Business
Credit Insurance: The Right Tool for Challenging
Times
By Sergio Laos
The past four years have been a nightmare for
executives across a broad spectrum of professions.
Perhaps few have felt the heat more intensely
than credit management professionals, who are
often tasked with weighing risks and returns and
trying to balance corporate risk tolerances within
their portfolios.
Rewind to 1999—U.S. and overseas economies
are booming; massive amounts of capital are allocated
to projects with seemingly limitless potential;
and a rising tide is lifting all boats, even as
businesses and investors would eventually discover
those boats with badly leaking hulls.
Back then, if an underwriter or broker had approached
a typical U.S. company with an offer to buy credit
insurance, chances are the sales pitch would have
fallen on deaf ears. Credit insurance seemed dispensable
in a world where the potential of losses due to
defaults or non-payments was not deemed to be
a significant risk to a business. In addition,
buying specialized risk-mitigation coverage was
seen as redundant where routine credit analysis
was used to evaluate potential customers and bank-issued
letters of credit were sufficient tools to guarantee
payment.
Fast forward to the present, a time where the
business climate has been turned upside down.
Economies here and abroad have been buffeted by
technology and telecom meltdowns, corporate governance
scandals, high-profile bankruptcies, and terrorism
and war. Almost overnight, selling on open account
has become a dicey proposition.
One would think that, when faced with such unprecedented
turmoil, executives and managers would take decisive
action to help shield their most important assets
or chief source of earnings from the gale-force
winds of risk.
However, a recent survey by commercial and industrial
property insurer FM Global, the Financial Executives
Research Foundation and the National Association
of Corporate Treasurers (NACT) indicates the risk-mitigation
message has not resonated fully with companies.
The survey polled CEOs, CFOs, treasurers and risk
managers at 400 large North American companies.
Two-thirds of the respondents said a physical
or financial disruption to his or her company’s
primary earnings source would result in a “sustained
hit” to earnings or could threaten the firm’s
“business continuity.” Yet 34 percent
of the respondents said their companies were not
well prepared to protect their primary source
of earnings in the event of such a disruption.
Only 14 percent of respondents characterized their
level of protection as “excellent.”
The study presented some encouraging news, however.
This year’s corporate preparedness findings
are a dramatic improvement over 2002’s results,
where half of the respondents said their firms
were not well prepared to absorb a disruption
to their primary earnings source. And in the 2003
study, the vast majority of all respondents—CEO’s,
CFO’s, treasurers and risk managers alike—considered
risk management a long-term investment that delivers
a “realized return” on their capital.
It is heartening that more companies are demonstrating
a keener awareness of risk and of the tools available
to protect their cash flow. In that vein, the
recent burst of interest in credit insurance—a
product that has been long overlooked, misunderstood
and under-appreciated domestically—is very
encouraging.
The surging demand for credit insurance is being
driven by several factors:
• An unprecedented focus on risk mitigation
and credit quality, with a shift from a strategy
of “growth at any price” to one that
emphasizes profits and cash generation.
• An accelerated push toward globalization,
which has thrust many U.S. companies into unfamiliar
terrain and has exposed their receivables to the
unpredictable, and sometimes unpleasant whims,
of foreign commerce.
• The financial benefits that accrue to
the credit insurance policyholder beyond the basic
tenets of payment protection.
Savvy credit professionals understand that credit
insurance is valuable both as a credit enhancement
measure and a traditional risk management tool.
A small to mid-size business typically self-insures
against bad debt by carrying a reserve on its
balance sheet. However, since accounts receivable
often represent more than 40 percent of a company’s
assets, this level of self-insurance protection
not only fails to shield adequately against potential
liability, but also ties up precious liquidity
and can strangle cash flow.
Through the use of credit insurance, a business
can adequately protect its receivables while freeing
up capital for more productive uses, thus enhancing
the use of its cash. A credit insurance policy
also enables the seller to finance its receivables
or to increase the loan to value (LTV) of their
existing receivables financing credit line. This
enables most of the transaction’s value
to be realized before payment is due, which allows
the seller to sell on open account terms without
tying up as much working capital.
Credit insurance’s value extends beyond
risk mitigation and cash flow enhancement, however.
If properly developed and executed, it can help
increase revenue, drive down borrowing costs,
generate new sales opportunities and maintain
ties with existing customers.
