What is Credit Insurance?
As a business owner, you dread this nightmare scenario: your company has a long and lucrative history a customer that becomes a very large part of your business. Without warning, the customer files for bankruptcy protection and suddenly YOUR business is in crisis mode. Your major source of cash flow has dried up, and you do not know how you will pay the bills.
What is Credit Insurance?
This does not have to be the scenario. An underutilized business tool called credit risk insurance can ensure that companies avoid this nightmare. At the most basic level, credit insurance is designed to protect companies from unexpected losses due to the insolvency or past due default by their insured customers. It is a proactive management tool that can be designed in a number of ways to meet the risk management needs of a business. If a customer becomes insolvent, the insurer bears the risk, with the exception of a deductible and co-pay which are a negotiated part of the insurance policy. It is important to note that credit insurance covers accounts generated after the policy begins, which is why it is a proactive tool. A business cannot cover past accounts by grandfathering them in under a new insurance policy.
The obvious benefit for all who have witnessed a bad debt nightmare is that credit insurance provides catastrophic loss protection for large account concentrations that have the potential to bring a company down. But, what if a receivable concentration is so high that an insurer will not cover it all? There is a market known as excess insurance that can provide additional coverage on these accounts. As a general rule, the excess carrier will provide a maximum limit equal to what the primary carrier is offering and their insured percentage mirrors what you have in your primary policy. Beyond this most obvious benefit, there are three other key benefits to using credit insurance.
Three Key Benefits to Using Credit Insurance
- It allows for safe sales expansion. As a company grows, competition often requires that it extend substantial credit to companies that it does not know well or which do not have much credit information available. By insuring its accounts, a growing company can largely mitigate this risk.
- You gain professional credit decision support and information on your customers. Your insurer is a business partner whose goal is to help you avoid credit losses before they happen and back you up when they do. Credit insurers have data, resources, and expertise that other businesses cannot come close to matching.
- Obtain additional borrowing. Whether it is covering a high concentration account, a slow paying account, or export sales, credit insurance can help you maximize the borrowing power that you have from your accounts receivable.
Credit insurance works best for companies that have high concentration accounts, have export sales, or are in industries that have a tendency to pay slowly.
We are all concerned about cost, so what is the cost of credit insurance and how can it be managed? The cost of credit insurance varies, based upon a number of factors including:
- Your historical loss experience
- Risk in the portfolio
- Spread of risk being provided
- Seasonality in the portfolio
- Risk retention on the client’s part
As a “ballpark” estimate, the typical annual premium runs approximately one-tenth percent to four-tenths of a percent of covered annual sales. A couple of ways to mitigate this cost would be to carry a larger deductible or a higher percentage of co-pay.
A good resource to perform a cost/benefit analysis can be found on the website of Global Commercial Credit www.gccrisk.com where they have a cost benefit calculator. You enter certain data and it shows you the anticipated cost and the financial benefit you can gain.
Alternatives to Credit Insurance
An alternative to credit insurance is the use of a put option. This can be useful to cover the risk in a single account, particularly when the insurance market is reluctant to insure it. This program involves a non-cancelable contract whereby the option seller agrees to buy qualifying accounts receivable at a pre-determined amount if your protected customer goes insolvent during the contract period. The protection would be provided by a financially strong counterparty. Put options can be arranged through credit insurance brokers.
Due to the very specialized nature of credit insurance, the use of a broker is highly recommended. A good broker will know the major insurers and their appetites to secure certain risks and the nuances of their policies. Their solid relationships with the insurers enable them to negotiate on your behalf using leverage that you simply do not have.
About the Author
Toby Dahm serves as senior vice president and ABL portfolio manager for Hitachi Business Finance. In this role, he assists in business development and is responsible for underwriting and managing all of asset-based loans.
Toby has more than 25 years of experience in commercial lending. He is active in the Association for Commercial Growth, the Commercial Finance Association, and serves as an advisory board member for The Salvation Army.
Contact Toby today at firstname.lastname@example.org or (248) 658-3208.