Trade Credit Insurance: A New and Sustainable Approach To Corporate Credit Management

Abstract

Credit managers ' faith in the traditional credit control procedures used to protect against extraordinary loss has been shaken. The Kmart bankruptcy demonstrated that no one can predict who will go insolvent, and it caught many creditors by surprise. Since that time, WorldCom, United Airlines, Global Crossing and Parmalat, among many others, have further confirmed how quickly apparent gold can turn to dust. According to statistics released by the Administrative Office of the U.S. Courts, 36,785 businesses filed for bankruptcy in the 12-month period ending March 31, 2004.

The number of bankruptcies is only part of the story. The WorldCom, Enron, Global Crossing, Kmart, Adelphia and NTL, Inc. bankruptcies during 2001 and 2002 were all among the top 10 largest bankruptcies in U.S. history. The Parmalat bankruptcy in 2003 was the largest bankruptcy in European history and cost U.S. firms $2 billion.

In the past, many prospective credit insurance customers often felt confident they could judge for themselves whether customers would pay, but not anymore. Today's uncertain economic climate has many financial officers considering risk management much more seriously. Of more than 400 finance directors from the U.S. and Europe who responded to a CFO Research Services' survey, only five percent report being "very satisfied" that their current risk management approach supports their companies ' business objectives.

More and more, financial officers and managers are increasing their demand for trade credit insurance. During the last several years, spending on trade credit insurance by U.S.-based companies has been growing by approximately 15 percent annually.

The failure of Enron, and other "blue chip" companies, will drive the use of credit insurance even further as risk managers turn to it as part of an integrated program of enterprise risk management.

Market Analysis

A number of business factors are driving concern about credit risk and jeopardizing corporate futures. These include:

* High leverage

* Weak cash flow

* Unstable currency factors

* One time write-offs

* GAAP vs. Pro Forma reporting

* Domestic and foreign competition

* Excess capacity

* Major technology investments

* Merger and acquisition integration challenges

* Bankruptcy laws unique to each country

* Managing accumulation of years of growth

* Creative financing

* Complex investing strategies

Reform in the accounting profession has compelled many non-public companies to take a closer look at their financial and accounting practices. According to a recent Robert Half Management Resources survey of 1,359 CFOs from a random sample of U.S. private companies, 31% of CFOs said they have voluntarily adjusted their accounts receivable and sales processes and 29% have adjusted their credit management and collections processes since the introduction of new regulations, such as the Sarbanes-Oxley Act of 2002.

Consolidation in many industries is also increasing credit risk. Shrinking customer bases create larger concentrations with fewer buyers, which results in greater accounts receivable exposure.

Concerns About Corporate Irregularities

The Credit Research Foundation canvassed a random sampling of credit professionals to determine their views on creditors' concerns about recent corporate reporting irregularities and their attitudes surrounding the difficulties of extending credit in the current business environment. The survey revealed the following:

* 98% of credit managers surveyed believe we have not seen the last of major frauds and financial scandals among U.S. companies.

* 87% are very concerned or more concerned than in the past about accounting irregularities.

* 84% of respondents feel that major accounting firms other than Arthur Anderson will be implicated in future financial scandals.

* 72% of credit managers are somewhat concerned about the reliability of financial information they receive from clients.

* 39% of respondents think these are the most difficult time in which they have practiced credit management.

Surprisingly, only 15% of those sampled reported being "very concerned" about their customers' financial stability in light of recent events. By this measure, it is apparently "the other guy's customers" who present the real concerns - is this a paradox, or myopia?

Credit Insurance Comes Home

According to the National Association of Credit Management, the thought process among credit managers is evolving and they are now looking at the most cost-effective way to manage their entire receivables portfolio rather than primarily collecting dollars.

In the past, credit insurance has been used by many U.S. commercial credit managers mainly to cover exports because credit insurance is often far less expensive than letters of credit. Credit insurance also allows the seller to provide open credit terms to approved customers with more flexibility and less frustration, and extends longer terms due. Today many of those same managers are increasingly seeking protection for domestic business transactions and see credit insurance as a welcome back-up. In addition, fraud can strike any unsuspecting lender, and even banks are frequent victims of fraud. Credit insurance can mitigate many of these risks.

Striking a Better Balance Between Opportunity and Risk

A growing number of credit professionals are turning to trade credit insurance companies to complement existing internal credit control procedures and gain the benefits of the credit insurers' expertise and experience in their market.

