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Purchasing on credit is part and parcel of today’s business world. From the average retail consumer to our federal government, the ability to leverage credit as a means of buying today and paying later is a critical function of the economy. For businesses, extending credit to clients and leveraging credit with your suppliers is simply how business gets done.
Yet what happens when a customer you’ve extended credit to never ends up paying? What if the customer goes bankrupt? In order to protect against just such a situation where your business faces financial losses from a non-paying customer on credit, businesses commonly take advantage of Trade Credit Insurance.
What is Trade Credit Insurance?
Trade Credit Insurance, also called credit insurance or export credit insurance, protects businesses against financial losses from nonpayment of goods or services by their buyers. If a buyer does not pay, often due to protracted default, bankruptcy, or insolvency, Trade Credit Insurance can cover some or all of the losses.
Your company sells restaurant supply equipment, and one of your regular customers is opening a fifth location of his fast casual restaurant chain. The customer needs to get his new restaurant up and running and places a large order from you. As part of the order, the customer requests to purchase on credit, as much of his capital is tied up in opening the new location. You have no problem extending him credit, as he has been a loyal customer in the past.
When the time comes to collect on the outstanding payment, your invoices and calls are ignored. You find out later that the customer has filed for bankruptcy and has abruptly shut down all of his restaurants, leaving you with an unpaid bill in excess of $80,000. Trade Credit Insurance would protect your business from the financial losses resulting from the unpaid order.
Trade Credit Insurance can be a crucial lifeline for many businesses, particularly when just one insolvent customer or unpaid order can easily strain your company’s financials and free cash flow. Trade Credit Insurance can protect against the following risks:
- Nonpayment or protracted default
- Customer insolvency, bankruptcy, or similar status
- Nonpayment due to political risk, like war or terrorism
Do I need Trade Credit Insurance?
If your company sells goods or services and allows customers to pay later, thereby adding items to your accounts receivables, Trade Credit Insurance may be a prudent purchase. In simple terms, Trade Credit Insurance helps you stem losses resulting from non-paying customers.
If your company does business internationally, Trade Credit Insurance may hold particular significance. As you open your business up to global trade, you also expose your company to global risks, of which there are many. Other countries may experience political risks like war, terrorism, riots, or changes in government regulations—all of which may impact a customer’s ability to pay on time or at all. Trade Credit Insurance can provide you with a safety net that allows you to offer terms of credit to your international customers with confidence.
Trade Credit Insurance can also help grow your business. Without some sort of financial protection, every sale you make on credit can be considered a risk, preventing you from expanding sales to further grow your company. For newer businesses, this is especially important, as the amount of capital you have in reserve may be limited. Moreover, for companies with a smaller customer base, each customer may represent a relatively large risk to the business. Trade Credit Insurance helps reduce your risk and allows you to pursue growth, without having to worry about a non-paying customer.
Your business designs and manufactures high-end furniture, and thus far you have only sold your product domestically. An international buyer reaches out to you to place a large order, and you see this as a great opportunity to expand your fledgling business globally. The buyer requests to finance part of the purchase on credit, as some of their working capital is tied up in other investments. Because the purchase is such a large order, offering credit is too much risk for you to take on, and ultimately, the deal falls through.
Benefits of Trade Credit Insurance
Aside from providing your business with a financial safety net that you can leverage to protect against non-paying customers and also pursue new business, Trade Credit Insurance policies also often come with the following beneficial services:
- Portfolio monitoring. Access to professional portfolio monitors who can proactively track customers and their ability to pay.
- Country reporting. For businesses looking to enter new countries, insurers can provide research and reporting needed to properly assess business risks in those markets.
- Accounts receivable support. Insurers can offer access to professional trade credit analysts who can help manage outstanding receivables.
- Collection services. Insurers often provide access to discounted debt collection services.
What does Trade Credit Insurance cover?
Trade Credit Insurance provides financial coverage for some or all of the losses suffered due to nonpayment of goods or services by a customer. Commonly, this coverage protects against customers who are unable to pay due to customer insolvency, protracted default, or political risk.
Trade Credit Insurance policies are often tailored to the insured depending on need, but standard policies do exist and are commonly used by smaller businesses with less complex requirements.
Businesses can decide how much coverage they need in their policy and whether to cover their entire customer portfolio or a subset. The following are four common types of Trade Credit Insurance policies:
- Whole Turnover: Insures against nonpayment from all buyers. This policy covers all of your customers, and generally companies only need to decide if they want to insure against all domestic sales, export sales, or both.
- Key Accounts: Insures against nonpayment from a set of key accounts. Typically, companies seek to insure their largest customers, those whose default would catastrophically impact their own business.
- Single Buyer: Insures against nonpayment from one single buyer. This type of policy is commonly used by businesses when the majority of their sales come from just one buyer.
- Transactional: Insures against nonpayment on a transaction-by-transaction basis. Companies with only one single buyer or with very few sales often use this type of policy.
Trade Credit Insurance vs. Self-Insurance
A common alternative to Trade Credit Insurance is the concept of self-insurance, which is when a company sets aside cash to cover losses in the event that a customer does not pay. While this is an oft-used tactic in business that foregoes the need to purchase an insurance policy, it is frequently an infeasible strategy, particularly for small and medium businesses.
Tying up capital to prevent against a loss that may never come is often prohibitive with smaller businesses that have less cash on hand. Moreover, for businesses that are able to earmark cash for a potential loss, one could argue that the cash could be used in better ways—from expanding the business to generating more sales. With Trade Credit Insurance, instead of tying up the entire amount of a sale to protect against potential nonpayment, you use only a fraction of the total amount for the same loss protection.
How much does Trade Credit Insurance cost?
The cost of Trade Credit Insurance depends on a number of factors, including the industry your business is in, your business’s financial history, the type of policy you choose, and the risks being covered.
Another important factor that insurers consider is the financial standing of your customers. Insurers will analyze each customer’s credit worthiness and assign a credit limit to each customer. This is the amount that the insurer will be willing to provide coverage for, and this limit can change depending on new information the insurer receives about the customer. Typically, limits are reduced or cancelled as a result of events that reduce the financial viability of a customer (e.g., a customer is sued due to alleged fraud).
For businesses that are involved in selling goods and services, especially those that sell internationally, Trade Credit Insurance can be a useful tool to protect against nonpayment of customers in the event of customer bankruptcy or insolvency, protracted default, or political risk. For business owners, these risks are hard to predict, and Trade Credit Insurance provides the financial safety net that allows you to grow your business without worrying about uncontrollable events. Particularly for smaller businesses, Trade Credit Insurance can help to leverage your capital more efficiently, while also providing the expert services of a reputable insurer to help strengthen your credit management practices.