What If Your Customers Can't Pay You? By Steven Gan, Stellar Risk Services
Article Date: 02-01-2009
Copyright(C) 2009 Associated Equipment Distributors. All Rights Reserved.
In these unprecedented economic times, commercial credit insurance could be an indispensable tool to protect your account receivables and minimize the impact on your company if customer goes bankrupt.
Editor’s Note: While CED recognizes that credit insurance may not be a fit for all AED dealers, it is our intent to raise awareness about this insurance product. In general, if 20 percent of your customer base represents 80 percent of your revenues, credit (or accounts receivable) insurance may
be worth investigating.
It seems that only about eight months ago our economy was still going strong and there was a feeling of continued prosperity ahead of us. Then suddenly we were totally shocked by the ultimate collapse of Bear Stearns (and its sale to JP Morgan at pennies on the dollar) and other major investment houses. Since last fall we have been watching AIG and the “Big 3” in the U.S. auto industry reduced to begging for loans before Congress – and it appears that there will be many more multinational companies falling into serious trouble.
By June of 2008, the number of bankruptcy filings nationwide totaled 33,822, which was up 41.6 percent from the 23,889 reported in June 30, 2007. Furthermore, according to the American Bankruptcy Institute, the total number of business bankruptcies (Chapters 11 and 7) for 2008 is expected to exceed 50,000. Where this economic black hole will lead us to is anybody’s guess, but with so many well known and “built to last” companies declaring bankruptcy, we can no longer assume that even our “blue chip” customers are immune to a financial collapse.
The purpose of this article is not to dwell on the “doom and gloom,” but rather to encourage you, the equipment dealer, to think seriously about the financial stability of your customers and to take as many credit risk management precautions as possible to protect your company in these very volatile and uncertain economic times.
Besides the equipment, trucks and parts inventories that are the prized assets of an AED dealership, your accounts receivables are also among your most valuable assets. However, it is an asset that, unfortunately, most company owners and managers may not really understand how to protect.
In its simplest terms, an accounts receivable represents the monies that your customer owes you. However, more completely it represents all of the labor and material resources that you have utilized in order to create, market, sell, and distribute your products and services, all on the promise that you will be paid.
And what happens if your accounts receivable doesn’t get paid? Can your company weather this loss? You may be thinking that you’re safe if customers are using capital that is financed from other sources to purchase your equipment, but if you are extending any type of credit to your contractor customers you may need to assess your risk exposure. In addition, the parts and service side of your business – which generates the highest margin of profit in your company – could also take a hit if a large customer defaulted or went bankrupt and couldn’t pay for work your company performed. Once a customer of yours is approved for AR insurance coverage, you are ensured payment regardless of what you sold, whether machinery, parts and service, or rental service.
The problem may not lie with your customer, who you know very well and with whom you have done business for many years. Rather, trouble could originate with your customer’s customer, about whom you may know very little. In normal times it happens occasionally that your customer’s customer may not pay, which in turn impacts your customer’s ability to pay you. However, in this economy, especially in view of all the bankruptcies related to certain industries such as auto, housing, and construction, it will most likely happen much more often and could seriously impact your cash flow, bringing your own company to a complete halt. We may think that we know our customer but often we don’t know our customer’s customer, and herein lies the risk.
With this in mind, accounts receivables insurance (also known as credit insurance), is a before-sales credit risk management product that insures your commercial accounts receivables against your customer’s failure to pay or bankruptcy. In other words, even if your customer defaults on payment or goes bankrupt, the credit insurance company will assure your payment.
In Europe, over 80 percent of all commercial transactions are covered under credit insurance. In the U.S., although credit insurance is not very well known, it is a multibillion dollar industry. The credit insurance industry is comprised of about 10 major insurance companies that include: Atradius, Euler ACI, Coface-USA, FCIA, QBE-USA, Ex-Im Bank, AIG, Lloyds, Chubb Group, and Zurich. Some of the credit insurance companies will underwrite both domestic and trade-export credit insurance, and others will concentrate only on trade export credit insurance. Some provide a variety of credit risk services such as credit reports and debt collection, while others provide only credit insurance coverage. Regardless, depending upon the insured’s industry, history of losses, and creditworthiness of its customers, credit insurance policies are very flexible and will be tailored to fit the insured’s needs.
