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Managing Corporate Credit Risk

Friday, August 1, 2008
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An Alternate Strategy for Increasing the Bottom Line

Roughly one-sixth of the assets of U.S. industrial firms are accounts receivable. The management of receivables has a significant impact on cash flow, credit, and the profitability of a company

With this in mind, it is not often that an insurance product can help create revenue and contribute to the profitability of a business.

While Trade Credit Risk Insurance was designed to cover bad debt resulting from a customer’s unpaid balance or bankruptcy, many companies with this coverage have been able to take advantage of additional benefits. Credit Risk insurance policies can be designed to cover trade receivables for loss caused by:

  • Customer insolvency: Bankruptcy filing under Chapter 7 or 11
  • Protracted default (slow pay): Non-payment within a specified timeframe
  • Political risk: Political or economic events in foreign countries that prevent or delay the transfer of payments, including:
    • Government moratoriums on fund transfers abroad
    • Contract frustration, where a foreign government makes a decision that prevents the intended performance of a contract

Credit insurance acts as a guarantee of payment. This allows companies to better manage credit risk, provide customers with improved credit terms, and become more competitive.

Don’t wait until the building is on fire…

The first time companies typically inquire about insuring trade receivables is after a key customer files for bankruptcy. By the time a customer cannot pay, it is usually too late to purchase desired policy limits to cover the lost receivables. Waiting to buy coverage until a customer falls into financial distress is about as easy as buying homeowners insurance for a house that is on fire. The reason this reactionary response usually fails is because underwriting a trade credit insurance policy is primarily based on financial stability of customers for whom credit is extended.

How Trade Credit Insurance is Underwritten

Insurers evaluate the following areas to determine whether or not they will insure receivables, and at what limits:

  • Financial Strength of Customers: Credit reports from companies like Dunn & Bradstreet and the China Credit Information Network provide an insurance carrier with information about the level of risk associated with guaranteeing a customer’s payment.
  • Trade Sector of Buyers: Certain industries are difficult to insure. For example, difficulties in profitability with auto manufacturers make an insurer reluctant to provide high limits for the receivables of an auto parts supplier.
  • Spread of Buyer Risk by Country: If significant amounts of credit are tied up with customers in a country with an unstable economic outlook, insurers are reluctant to put up high limits due to the possibility of a catastrophic loss.
  • Payment History or Trading Experience with Buyers: Just as an insurer evaluates loss history when quoting property or liability insurance, a trade credit insurer evaluates the past payment experience of the customers with outstanding receivables. The potential for a loss is not limited to a customer’s financial mismanagement. A natural disaster like a flood or tornado could temporarily force a customer out of business and render them unable to pay. This is true if a customer has not purchased adequate Business Income and Extra Expense limits to pay for lost profits and continuing expenses. In emerging markets like China, business income insurance is a relatively new concept and is not widely purchased, which can have a negative effect on the profitability of a U.S. business.

Five Benefits of Trade Credit Insurance

A Trade Credit Insurance policy can provide a number ancillary benefits and present ways to help pay for itself. Benefits include:

  1. Improved Financing: Trade credit insurance allows a company to guarantee payment of receivables. A company can then approach a lender and borrow funds against those guaranteed receivables, resulting in better credit terms.
  2. Sales Tool: Customers can enjoy increased ease of doing business if they do not have to post costly and complicated Letters of Credit to guarantee payment. Instead, an insurer can guarantee the receivables and the cost of the insurance policy can be passed through to the customer.
  3. Increased Sales: Some companies limit growth because of concern over the risk of default with outstanding receivables. By guaranteeing payment, companies can extend greater credit limits while keeping risk at a manageable level, allowing the company to sell more product.
  4. Risk Mitigation: When a small number of customers constitute a majority of revenue, a loss to a single customer can have a devastating impact on the bottom line. A trade credit policy can reduce the severity default and help ensure continued profitability.
  5. Enhanced Credit Management Process: Since an insurance company carefully evaluates the finances of those to be insured, they can help determine how to set up credit terms with a new customer. For example, if the insurer declines to provide coverage, it is because of increased financial risk. This means that the terms of sale might need to be restructured and alternative financial guarantees be instituted, like cash in advance.

Credit Risk is something that has gained a lot of attention with the current financial crisis. Many companies are examining the credit threat to their balance sheets for the first time and are looking for ways to protect their business. Proper management of credit can lead to higher revenues with controlled risk – something that goes a long way toward improving the bottom line.

 

* Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2003) Fundamentals of Corporate Finance 21 707

Material posted on this website is for informational purposes only and does not constitute a legal opinion or medical advice. Contact your legal representative or medical professional for information specific to your legal or medical needs.

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