Unexpected Risk Not Just Bad Decisions

A CreditWorthy News clip as printed on newsworthy.com, September 18, 2002
By Victor Sandy

In managing credit risk, the perception has typically been that any given credit risk is evaluated by the credit professional and if approved and a loss occurs later, it was a mistake on the part of the credit reviewer. Nowadays, however, it’s not even a matter of making a mistake. Unfortunately, many credit risk managers and those they have to answer to don’t differentiate between the two types of credit risk they face. The risk everyone most commonly addresses is the expected risk of a credit loss. To manage this risk we gather information- financials, bank and trade references, credit apps, site visits, etc. We evaluate the risk based on this information and make a decision accordingly.

However, this is only half the battle, as like many credit managers will assert, “we never make a bad credit decision, something bad happens after we make a good decision.” That is, there is a whole additional layer of risk, which we refer to as unexpected risk. For this exposure, no amount of information-gathering and analysis can protect you. Sometimes, the account you thought was “good as gold” becomes a sudden, unexpected credit problem. Enron is a perfect example of unexpected risk. We are seeing more of these types of losses resulting from financial fraud and mismanagement, class action lawsuits and from the “domino effect” of a company’s key customer defaulting causing a chain reaction of defaults through several levels of suppliers.

Unexpected credit losses are a way of life, even more so these days, so there are only a couple of real alternatives. Either you stop granting credit, which is certainly not practical, or you hedge the risk.

One of the least expensive ways to hedge against unexpected credit losses is to insure your receivables against insolvency and past due default. Credit insurance has been around for over 100 years, and recently has become more popular and widely used. It reduces or eliminates the risk of a large, unexpected credit loss that could be catastrophic to the business, while providing a safe haven in which to grant credit and safely expand sales. As a sales expansion tool, sales and credit can partner together through the policy to help the business grow without having to take on the risk. With credit insurance covering the unexpected risk and providing decision support on the expected risk, companies can avoid the “mistakes” that are a fact of life.