Why has it taken more than one century for credit insurance to become more widely used by American chief financial officers and credit professionals?
It’s primarily due to the fact that there are a number of typical misconceptions about this type of credit risk mitigation strategy.
The practice of insuring commercial accounts receivables against default has existed in the United States for more than 120 years. In fact, like many technological and financial innovations implemented by companies globally, credit insurance was invented in the United States. Yet as a risk mitigation strategy undertaken in the normal course of business, its usage by American companies pales in comparison to corporations in Western Europe. Easily 1/3 of European corporations of all sizes have credit insurance. In the United States, it’s fewer than 1 in 10, but has grown from 1 in 50 companies since the early 1990s.
Why is that?
In order to understand the phenomenon behind this trend, we need to debunk the most common prevailing myths concerning the concept of credit insurance. Regardless of where they reside, those executives who aren’t aware of recent market developments often say, “I’m ruling out credit insurance because….”
I. “…we must insure our entire portfolio of customers”
From the early 1890s until the mid-1990s, the U.S. marketplace had at most five or six insurance underwriters. In the last 20 years, that number has swelled to at least 13 insurers, excluding the United States Export Import Bank. During the U.S. market’s first century as an oligopoly, companies were usually obliged to cover their entire customer base in order to obtain coverage. However, in recent years, underwriting guidelines in this respect have become much more flexible, particularly with the entry of several new underwriters. With a far more competitive marketplace, underwriting standards have now evolved to the point where companies can elect to insure only specific customers or even just one customer. Insureds can now request coverage on their customers based upon a much wider range of selection criteria such as those buyers within a certain subsidiary, division, size range, distribution channel and yes, even credit quality.
II “…we’re very comfortable with our customers and we’ve had minimal bad debt expense”
Experience over the past 20 years has proven time and again, that many large companies pay their suppliers in a prompt fashion literally right up until the day those same companies file for Chapter 11. Unlike the years prior to the 1990s when a company’s bankruptcy filing was a real stigma on the quality of the company’s management, a Chapter 11 filing is now often viewed as a valid operating strategy, even for a company which on paper is NOT insolvent. The U.S. bankruptcy process has devolved into a means of avoiding environmental, pension or legal liabilities. In a number of other industrialized countries, bankruptcy laws have similarly changed over the past decade to become more debtor-friendly. This global trend promises to make default predictability much more challenging all over the developed world.
The past is not always a good indication as to what will happen in the future. Companies should always be prepared for the worst-case scenario and mitigate that potential risk, as unlikely as it may seem. Most companies would never consider not insuring other assets, like property, plant & equipment. Given that accounts receivable are often a company’s largest and most liquid balance sheet asset, why should that remain uninsured?
III. “…credit insurance only makes sense if loss payments exceed premium”
Credit insurance is a risk transfer mechanism, not an investment vehicle. There is no value proposition if a policy is structured which simply trades premium dollars for loss payments. However, what if:
a) having an investment-grade, credit-risk sharing partner could help your company achieve incremental sales with customers you’ve been too conservative because of a lack of data, weaker credit quality or the customer(s) are in foreign geographic markets with which you are not familiar? If the answer to any of these questions is “yes”, the incremental revenue achieved often makes the entire contract self-funding.
b) your company could trade non-tax deductible reserves for bad debt for a tax deductible premium and leverage your coverage per premium dollar spent by at least 40x? Moreover, auditors often view credit insurance as effective in augmenting an insufficient reserve as it is for reducing an excessive reserve.
c) you could increase your company’s working capital availability under a secured line of credit by having previously ineligible receivables be made part of the borrowing base now that the receivable(s) are insured?
Unlike many other property and casualty insurance products, credit insurance is multi-dimensional with a number of other tangible ancillary benefits.
IV. “…credit Insurance is too expensive”
Depending upon the size of the credit insured portfolio, geographic spread of risk, credit quality, tenor, historical loss experience, etc., the premium associated this sort of coverage can range typically from .05% to .75% as a percentage of insured sales. Is that fraction of a percentage point too expensive when viewed from the perspective of your company’s stakeholders? Would your shareholders, lenders, employees and vendors all agree with the assessment that “credit insurance is too expensive” in the event that your company suffer a large payment default which could have been credit insured?
V. “Insurers won’t cover the accounts we’re most concerned about or they’ll pull coverage at first sign of trouble.”
The competition to underwrite credit protection has become so intense that credit insurers, banks and hedge funds now compete against each other to write coverage on both investment grade and sub-investment grade risks. This level of competition between protection sellers is unprecedented and represents an extraordinary opportunity for protection buyers as potential consumers of credit protection products. Never before have corporations had so many choices.
In fact, the concept of non-cancellable coverage has become increasingly popular for finance and credit executives. Almost all of the insurers and banks who underwrite credit protection globally now do so on the basis of committing to specific, insured credit limit(s) which can not be reduced or cancelled during the insurance policy period, even if there is a deterioration of the insured customer’s credit quality.
A company’s best strategy is to find an expert advisor who can educate stakeholders on today’s rapidly evolving marketplace and help you navigate the myriad of possible solutions.
Author: Marc D. Wagman is the Managing Partner of Aequus Trade Credit, an expert specialty broker of credit protection products ranging from traditional credit insurance to political risk insurance and credit derivatives. With more than 20 years of experience in credit risk mitigation, the capital markets and commercial finance, Marc is a nationally recognized leader in his field. Prior to joining Aequus in 2003, Mr. Wagman was Vice President-Sales for Euler Hermes ACI in New York where he concentrated primarily on export-oriented companies. In the early 1990s, he sourced trade claims and sold receivable puts for Avenue Capital, a New York City based hedge fund.
Marc began his career as a treasury and financial analyst for The CIT Group, Inc., where he co-managed CIT’s interest rate swap portfolio and received formal credit training. Later in his tenure with CIT, he worked as a research analyst in CIT’s economics department. Marc graduated from Rutgers University with a Bachelors Degree in Political Science, and he obtained his M.B.A. in Finance from Fordham University’s Graduate School of Business.
Interesting perspective on the value proposition. I have always been hesitant to use or recommend credit insurance products. The competitive nature of today’s credit insurance market along with uncertainties post recovery justify a second look. The ROI has many components as highlighted in this article. Good Job.