Trade Credit Insurance

Trade Credit Insurance is a tool that safeguards businesses against losses resulting from non-payment or default by customers. It provides coverage for accounts receivable. This safeguards businesses' cash flow and financial stability. By mitigating the risk of customer insolvency or default, trade credit insurance helps businesses to trade with confidence and pursue growth opportunities while minimizing the impact of credit risks.

A trade credit insurance policy is significant for businesses as it offers protection against the risk of non-payment or default by customers. TCI improves cash flow stability and enables confident expansion into new markets. However, it has limitations, including exclusions for certain types of debts or customers, potential premium costs, and deductibles.

• Trade credit insurance is a tool that allows businesses to offset the risk of non-payment or default by customers. It allows businesses to maintain a stable cash flow.
• These policies have a premium payment and a deductible amount. This minimum amount is what the company has to bear in case of default or non-payment.
• Different policies cover different circumstances. The most common ones are non-payment, default, accounts receivables, or insolvency.
• However, the costs of acquiring such a policy are high, and not all businesses can afford such an additional cost.

Trade credit insurance is a tool designed to protect businesses against losses arising from non-payment or insolvency of their customers. In simpler terms, it is a risk management tool. It provides coverage for accounts receivable, safeguarding businesses against the financial impact of default by buyers.

Essentially, when a company extends credit terms to its customers, there is always a risk of non-payment due to various reasons. Examples include bankruptcy, insolvency, or protracted default. Trade credit insurance policy mitigates this risk by compensating businesses for the amount owed by the defaulting customer.

The process typically begins when a business purchases a policy from an insurance provider. The policy outlines the terms and conditions of coverage, including the maximum amount of credit exposure, the deductible, and the premium amount. Once the policy is in place, the insured business can trade with confidence, knowing that it is protected against the risk of non-payment. If a customer defaults, the insured business submits a claim to the insurance provider for the outstanding payment not received. This provides evidence of the debt owed and the defaulting customer's inability to pay. The insurance provider then assesses the claim and, if approved, compensates the insured business for the outstanding debt up to the policy limit, minus any deductible.

It helps businesses safeguard cash flow by making sure that businesses receive payment for goods or services delivered on credit terms. This, in turn, lowers the risk of financial losses and improves liquidity. Secondly, it enables businesses to expand their customer base and pursue growth opportunities by offering competitive credit terms without the fear of non-payment. Additionally, it can improve business relationships by providing reassurance to customers and suppliers. Thereby, improving trust and reliability in the marketplace.

Any service provided to mitigate risk or cover losses comes at a cost and covers certain circumstances within the policy. It is also essential to understand that different policies might have different coverages.

Let us understand the cost and coverage provided by trade credit insurance companies through the discussion below.

Cost

• Premium: The premiums in this regard are typically calculated as a percentage of insured sales or accounts receivable. The premium rate is fixed based on factors such as the industry, the creditworthiness of customers, the volume of sales, and the policy coverage limits.
• Deductible: Many such policies include a deductible, which is the amount that the insured business must pay out of pocket before the coverage from the insurance applies. Higher deductibles typically mean lower premium costs.

Coverage

• Insolvency or Default: The insurance covers losses resulting from the insolvency or default of customers, including bankruptcy, liquidation, or protracted default.
• Non-Payment: It protects against non-payment due to reasons such as political risks, currency inconvertibility, or payment disputes.
• Accounts Receivable: Trade credit insurance typically covers a portion or all of the insured accounts receivable, providing reimbursement for losses incurred on unpaid invoices.
• Policy Limits: Coverage limits define the maximum amount that the insurance provider will pay out for a single claim or over the policy period. Businesses should carefully review policy limits to ensure adequate coverage for their credit risks.

Depending on the nature and scale of the business, risks, and volume of insured trade receivables, there are different types of policies offered by trade credit insurance providers. Let us discuss the major ones through the explanation below.

1. Whole Turnover Policy: This type of policy covers all of the insured business's trade receivables, providing comprehensive protection against the risk of non-payment from all customers.
2. Key Account Policy: Key account policies focus on insuring specific high-value customers or accounts deemed critical to the insured business operations. It allows businesses to tailor coverage to protect their most significant revenue sources.
3. Excess of Loss Policy: Excess of loss policies give businesses coverage for losses that exceed a predetermined threshold or deductible. These policies are typically used to supplement primary trade credit insurance coverage and protect against catastrophic losses.
4. Single Buyer Policy: Single buyer policies provide coverage for losses resulting from the default or insolvency of a specific customer or buyer. It is suitable for businesses with a concentrated customer base or significant exposure to a single customer.
5. Export Credit Insurance: Export credit insurance specifically covers trade receivables arising from export transactions. Thus, protecting businesses against the risk of default or non-payment by foreign buyers or political risks associated with international trade.

Now that the costs, coverages, types, and exclusions of TCI are clear, let us understand the practicality of the concept through the examples below.

Example #1

Liam is a business owner who provides his customers with a 60-day credit window for them to pay for goods purchased. However, upon analyzing the financials, the team realized something alarming. They found that this 60-day window was affecting cash flow but also putting a dent in the company's profitability as 5% of clients defaulted on their payments.

