By Jerold Oshinsky, Andrew C. Cooper, and Charles A. Luftig
With the market’s direction uncertain and bankruptcies continuing to plague businesses both large and small, companies need the protection of a thorough review of the insurance policies covering their assets. But one of the largest assets for many companies -- accounts receivable -- is often the last to be insured.
Consider two business scenarios:
- A cleaning fluids supplier generates a large percentage of its accounts receivable through a handful of major clients. When one files for bankruptcy after defaulting on several payments, the supplier is left with serious liquidity problems. In response, it could impose restricted credit limits on its customers. This would certainly limit the supplier’s credit risk, but would also reduce its business opportunities. Instead, by purchasing credit insurance, the company can reduce the risk without restricting its ability to engage in future business transactions.
- A paper manufacturing company needs $2 million to buy new production equipment so it can pursue a new market opportunity. Its receivables, however, are concentrated among several debtors, and the bank will not loan money to the company because of the risk that one of these debtors might default on its payments. With the purchase of credit insurance, the company can reduce its exposure to the risk of nonpayment and remove the main obstacle to receiving the needed capital. It also can skip the process of obtaining costly letters of credit from its old and new clients.
As these examples suggest, nonpayment, or even the threat of nonpayment, can curtail business opportunities and threaten the vitality of a business. In fact, more than 10% of bankruptcies are caused by failed companies that default on their debts. Businesses do not just collapse in isolation -- they also drag down other companies that rely on them. Credit insurance can insulate a company against defaulting clients through reduced credit exposure and greater capital availability.
How business credit insurance works
Credit insurance, also called accounts receivable insurance, protects a company’s trade credit exposure against the failure of its customers to pay their trade debts. The insurance is triggered by the indebtedness of a policyholder’s clients that are in protracted default on their payments or that have become insolvent.
Credit insurance offers a company an effective solution for minimizing risk levels and maximizing capital availability, regardless of the size of the business. For large companies, it can prevent catastrophic losses on large, unexpectedly defaulted accounts, making cash flow more predictable. It also can account for bad debts -- a company can reduce its reserve capital for troubled accounts to the amount of self-insured retention.
This coverage plays an especially important role if a company’s goods are also sold abroad, where change in regulations can alter contracts, perhaps preventing or delaying payments. Carriers can write policies to include coverage against these types of political nonpayment risks.
Credit insurance also can help smaller, domestic market companies secure capital from lending institutions that normally would be uneasy about concentrated creditors. It can also mitigate the risks associated with opening up a new market, or giving credit to a new client, without spending the time and money it takes to obtain letters of credit.
Perhaps most benefited by credit insurance are industries that rely on consumer credit or loans. Consumer lending companies, for example, have a certain percentage of customers that will default on their obligations regardless of how strict the company sets its credit requirements. If the lender has credit insurance, even if there are a greater number of defaults than its business model projected, the company will be protected under the policy and will be guaranteed a predictable flow of income.
Types of Credit Insurance Policies
Credit insurance policies vary considerably depending on the size of the business seeking the coverage and the types of policies offered by the insurance carrier. Each policy contract takes into account the characteristics of the business seeking coverage, and much of the contract language can be customized to fit the needs of the specific policyholder. Despite this variation, there are several policy structures common to all insurers.
The largest credit insurer in the United States, EULER American Credit Indemnity ("EULER"), typically writes ‘whole turnover’ policies. This type of policy is written to cover a company’s entire book of business, with the standard level of indemnity around 85% of any particular loss. Other insurers may allow specific account exclusions, but normally whole turnover policies cover all of a company’s accounts.
Some insurance companies offer a variation on this type of policy called a dual coverage structure. This provides "ground up" coverage for larger accounts (accounts that are individually reviewed and underwritten for a specific coverage amount to cap severe credit exposure), and a "discretionary limit" for smaller accounts (an amount that allows policyholders to decide which accounts to insure).
