more inexpensive and streamlined alternative. Key Account Policy This type of policy is designed for companies who are not interested in insuring their entire portfolio, but only top or key accounts. Under a Key Account policy the underwriter names each buyer, with an approved credit limit, to the policy by endorsement. The insured can choose the buyers where coverage is requested, as long as there is a suitable spread of risk and, more importantly, there is not an adverse selection of risk. A typical Key Account policy would be structured to cover the top 5, 10 or 20 of the insured s largest exposures. A policy can also be structured with a coverage floor where the insured is required to cover all buyers with credit exposures in excess of a pre-determined amount, i.e. $500,000, $1,000,000, etc. or greater. Single Buyer Policy Offers coverage on account and is typically reserved for an insured which has a disproportionate amount of exposure with one account vis-à-vis the rest of their customer portfolio. Under this type of policy underwriters will typically require the risk to be a large, established entity with audited financial statements. Top Up Policy The insured approaches a secondary carrier to provide coverage excess of the primary buyer limits issued by a primary insurance carrier. What are the alternatives? Insurance is not the only strategy for mitigating trade credit risks. It was common practice to look to the capital markets for trade receivable protection when large amounts were at stake, in particular, credit default swaps, however, these instruments are only available to offset the risk of publically traded companies and are typically much more expensive than trade credit insurance coverage. Other alternatives include, letters of credit, factoring and self-insurance in the form of bad debt reserves. Letters of Credit Letters of credit are used in international transactions to guarantee a supplier that the buyer s payment obligations will be received on time and in the correct amount. If payment is not received, the confirming bank will cover the obligation. Letters of credit differ from insurance as it is the responsibility of the buyer, not the supplier, to request it from the bank. This may cause liquidity issues for the buyer as letters of credit reduce the amount of availability under a company s credit facility. For example, if a company has a $10 million line of credit and is required to post a $2 million letter of credit, the company now only has $8 million available to draw. This is one of the reasons buyers prefer not to open letters of credit in favor of their suppliers as it has the potential to reduce their working capital availability. Letters of credit also only provide coverage for a single transaction with a single buyer. Keeping track of each individual transaction can create logistical and paperwork issues for suppliers and buyers alike. When taking all of the costs and fees associated with letters of credit, trade credit insurance becomes a much more inexpensive and streamlined alternative. 4

5 Factoring Factoring refers to the selling of accounts receivable to financial institutions, known as factors. The factor purchases a percentage of the face value of a trade receivable. Many factors will also offer ancillary services such as debt collection, invoicing, credit information and other bookkeeping activities. While factoring offers these services and the benefit of immediate cash in exchange for a portion of the receivables, it is usually more expensive than insurance. Self-insurance Some companies choose to self-insure by creating bad-debt reserves to cover losses due to the default of outstanding receivables. While this approach eliminates the cost of having to rely on a third party for trade receivable protection, there is no standard practice of setting this reserve. Some companies use a percentage of sales, other use past loss experience, while others calculate it as a percentage of overall receivables. The shortcomings of relying on a bad debt reserve are that it typically does not account for the large and unexpected catastrophic loss. For example, assume a company with $100 million in sales creates a bad debt reserve of $350,000 and their fifteen largest customers have credit exposures ranging from $500,000 to $10,000,000. If one of these larger customers is unable to pay, the $350,000 bad debt reserve may be a fraction of the overall loss. By purchasing a trade credit insurance policy the company can more accurately budget and forecast premium costs versus bad debt losses. The benefits of trade credit insurance While there are many benefits of a trade credit insurance policy, there are three main motivations behind the purchasing decision: Increase sales By offering customers and prospects more favorable credit terms, companies may trade in confidence by safely expanding into new markets all while eliminating the need for costly letters of credit. Enhance borrowing power By including foreign receivables and excess concentrations back into their borrowing base, and by assigning a trade credit insurance policy to a financial institution, the insured may be able to negotiate better terms and conditions on their loan since the accounts receivable are now insured. Mitigate financial risk Receivables are typically the largest asset on a company s balance sheet and usually the only one not insured. It is also the one asset which has a direct correlation to the income statement. By insuring receivables against the risk of non-payment, the insured is mitigating what may be a devastating financial situation in the future. 5

6 Other benefits include: Information Purchasing trade credit insurance provides the insured access to the insurer s knowledge, expertise and advice of buyers, markets and industries. Stability Trade credit insurance can help provide certainty and stability as premium costs can be accurately budgeted and accounted for versus relying on an arbitrary bad debt reserve. Trade credit insurance also helps reduce earnings volatility since the risk of non-payment is mitigated. Conclusion Due to an unpredictable economy and stagnation in much of the industrialized countries, companies are now seeking out opportunities in areas like the Middle East, Western Africa and points across the globe. Trade credit insurance is a tool which may help mitigate the risk of conducting business both domestically and internationally. While trade credit insurance is a relatively newer concept in the United States, the demand is strong and the market is flourishing. The globalization of the United States economy as well as the recent economic and political crisis over the past four years have all led to increased awareness of the risks inherent in global trade and the tools which can help mitigate these risks. A A (06/13) The information in this article was compiled from sources believed to be reliable for informational purposes only. Any and all information contained herein is not intended to constitute legal advice and accordingly, you should consult with your own attorneys when developing programs and policies. We do not guarantee the accuracy of this information or any results and further assume no liability in connection with this article. Nothing herein should be construed as a solicitation, offer, advice, recommendation or any other service with regard to any type of insurance product underwritten by the local individual member companies of Zurich in North America, including Zurich American Insurance Group. Zurich 1400 American Lane, Schaumburg, Illinois Zurich American Insurance Corporation