Trade credit insurance is a form of risk management designed for businesses needing to protect their accounts receivable from loss due to credit risks such as protracted default, insolvency or bankruptcy.
It is purchased by companies to protect themselves in the event a key customer or group of customers fails to pay debts owed to the company. The premium is usually charged monthly, and is typically calculated as a percentage of sales for that month or as a percentage of all outstanding receivables.
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How Does Trade Credit Insurance Work?
Trade credit -- or deferred payment for goods or services -- is offered by businesses to their customers as an alternative to prepayment or cash on delivery terms, providing time for the customers to generate revenues from sales to pay for the products or services.
This requires the business selling its goods or services to assume the risks of non-payment.
This arrangement acts like a loan between the buyer and seller, but this is not a secure asset until it is paid. If the customer's debt is covered by a trade or business credit insurance policy, this large, risky asset becomes more secure. The asset may then be viewed as collateral by lending institutions and can be used as a trade finance tool.
For example, if a steel company sells a large shipment of raw product to a major customer, they may agree that the payment for this shipment can be spread out over a year or more. This gives the customer time to make the raw steel into other products to sell to its own customers.
The steel company will want trade credit insurance on that outstanding debt in the event its customer goes out of business or lands itself in bankruptcy court. If the steel company does not receive payment as outlined in the sales agreement, the trade credit insurance coverage will kick in to pay a portion of the debt.
The portion typically varies from 75% to 95% of the invoice amount, but may be higher or lower depending on the type of trade credit insurance policy purchased.
One of the hidden benefits of trade credit insurance is that the steel company can use the insured debt as collateral when seeking financing for its own business dealings. Without insurance, the unpaid debt is a negative on the balance sheets, whereas trade credit insurance turns it into a positive.
Where Can Trade Credit Insurance Be Applied?
Policy holders must apply a credit limit to each of their buyers for the sales to be covered by trade credit insurance. The premium rate reflects the average credit risk (determined by the insurance company) of the insured portfolio of buyers. Trade credit insurance can also cover a single transaction or trade with only one buyer.
Using the example of the steel company, it may be wise for them to consider trade credit insurance on that major purchase alone, or on a number of its customers if the revenues from those sales equal 30% or more of their total income.
They also have the option to purchase a whole turnover trade credit insurance policy that covers the sales of all of their customers. The insurance company will determine how likely it is that the customer or customers will pay for the shipment or shipments.
That risk assessment will be factored in to how much of the debt will be insured and the premiums paid by the steel company.
When Businesses Should Consider Trade Credit Insurance
Trade or business credit insurance can help businesses big and small. A modest company may earn most of its revenues from a single customer.
The owners will want an insurance policy to protect their bottom line in the event that customer defaults on their payments, dissolves their own business, or files for bankruptcy. Others who should consider trade credit insurance include:
- Any company that sells goods and services on credit terms rather
than requiring payment up front and is exposed to the risk of
non-payment should consider this coverage.
- Any business that deals in international exports should consider this coverage, sometimes called export credit insurance.
For example, say a manufacturer of agricultural equipment sells most of its machinery to a single distributor. They can consider a long-term trade credit insurance agreement that cannot be canceled if they are happy with the business interactions and have no reason to believe the distributor is going anywhere any time soon.
Or, the tractor maker can consider a medium-term trade credit insurance policy (typically with a duration of five years or so) that will insure their payment schedule while they diversify their customer base. They can expand their sales into more markets, knowing that even if their biggest customer defaults, they won't be left holding the bag.
Large companies, and especially multinational entities, invest in trade credit, business credit, or export credit insurance as a means to:
- Reduce their bad debt reserves
- Facilitate attractive bank financing
- Mitigate their risks
- Provide a cost-effective way to collect debt, since many insurance companies offer third-party debt collection services as part of a trade credit insurance package.
It is also helpful for large businesses to have get the credit worthiness of their customers vetted by the insurance company when the terms of the trade credit policy are assessed. This can help them determine whether they want to be in business with the customer in the first place.
Finding the Right Trade Credit Insurance Policy
When looking for a trade credit insurance policy that meets your financial needs and goals, you want an insurance broker who works for your business interests, not the insurance company's.
Knowledgeable, independent insurance agents can help your business navigate policy options and premium agreements so you can find the policy that's the best fit for your individual requirements at the most competitive rates.
Our agents help businesses big and small mitigate their risks and protect their companies with trade credit insurance policies. Find a local agent today.