Credit insurance reinforces and enhances credit managers' approval of customers and understanding of related market risks, provides a "sanity-check" on their judgment, and protects their businesses against any losses which may result from events over which they have no control.

Because even the most experienced and savvy credit managers are unable to predict unexpected credit losses from reliable accounts, credit insurance serves as a safety net for accounts receivable.

Many credit insurers maintain large global databases on millions of companies and buyers whose performance they are underwriting. Trade-credit underwriters obtain a wide, trade-sector based underwriting view of corporate credit risk and often recognize the reality of an impending payment risk more quickly than a credit manager for several reasons.

First, trade-credit underwriters are not subject to internal company sales volume considerations as are typical corporate credit managers. A second and probably more powerful factor is that trade-credit underwriters are far less prone to the psychological factor known as "anchoring." This well-established principle states that people put in decision-making positions tend to overvalue what has happened in the past - to believe even in the face of contrary evidence that what happened in the past is most likely to be what will occur in the future.

The trade-credit underwriter, free of any history of personal experience with a given "good customer," is thus in a far better position to provide a truly independent assessment of future risk. This independent view and trade sector intelligence can help underpin a prudent credit manager's caution.

Many credit managers do not have the time or staff to sift thru 1OK's and 1OQ's to identify troublesome issues such as cross default agreements and debt trigger/covenants. Many companies only have access to free Web-based reporting services as opposed to real-time databases of news, financial reports, business media and market pricing for securities.

Political risks frequently arise when a country's leadership is in question or its economy destabilized by unforeseen events. This may cause currency issues whereby payments may not be tendered and workout is needed. Global credit insurance companies have underwriters who specialize in geo-political regions and with foreign issues and cultures.

Credit insurers are also flexible enough to meet with prospects and customers on an open or confidential basis to gather information needed to support their trading interests.

Case Study: Royal Greenland

Royal Greenland Group supplies a wide range of seafood to food retailers and caterers across the globe. Its international operations and corporate product and design development are based in Denmark.

The Scandinavian countries are viewed as Royal Greenland's domestic market and account for about 10% its sales of $575 million. The remaining 90% is achieved by exports, principally elsewhere in Europe, plus North America and the main Asian markets.

As the group expands into new markets, advice on the financial standing of potential customers is provided by a leading global credit insurer to supplement Royal Greenland's own research.

Group Finance Manager Claus Loekke says, "Our credit insurer has locations all over the world and is in a position to know what is going on. It has a number of insured's with coverage on the same buyer, which means we get immediate information about signs of trouble over payment. In addition, we wanted a person not involved in the company to help keep an external eye on the market."

The insurance coverage and its credit limits also serve an internal diplomatic role. In situations where a buyer's credit worthiness is in doubt, Loekke must give sales and marketing colleagues the unwelcome news that they should avoid the customer. However, the typical confrontations that occur between the credit control and sales sides of businesses are adjudicated by the informed views and strictures of the credit insurance underwriters.

These complementary internal and external credit control policies and procedures have kept insurance claims small and infrequent. An exception came in 2002, when a major customer suddenly went into bankruptcy.

"It was through a situation that nobody could have foreseen," Loekke said. "When a big customer goes bankrupt, you not only have a loss of future income but you have lost a lot of immediate income. This was that 'big bang' we were afraid of and the reason why we took out a credit insurance policy."

Need for Credit Terms for Companies; In Emerging Markets

Technological advances and trade liberalization has opened the global market to more U.S. businesses. But new opportunities afforded by international trade bring intricate new problems - cultural differences, language barriers and complex foreign and legal accounting systems. Lack of regulation and reliable credit information, smaller company sizes and insufficient financing also pose significant challenges to credit managers at businesses looking to expand into emerging new markets.

Trade credit insurance enables companies to maximize export sales opportunities and enter new markets by offering expanded account credit terms and eliminating the need for letters of credit. For a large number of importers in these emerging economies, the largest source of funding is supplier credit. Political risk coverage is also available, which helps cover non-payment by buyers due to a political or economic event or a government moratorium that prevents transfer of payments.

Pricing Structures

Trade credit insurance policy pricing varies, and is determined by industry, policy structure, credit worthiness of the buyer risk involved, country, past loss history, terms of payment, and level of retention. This supports the assertion that insurance should be viewed as a partnership with the credit management objective. The better job a credit manager does, the more economical the insurance is to protect the company against catastrophic loss.