Therefore, Liam and his team decided to purchase a TCI policy for $300,000, covering losses up to the amount of the policy. The policy is valid only for default of payments from clients who purchased from the company at least 45 days before the commencement of the policy.

Example #2

The uncertainty and protectionism triggered by the COVID-19 pandemic and subsequent lockdowns significantly impacted global trade, straining business finances. Consequently, trade credit insurance products have surged in popularity as they provide vital protection against unforeseen circumstances.

This surge has become a key driver for the trade credit insurance industry post the pandemic. In 2019, the products segment dominated, accounting for over four-fifths of total revenue. However, the services segment is forecasted to experience the highest CAGR of 10.6% during the forecast period.

According to Allied Market Research, in 2019, the global trade credit insurance market clocked $9.38 billion and is likely to reach $18.14 billion by 2027. This growth is expected at a CAGR of 8.6% from 2020 to 2027.

The benefits of having a suitable policy from trade credit insurance companies are listed below.

• Trade credit insurance safeguards businesses against losses arising from customer insolvency, default, or non-payment, ensuring that they receive payment for goods or services delivered on credit terms.
• By mitigating the risk of non-payment, TCI improves cash flow stability for businesses. Thereby, reducing the impact of bad debts on working capital and liquidity.
• This insurance enables businesses to offer competitive credit terms to customers. This attracts new clients and expands sales opportunities without the fear of credit risks.
• Insured accounts receivable can act as collateral for financing arrangements. The TCI facilitates access to working capital financing and credit facilities from banks and other financial institutions.
• With the assurance of payment protection, businesses can pursue growth opportunities more confidently, and invest in new markets. Moreover, they can expand their customer base domestically and internationally.
• This policy promotes business stability by minimizing the financial impact of customer defaults, insolvency, or economic instabilities. The stability allows businesses to focus on their core operations and long-term growth objectives.

While it may be the best decision to get a suitable policy from trade credit insurance providers in some situations, it is also essential to know about similar alternatives to ensure the business gets the best coverage most cost-effectively. Let us discuss a few alternatives through the points below.

• Self-Insurance: Some businesses choose to self-insure against credit risks by setting aside reserves or establishing contingency funds to cover potential bad debts. While this approach offers flexibility and control, it also exposes businesses to the full financial impact of non-payment.
• Factoring: Factoring is the process of selling account receivables to a third-party financial institution (factor) at a lower or discounted rate in exchange for immediate cash. While factoring provides immediate liquidity, it may be more costly than trade credit insurance and may not offer protection against non-payment.
• Letters of Credit: Letters of credit or LCs are financial instruments that can be procured from banks that guarantee payment to suppliers upon fulfillment of specified conditions. While letters of credit assure payment, they may involve additional administrative costs and may not be suitable for all transactions.
• Credit Monitoring Services: Credit monitoring services provide businesses with insights into the creditworthiness of customers and suppliers, helping them to make wiser credit decisions and mitigate credit risks. While these services offer valuable information, they do not provide financial compensation for non-payment.

While a trade credit insurance policy covers a business' existing receivables, there are a few factors or circumstances that do not get included. Let us quickly discuss them through the points below.

• These policies usually exclude coverage for debts that existed before the policy's effective date. In simpler terms, debts incurred before obtaining the insurance are typically not covered.
• Some policies may exclude coverage for specific customers deemed to be high-risk or financially unstable. Insurers may exclude specific customers from coverage based on their credit history or financial standing.
• These insurance policies commonly exclude coverage for losses resulting from acts of war, terrorism, civil unrest, or political instability. These events are considered high-risk and are typically excluded from coverage.
• Disputes arising from contractual obligations between the insured business and its customers may be excluded from coverage. Trade credit insurance typically covers defaults due to financial insolvency rather than disputes over contractual terms.
• Losses resulting from fraudulent activities, such as fraudulent orders or misrepresentation of creditworthiness by customers, are often excluded from coverage.
• Some policies may exclude circumstances where losses result from the voluntary insolvency or intentional default of customers. Insurers may view such situations as an indication of fraudulent behavior and may not provide coverage.

Let us understand the distinctions between the two concepts through the comparison below.

Trade Credit Insurance

• A trade credit insurance policy explicitly covers trade receivables arising from sales of goods or services on credit terms, protecting businesses against the risk of non-payment by customers.
• It is designed to mitigate credit risks associated with commercial transactions between businesses, providing coverage for defaults, insolvency, and non-payment.
• Trade credit insurance facilitates business-to-business trade by offering protection against credit risks.
• It helps businesses to extend credit terms to customers and pursue growth opportunities by concentrating on their core business activities.

Credit Insurance

• Credit insurance provides coverage for a broader range of credit-related risks beyond trade receivables, including consumer credit, mortgage loans, and other financial transactions.
• It offers comprehensive protection against credit risks, including defaults, insolvency, bankruptcy, and other credit events, across various types of credit transactions.
• Credit insurance can be applied across different sectors and industries. It covers both commercial and consumer credit transactions.
• With such diversity, it offers flexibility in risk management strategies.

This article has been a guide to what is Trade Credit Insurance. We explain its cost, coverage, exclusion, benefit, alternative, & comparison with credit insurance. You may also find some useful articles here –

• Export Credit Insurance
• Errors and Omission Insurance
• Trade Credit