At the most basic level, credit risk insurance is designed to protect a company from unexpected losses due to the insolvency or payment default on the part of the insured’s customers. The above-mentioned underwriters who specialize in this unique coverage will, in most cases, conduct credit evaluations on the accounts that a company wishes to insure and approve them for specific credit limits. The credit limits are based on requests by the insured and the results of the credit investigation.
Given this active credit investigation on the part of the insurer, credit insurance should be approached as a tool you can use to grant credit to companies while sheltering yourself from possible loss.
The first step in determining whether a credit insurance program is a good fit for your company is to identify the potential risk within your customer base and accounts receivable portfolio. If there are significant customers overseas to whom you are selling on credit, this would be considered a risk. Or, if there is a significant pool of customers within your customer base that comprise a large percentage of the total sales, whereby even one default would have an impact on cash flow, his too would be considered a risk situation.
Credit insurance policies can be tailored for specific credit risks, so coverage details vary. Some policies may cover an entire accounts receivable portfolio while others may cover only the top 10 customers. Some policies may contain both deductibles and co-insurance – it all depends on the needs of the policyholder and the risks within the portfolio.
The main events that are covered under a credit insurance policy are (1.) payment default and (2.) bankruptcy of a customer. Payment default is defined as the customer having the will and volition to pay but not the ability to pay. Disputes against the product or services sold are not immediately covered by the credit insurer. If disputes cannot be resolved amicably, then they would need to be settled in court with a judgment in favor of the policyholder before any reimbursement would occur. Conversely, any time that a bankruptcy is declared, whether it is Chapters 11 or 7, the claim will be immediately recognized by the credit insurer and payment will be forthcoming shortly.
Although credit insurance is a safety net that protects a company’s receivables, not every customer can be covered under a policy. Prior to creating a policy, credit insurers will perform an underwriting process in which the creditworthiness of all the major accounts is reviewed. During this process, any negative information – such as lawsuits, history of nonpayments, or other issues against the customer – may come to light, which could affect the possibility of coverage. Depending on the degree of the negative information, some policyholders may be covered only up to a certain limit or not at all.
How Much Does Credit Insurance Cost?
Generally speaking, the premium is based on a potential insured’s estimated annual sales. For example, if sales were about $10 million then the premium rate would range between 0.2 and 0.4 percent and the premium would be about $20,000 to $40,000 per premium period (usually one year).
There are several factors that influence premium rates, including:
Depending on the amount of the deductible and the coinsurance that an insured has with their policy, credit insurance generally pays out 80 to 90 percent of the loss. Payments will be reduced by the return or salvage of any equipment and inventory. Subsequently, the credit insurance carrier takes over the receivable as the creditor and either performs collection activities against the debtor or stands in line as one of the unsecured creditors. In addition, depending on other secured interests that the creditor may have against the debtor, all these secured interests will need to be perfected prior to any payouts.
- Industry of the insured
- Pool of customers being covered
- Creditworthiness of customers
- Customer location (domestic or international)
- Deductible amount (This is always an annual aggregate amount)
- Previous loss history
- Financial condition of the insured
- Internal credit management control of the insured
Enhancement of Borrowing Power
Although the main goal of credit insurance is accounts receivable loss protection, it is often used as a way of enhancing borrowing power. If the insured is using its receivables as collateral for a line of credit (working capital loan), credit insurance can provide additional comfort and protection to the lender so that they may be able to enhance the borrowing arrangements. They do this by increasing the percentage they will advance against insured accounts, and/or roping more accounts into the borrowing base – such as large concentrations, slow payers, export customers, etc. This allows the insured to maximize the amount of working capital available from the same pool of receivables. If the insured is in a high growth mode and finds himself in need of more working capital, credit insurance is a great way to resolve this problem.
Credit insurance is one way you can continue to offer your customers credit terms while at the same creating a safety net that will not only protect your accounts receivables from getting hammered, but to actually support your company’s continued success during these very turbulent times.
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