For example, take a U.S.-based electronics distributor
with a growing global footprint. The business
has $120 million in annual sales and a gross profit
margin of 17.6 percent. In light of the heightened
macro-economic uncertainties, as well as the risks
embedded in expanding into unfamiliar international
markets, the company decided it needed a strategy
to help tighten controls over its credit management
programs, protect its cash flow against the threat
of delinquencies or defaults, gain financial flexibility
and create new sales channels.
With a credit insurance policy adding an extra
layer of protection, the company strengthened
its collateral position. As a consequence, its
lender increased its credit line by more than
$1.5 million, and shaved its borrowing costs by
25 basis points.
The distributor expanded its operations, reduced
its interest expense, and was able to stay the
course with accounts that, absent the credit insurance
policy, it might have been forced to cut off.
The bottom line: A $7 million increase in sales
and a $1.2 million increase in gross profit, which
is a $9.19 million gain in profits for every $1
million invested in the policy.
International Benefits
Perhaps the most durable benefit of credit insurance
lies in its power to help businesses capitalize
on the growth of world trade while protecting
them from the corresponding risks.
The past 30 years have been marked by breathtaking
growth in global commerce. Today, exports account
for one-fourth of world GDP. Since 1975, the volume
of ocean-freighted cargo has tripled. Until the
tragic events of September 11, 2001, global shipping
of air cargo had doubled from 1996 levels alone.
More than 300 million regular users surf the Internet,
a number that is growing every day. And $10 billion
worth of foreign exchange transactions occurs
every second. In 1990, Forex transactions totaled
$10 billion a day.
International commerce carries with it as many
hazards as opportunities, however. U.S.-based
firms now stepping onto the world stage are discovering
what their European counterparts—many of
whom have long relied on credit insurance—have
known for years: That even in “normal”
times, trading beyond the home market means confronting
a maze of bewildering regulations, formidable
language and cultural barriers, and sometimes,
undependable foreign buyers who work under a drastically
different set of business principles.
Throw in political risks such as, currency crises
and governmental corruption, and credit risk becomes
far more than an abstract concept. It becomes
a stark reality.
Letters of credit (LCs), one of the traditional
means of global receivables protection, are an
appropriate vehicle for businesses selling into
emerging or unstable markets, interacting with
buyers who have erratic track records, or engaging
in “spot” transactions. By contrast,
credit insurance is relatively easy to secure
for mature, established markets, but difficult
to obtain for less-developed, volatile markets.
The notable exception is government-backed credit
insurance programs such as the Export-Import (Ex-Im)
Bank’s trade credit insurance.
Some in the commercial finance industry position
LCs and credit insurance as separate products.
They argue that businesses should not consider
combining the two when mapping their risk reduction
strategies.
There are justifications for this view. By tying
up capital and reducing cash flow, LCs can be
more resource intensive for companies than credit
insurance. However, others take the view that
LCs and credit insurance are complimentary solutions,
particularly for countries where political or
economic instability might threaten to disrupt
the flow of business transactions. In that case,
LCs might be used, but the exporter would be wise
to back up the LCs with credit insurance.
A Slam-Dunk? Not!
With the many economic uncertainties confronting
executives and managers, a robust offering such
as credit insurance would seem to be a welcome
value proposition.
The truth of the matter is that many decision-makers
have misconceptions and preconceived notions about
how credit insurance would be deployed within
their organizations.
Some feel the existence of an in-house credit
department renders credit insurance dispensable.
Some feel they are pressured into being sold still
another insurance policy. Often internal pressures
and conflicts arise that pit the credit manager
seeking to develop optimal risk aversion programs
against a cost-conscious senior level decision
maker, who views credit insurance as an unnecessary
expense and does not see it as part of a vitally
important risk protection program that supplements
an existing credit portfolio and the people who
manage it.
To that end, credit insurance should be part of
an overarching business strategy that integrates
sound risk-mitigation and credit-enhancement policies
into broader shipping, logistics and financial
strategies. Credit insurance should be viewed
not as an isolated product, but as part of a holistic
approach to promote global competitiveness.
The internal tug-of-war between credit managers
and their CEOs and CFOs will be an ongoing issue
to be worked through by all respondents to the
previously mentioned corporate survey. However,
findings in this survey indicate that CEOs and
risk managers view risk management as a long-term
proposition, which is an important step forward.
The report on this survey urges that respondents
with potentially conflicting agendas improve their
communication so that they can harmonize their
views and achieve a more strategic perspective
of risk management.
“If this can be accomplished, companies
should be able to effectively address the stable
inventory of long-term risks, as well as the ‘threats-of-the-day’
that command so much press attention,” states
the report.
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