EULER’s standard policy covers losses associated with the insolvency or protracted default of a policyholder’s covered buyer, if the loss is greater than the non-qualifying loss amount (the minimum loss a company may recover -- a level that changes depending on the particular policy). From this loss amount, any disputed portion of the payment is deducted, and the remaining portion is paid up to the credit limit assigned to each buyer.
For companies not wishing to pursue a whole turnover policy, but instead wanting coverage on several concentrated debtors, another type of policy is the named policy form, also called the key accounts type. This policy covers the largest accounts of a company and is pre-approved by buyer underwriters. The advantage of this policy is that it can be tailored to fit any portfolio risk, often resulting in more targeted coverage with lower premium payments.
One important feature in all of these policies is the level of self-insured retention (the amount of risk a company shares with its insurer). The advantage of splitting the risk is that it reduces premiums. The disadvantage, of course, is that the policy becomes a "co-insurance" policy that pays out a lower percentage of losses; or, as some policies require, the policyholder will have to pay a deductible to recover on losses suffered (either the insurer pays the excess of the loss over the deductible or uses an annual aggregate deductible amount).
The total level of coverage within each of the policies is greatly affected by the specific contractual provisions. Some policies feature waiting-period insolvency that can affect payouts, and others either specifically include or specifically exclude coverage for particular instances of insolvency, such as forced liquidations or protracted disputes.
It should be noted that there are strict procedural provisions can give rise to litigation; if not precisely followed, they could result in nonpayment on the policy. Common provisions specify that claims not filed within the maximum claim filing period are presumed withdrawn, and losses from shipments that occurred after a buyer has become insolvent are not considered covered.
The premiums paid on these policies are a function of the extent of the coverage and the size of the company. Most policies are structured to reflect the mix of small, medium, and large accounts in a company’s portfolio. But, depending on the credit insurer, the policy may be written after reviewing the majority of a company’s accounts, or just the largest accounts (for companies with mostly concentrated debtors). For EULER’s whole turnover policy, the premium is calculated using a percentage of a company’s sales. The rate varies between 0.1% and 1%, depending on the company’s trade history and historical debt loss.
One downside to credit insurance is that there are credit limits that reduce payouts on specific transactions that exceed preset limits. These, of course, vary depending on the type of policy and level of coverage generally. The second downside is that the policyholder must give up some of its earnings. Still, increased capital availability, decreased risk associated with defaulting debtors, and more predictable cash flow make credit insurance a beneficial investment for most companies.
Making a credit insurance policy work for you
Credit insurance policies contain traps for the unwary. Common disputes between policyholders and insurance companies arise over provisions that exclude from coverage accounts receivable that are merely disputed, rather than defaulted. Such an instance can occur when there is a disagreement between the policyholder and its customer over the amount owed, or a complaint over the goods or services provided. As a general rule, insurance companies will not cover losses from disputes, charge-backs, deductions, and other such instances that occur in the normal course of business. Even clauses as innocuous as choice-of-law provisions can have a large impact in the extent of coverage and projected payouts.
One strategy used to avoid coverage litigation is to have the insurance carrier approve business transactions before they occur (front-end approval). Should the policyholder's client default, whether coverage applies will already be a settled question. However, front-end approval slows business dealings and creates additional procedural requirements to follow. The alternative is to submit claims after transactions already have occurred (back-end approval). This is much faster than front-end approval, but creates more litigation -- especially as losses increase. Often policyholders think their transactions are covered, only to discover that the carrier has denied coverage, based on a strict reading of the policy.
Consider whether your company would benefit from securing its accounts receivable or increasing its capital liquidity. If you decide to pursue credit insurance, you should have a knowledgeable attorney tailor its language to fit your company's needs before you purchase the policy. With assistance, you will be able to determine how much coverage to expect, and what procedures to follow in order to secure payment in the event the coverage is needed.
Even if your company already has credit insurance, an attorney with knowledge of insurance law should review the policy in order to determine your company’s level of coverage. Predictable income streams and reduced risk are achieved only when there is a measure of certainty over what a credit insurance policy does and does not cover.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.