By Gene Ferraiolo, Partner, Trade Risk Group LLC

Today, most every company faces a problem with accounts receivable risk. The risk that a company’s accounts receivable will be unpaid has become much worse in recent years, both in frequency and severity. Corporate insolvencies have risen to record numbers each of the last three years. Furthermore, as industries have consolidated, the size of the bankruptcies has skyrocketed, leaving creditors on the hook for greater amounts of money. To address this risk, many companies are turning to credit insurance and are finding out that, in addition to risk mitigation, credit insurance can provide sales support and can act as an enhancement for bank financing.

WHAT IS CREDIT INSURANCE?

Credit insurance is an insurance product that protects a company’s accounts receivable against a bad debt due to insolvency or protracted default. Simply put, credit insurance makes certain that valid (non-disputed) accounts receivable will be paid, either by the debtor or by the insurance company. Companies typically buy credit insurance for one or more of the following reasons:

• Risk Mitigation
  A company’s accounts receivable is typically one of its top 5 assets. While the other 4 (property; equipment; inventory; cash) are insured, accounts receivable often go uninsured, even though they may be the most vulnerable to loss and the most likely to be affected by business cycles. Insuring its accounts receivable can provide a company with significant balance sheet protection. By protecting itself against bad debt, especially catastrophic bad debt from a large, unforeseen loss, credit insurance enables a company to maintain its cash flow and profits. Additionally, credit insurance can allow a company to reduce its bad debt reserves, freeing up working capital and taking advantage of the tax deductibility of the insurance premium.
• Sales Tool
  If a company’s credit practices are constraining sales, credit insurance can help. This is especially true for exporters who require letters of credit as payment terms from their foreign customers. While these payment terms address the issue of credit risk, they may result in sales being lost to competitors who are willing to offer open terms. By using credit insurance instead of letters of credit, an exporter can help grow its sales while eliminating the administrative burden of letters of credit. The same benefit applies to companies looking to expand into new markets, or acquirers who do not have a familiarity with the customer base of the company that they have acquired.

  Example: If a company that has 20% gross margins and a Days Sales Outstanding of 45 days is able to increase its credit limit on a customer from $200,000 to $300,000 because of credit insurance, it will gain $160,000 in increased annual gross profit from that customer.

• Financing Tool
  One of the biggest uses of credit insurance is in connection with bank financing. If a company’s accounts receivable are being used as collateral for a loan, credit insurance can facilitate the bank’s ability to lend, and the borrower’s ability to borrow. Typically, a portion of a borrower’s A/R might be excluded from the borrowing base for various reasons (either there is too much concentration with certain customers, foreign receivables, etc). By insuring those receivables, a company can makes those ineligible receivables eligible, thereby maximizing the value of its borrowing relationship. Additionally, banks will often reduce interest rates or waive some security requirements in connection with the borrower’s purchase of credit insurance.

Credit Insurance works in partnership with a company’s credit management. Beyond the actual coverage, credit insurance creates an active relationship between the underwriter and the company’s credit staff, enabling the company to benefit from the insurance company’s significant underwriting skills, information, leverage on debtors, and credit management discipline.

POLICY TYPES

Credit insurance policies can take many different formats. Policies can be written for domestic business only, for export business only, or for both domestic and export business combined. Under every policy type, the insured will still assume some credit risk, typically in the form of a deductible (annual and/or per occurrence), or coinsurance, which is a percentage (10% to 20%) of each loss that is borne by the insured.

The two most typical policy structures are:

• Whole Turnover
  This is the broadest policy structure, covering all of a company’s accounts receivable. Under this structure, a company is given a discretionary credit limit, which enables them to qualify smaller customers for coverage on their own using guidelines set by the insurance company. Customers whose exposures are greater than the discretionary limit are underwritten individually by the insurance company and specifically scheduled onto the policy.
• Key Account
  This is a more targeted policy structure which covers only larger exposures. Under this structure, a company continues to self-insure its smaller exposures, but applies for coverage for all of its customers that are above the pre-determined key account level. For example, a company sells to 100 customers; 20 with average exposures in excess of $50,000, and 80 with average exposures below $50,000. A key account policy can be written to cover the top 20 customers only, providing catastrophic protection at a lower premium relative to a whole turnover policy.

POLICY PRICING

Policies are typically priced using a sales based model. The insured estimates sales for the upcoming 12 months to the accounts being insured, and the insurance company sets the rate based on their underwriting analysis of the insured and the insured’s customers. This rate is then multiplied against projected sales to determine premium. Premium rates depend on a number of factors such as; volume of sales being covered, industry sector, historical bad debt experience, level of credit limits needed, and policy structure. Rates are a fraction of 1% of covered sales, and can range from 0.1% to 0.4% for domestic coverage, and the same or higher for export coverage depending on the type of countries being covered.

