Trade credit insurance is a financial tool which manages both commercial and political risks that are beyond a company’s control. Balance sheet strength is ensured, cash flows are protected, and loan servicing costs, and asset valuation are enhanced. It also allows businesses to feel secure in extending more credit to current customers, or to pursue new, larger customers that would have otherwise seemed too risky, significantly reducing the risk of entering new markets.
The protection it provides allows a business to increase sales with existing customers without increasing its exposure. Insured companies can sell on open account terms, where they may be restricted today, or only sell on a secured basis. For exporters, this can provide a major competitive advantage.
Companies invest in trade credit insurance for a variety of reasons, including:
- Sales expansion – if receivables are insured, a company can safely sell more to existing customers or go after new customers that may have been considered too risky without insurance.
- Expansion into new international markets.
- Better financing terms – in many cases, a bank will lend more against insured receivables; this may also provide cost advantages.
- Reduce bad-debt reserves – this frees up cash for the company. Also, trade credit insurance premiums are tax deductible, but bad debt reserves are not.
- Indemnification from customer non-payment.
- Protection of the organization from an unexpected catastrophic event.
While protecting capital, cash flow and earnings are what most companies recognize as the main reasons to purchase trade credit insurance on their AR, as it helps them increase their sales and profits.
Trade credit insurance can also improve a company’s relationship with its lender. In some cases the bank actually requires credit insurance to qualify for a loan. For example, a $25 million scrap metal dealer had extreme concentration in its accounts receivable because it only had eight active accounts. The smallest of these customers had A/R balances in the low six-figure range, and the largest was into the low seven-figure range.
The company’s bank was concerned about this concentration and required credit insurance to fully leverage the accounts receivable as collateral. The scrap metal dealer purchased a policy that specifically named all its buyers, providing the bank the comfort level it needed to increase the eligible receivables.
In fact, the bank increased its advance rate from 80% to 85% for this customer. The net result was that the scrap metal dealer was able to obtain an additional $400,000 in working capital because of its trade credit insurance coverage. The cost of the policy was $25,000 so the return on this investment was excellent, and the scrap dealer was able to use the additional cash to continue funding the growth of the company.
In the face of the global recessionary climate, increased business failures both domestically and globally, and the tightening of credit across the board, it becomes obvious that business leaders must be more vigilant than ever regarding the management of accounts receivable. By maintaining a strong relationship between the insurer and the credit management department, trade credit insurance may be the wisest investment a company can make to ensure its profits, cash flow, and capital are protected.