Don’t let this economic black hole melt down your receivables.
As late as mid-2008, our economy still seemed to be going strong amid a feeling of continued prosperity ahead. Then, we were totally shocked by the ultimate collapse of multiple major investment houses. Since then, we have witnessed the collapse of the U.S. auto industry and have been grappling with an economy that has produced thousands of business bankruptcies.
The number of business bankruptcy filings nationwide in 2008 totaled 43,546, almost double that of the 23,889 filings reported in 2007. Furthermore, according to the American Bankruptcy Institute, the total number of business bankruptcies (companies declaring either Chapter 7 or 11 bankruptcy) for 2009 was more than 70,000. Where this economic black hole will lead is anybody’s guess, but since so many well-known and “built to last” companies have declared bankruptcy, we can no longer assume that even our blue-chip customers are immune to financial collapse.
I’m not trying to be all gloom and doom, but at this point you should be seriously thinking about the financial stability of your customers and taking as many credit-risk management precautions as possible to protect your company in these very volatile and uncertain economic times.
Besides equipment and machines, MHEDA members’ accounts receivable are also a very valuable asset. However, it is an asset that many company owners and managers may not fully understand.
In its simplest terms, an account receivable represents the money that your customer owes you. More completely, it represents all of the labor and material resources that you have utilized in order to create, market, manufacture, sell and distribute your products and services, all on the promise that you will be paid.
What happens if your receivables don’t get paid? Can your company weather this loss? The problem may not lie with your customer, who you may have done business with for many years, but with your customer’s customer, about whom you know very little. In normal times, this happens occasionally; in this economy—especially with all the bankruptcies related to industries such as auto, housing, manufacturing and construction—it will most likely happen much more often. This could seriously impact your cash flow, bringing your own company to a complete halt.
Accounts Receivable Insurance
With the above in mind, accounts receivable insurance (also known as credit insurance), is a before-sale credit-risk management product that insures your commercial accounts receivable against your customer’s failure to pay or bankruptcy. In other words, even if your customer defaults on payment or goes bankrupt, the credit insurance company will assure your payment.
In Europe, more than 80 percent of all commercial transactions are covered under credit insurance. In the United States, although credit insurance is not very well known, it is a multi-billion-dollar industry. The credit insurance industry comprises about ten major insurance companies, including Atradius, Euler ACI, Coface-USA, FCIA, QBE-USA, Ex-Im Bank, AIG, Lloyds, Chubb Group and Zurich. Some credit insurance companies will underwrite both domestic and trade-export credit insurance, and others concentrate only on trade-export credit insurance. Some provide a variety of credit risk services such as credit reports and debt collection, while others provide only credit insurance coverage. Regardless, depending upon the insured’s industry, history of losses and the creditworthiness of its customers, credit insurance policies are very flexible and will be tailor-made to fit the insured’s needs. At the most basic level, credit insurance is designed to protect a company from unexpected losses due to the insolvency or payment default of the insured’s customers. The above-mentioned underwriters will, in most cases, conduct credit evaluations on the accounts that a company wishes to insure and approve them for specific credit limits. The credit limits are based upon requests by the insured and the results of the credit investigation. Given this active credit investigation on the part of the insurer, credit insurance should be approached as a tool you can use to grant credit to companies in the event of a possible loss for which you are looking to shelter. The first step to understanding if a credit insurance program is a good fit for your company is to identify the potential risk within your customer base and accounts receivable portfolio. If there are significant customers overseas to whom you are selling on credit, then this would be considered a risk. If there is a significant pool of customers within your customer base that occupy a large percentage of the total sales, whereby even one default would have an impact on cash flow, then this also would be considered a risky situation.
Credit insurance policies can be tailored for specific credit risks, so coverage details vary. Some policies may cover an entire accounts receivable portfolio, while others may cover only the top ten customers. Some policies may contain both deductibles and co-insurance—it all depends upon the needs of the policyholder and the risks within the portfolio.
The main events that are covered under a credit insurance policy are payment default and customer bankruptcy. Payment default is defined as the customer having the will and volition to pay but not the ability to pay. Disputes against the products or services sold are not immediately covered by the credit insurer. If they cannot be resolved amicably, then they will need to be settled in court with a judgment in favor of the policyholder before being reimbursed. Conversely, any time that a bankruptcy is declared, whether it is Chapter 11 or 7, the claim will be immediately recognized by the credit insurer and payment will be forthcoming shortly.
Although credit insurance is a safety net that protects a company’s receivables, not every customer can be covered under a policy. Prior to entering into a policy, credit insurers will perform an underwriting process in which the creditworthiness of all the major accounts is reviewed. During this process, any negative information—such as lawsuits, history of non-payments or other issues against the customer—may come to light, which could affect the possibility of coverage. Depending upon the degree of the negative information, some policyholders may be covered only up to a certain limit or not at all.
How Much Does Credit Insurance Cost?
Generally speaking, the premium is based upon a potential insured’s estimated annual sales. For example, if sales were about $10 million, then the rate would range between 0.2 percent and 0.3 percent and the premium likely would be between $20,000 and $30,000 per premium period (usually one year).
Several factors influence a premium rate:
- Industry of the insured
- Pool of customers being covered
- Creditworthiness of customers
- Customer location (domestic or international)
- Deductible amount (This is always an annual aggregate amount)
- Previous loss history
- Financial condition of the insured
- Internal credit management control of the insured.
How Much Is Paid Out?
Depending upon the amount of the deductible and the co-insurance that an insured has with their policy, credit insurance generally pays out 80 percent to 90 percent of the loss. Payments will be reduced by the return or salvage of any equipment and inventory. Subsequently, the credit insurance carrier takes over the receivable as the creditor and either performs collection activities against the debtor or stands in line as one of the unsecured creditors. In addition, depending upon other secured interests that the creditor may have against the debtor, all these secured interests will need to be perfected prior to any payouts.
Enhancement of Borrowing Power
Although the main goal of credit insurance is accounts receivable loss protection, it is often used as a way of enhancing borrowing power. If the insured is using its receivables as collateral for a line of credit (working capital loan), credit insurance can provide additional comfort and protection to the lender so that they may be able to enhance the borrowing arrangements. They do this by increasing the percentage they will advance against insured accounts, and/or roping more accounts into the borrowing base, such as large concentrations, slow payers, export customers, etc. This allows the insured to maximize the amount of working capital available from the same pool of receivables. If the insured is in a high growth mode and finds himself in need of more working capital, credit insurance is a great way to resolve this problem.
This should give you a solid idea of how you can continue to offer customers credit terms while at the same time create a safety net to support your company’s continued success during these very turbulent times.
|Meet the Author
Steven Gan is the founder and president of Stellar Risk Management Services, located in Northbrook, Illinois, and on the Web at www.stellarrisk.com.