MARKET OVERVIEW

The makeup of the marketplace for credit insurance in North America has changed dramatically in the last decade, as a result of the influence of the European credit insurance companies. Credit insurance is used extensively in Europe. Estimates are that approximately 70% of European companies use it, and it is ingrained into the business culture. This is attributed to the necessity for cross-border business that has always existed in Europe, where the underwriter would take over the task of evaluating financial statements in different languages, and become the expert in the various bankruptcy laws in the individual countries. Additionally, banks and insurance companies have combined their businesses in Europe for many years, and the use of credit insurance in connection with bank financing has been more commonplace.

Here in the United States, while the use of credit insurance is growing, it is currently only being used by approximately 4% of US companies. The European underwriters began to make serious commitments to this market within the last ten years, mostly by acquiring US credit insurance underwriters to establish their presence here. What this means for users of the coverage is a significant increase in the capacity of service that the underwriters can now offer to insureds – greater information (one underwriter claims that it has a worldwide database of information on over 40 million companies), greater credit limit capacity through larger reinsurance treaties, and state of the art technology, including on-line interaction with insureds.

The marketplace currently is made up of eight underwriters, and can be divided into two distinct underwriting philosophies - explicit underwriters and implicit underwriters:

• Explicit Underwriters
  Explicit underwriters are buyer underwriting oriented, meaning that they have invested to build an infrastructure of underwriters and a database of information on debtors to play a very active role in the function of setting and monitoring credit limits. Named credit limits are explicitly set by the underwriter and, if a credit limit is in place, the insured has coverage. The relationship between these underwriters and the insured is a very active one, and a big part of what the insured is looking for from these underwriters is for them to serve as an extra layer of credit management. This type of underwriting philosophy is especially suited for small to midsized companies, but is not limited to them. The insured’s risk retention under this type of underwriting philosophy is usually limited to a small deductible and coinsurance, or coinsurance only.
• Implicit Underwriters
  Implicit underwriters are credit management underwriting oriented, meaning that they place much more of their underwriting emphasis on the credit management practices of the insured. These underwriters have relatively small underwriting staffs, as they prefer to limit their buyer underwriting effort only to the very top end of the insured’s customer portfolio. Instead, these underwriters typically grant the insured a very high discretionary limit to cover the majority of their accounts. Coverage is implied, in that it is contingent upon the insured exercising good credit judgment and acting in accordance with their stated credit controls and procedures. The relationship between these underwriters and the insured is not as active as it is with an explicit underwriter. The insured’s retention is usually in the form of a large deductible and coinsurance, and the typical company that buys this type of policy is a large company with sophisticated and well-defined credit procedures in place – the policy acts as a backstop against an unusually large loss or loss year.

DISTRIBUTION

Historically, credit insurance has been distributed primarily by direct sales agents working for a single underwriter. With the influence of the European underwriters, however, the trend is significantly moving towards the utilization of specialty brokers to distribute the product. Specialty brokers have the advantage of bringing multiple underwriters to the client, as well as specialized knowledge of the technical aspects of the various policies as well as the strengths and weaknesses of the underwriters in the marketplace.

HOW CREDIT INSURANCE CAN ENHANCE PRIVATE EQUITY TRANSACTIONS

Credit insurance can benefit private equity transactions in a number of ways. From a risk mitigation standpoint, when you acquire another company, you inherit a customer list or a trade sector that you might not be familiar with. Vetting that customer list through the underwriter provides you with excellent feedback on the creditworthiness of those customers, not to mention the valuable protection that you secure at a vital time during the acquisition and beyond.

If you are acquiring a company that exports using letters of credit, credit insurance can allow you to increase revenue by using the ability to offer open terms as a tool to get more business and increase the return on your investment.

Perhaps the most direct benefit that credit insurance can bring to a private equity transaction is in connection with the financing of the transaction – either the acquisition itself, or to enhance the working capital financing post-acquisition by increasing the level of accounts receivable that are eligible to be financed.

Credit insurance is a versatile tool that can enhance the success of a transaction in many ways.

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Trade Risk Group is a leading national specialty broker of credit insurance. They help companies of all sizes to obtain effective credit insurance policies to cover their domestic and/or export business, and to help service those policies going forward. Gene can be reached at 877.442.7475; email: gene.ferraiolo@traderiskgroup.com; or visit their website at www.traderiskgroup.com.