Trade credit insurance companies can customize a policy based on individual company needs. A typical premium rate is about 0.2 to 0.7 percent of insured sales for international transactions and about 0.1 to 0.5 percent of insured sales for domestic.

Credit-limit fees typically range between $25-$75 per limit for domestic accounts and $50-$ 125 for export limits on foreign companies.

Credit insurance policies typically include protection against a wide range of domestic and international trade hazards including buyer insolvency, protracted default, political risks, an act of war that prevents contract performance and failure of a publicly owned buyer to perform its obligation under a contract.

Generally, insured sales of at least $10 million per year are required for a company to obtain an international trade credit insurance policy that includes political risk coverage, although exceptions exist.

Policies can be purchased directly from trade credit insurance company agents or through specialist brokers. Agents and brokers are often able to provide market specific knowledge, assist with policy structure and help negotiate premiums. The cost of a broker is typically borne by the insurance carrier, so clients incur no retainer or fees.

Credit Enhancement

There are a few highly specialized credit insurance products specifically designed to enhance credit terms. An example is to insure excess concentrations with AAA or AA rated paper, which can increase advance rates, and reduce abnormally high loss reserves, making trade receivables programs more economical.

CFOs purchase such products to increase funding while keeping the cost of capital competitive. Unlike traditional credit insurance, the buyer of this type of protection is not primarily seeking risk mitigation.

Case Study: Insuring Excess Concentrations

A large energy trading company wanted to establish a working relationship with local suppliers of gas and electric power that deliver energy to commercial and consumer customers. A new securitization program was needed because of the energy trading company's need for greater liquidity. The company's bank indicated that the company could receive up to $25 million in funding at the beginning of the program, which was projected to grow significantly during the first year.

The funding potential for the program was limited by the fact that the three largest obligors were all single "A" rated by Standard & Poor's and had concentration limits imposed on them by the rating agency's methodology. The energy company asked Atradius Trade Credit Insurance to insure the excess concentration, the amount of receivables over and above the concentration limits, of the three largest obligors. Through the use of Atradius' credit enhancement product, the bank was able to increase the advance rate from 65% to 85% and provide an additional $15 million in funding to the energy company.

Less Traditional Programs

By relying on underwriting that includes qualitative and quantitative factors, credit managers are able to work with some credit insurers to insure one or a limited number of buyers.

Single-buyer policies offer cover on single or multiple shipments to one buyer and protect the exporter from the date of contract until the date of payment. The credit manager specifies the shipments to be covered and the length of time needed for the shipments to occur. The maximum policy period during which shipments can be made is generally one year.

There are also many key account programs available, which primarily consist of a limited number of about 5 - 25 quality buyers.

In Summary

Most companies believe their biggest clients are a solid credit risk; however, virtually every insolvent company was once someone's solid gold customer.

The ongoing uncertain global economic climate, the emerging trend of corporate credit problems and growing global economy has brought a vast array of new challenges to the credit profession. Many credit professionals are finding that trade credit insurance offers a new and more sustainable approach to integrated, enterprise-wide corporate credit management. The ability to get direct access to an underwriter who has an enormous amount of information on both public and private companies worldwide adds further support to the ultimate sales decision. It also helps to secure the transaction much more economically than traditional bank security and justify decisions to upper management.

Credit insurance serves as a productive complement to existing credit control procedures and helps bring opportunity and risk into better balance by protecting against bad debt losses while enabling policyholders to safely increase open credit sales, maximize borrowing power, stabilize cash flow and enhance earnings by reducing bad debt reserves.

By: Arjan van de Wall, Artradius

Arjan van de Wall is Vice President of Sales and Marketing at Atradius Trade Credit Insurance. Atradius offers commercial credit insurance, trade receivables securitization, debt collection and other credit management services to meet the needs of U.S.-based companies. Its credit insurance policies cover losses due to bankruptcy, payment default or events in overseas markets such as political turmoil or import and trade restrictions.

Further information about commercial credit management is available from specialist credit insurance brokers or contact Mr. van de Wall at (410) 246-5511 or arjan.vandewall@atradius.com or visit www.atradius.us.

Copyright Credit Research Foundation 2004
Provided by ProQuest Information and Learning Company. All rights Reserved