Trading Companies coping with Credit Risk Management
Until recently, trading companies had little need for credit risk management as most banks were willing to directly finance operations themselves without requiring a non-payment guarantee. Times have changed and more and more banks insist on the setting up of a credit insurance policy.
Traditional credit insurers were unable to meet with this new demand, partly due to the shortfalls of “standard” insurance policies. Typically, trading companies perform short-term “one shot” deals involving large outstanding amounts.
With this new clientele, insurance companies faced a second dilemma. Trading activity remained largely unknown in the world of credit insurance despite operating for the most part in countries where political risks were high.
Combined with requests for large single limits (often in excess of USD 10Mio), insurers faced a lack of available information on debtors together with countries where there are significant political risks. As a result, we can understand the struggle faced by trading companies to find adequate solutions that meet with bank requirements to secure funding.
Solutions are now available. These can be divided into two main categories:
Credit Risk Management: Single Risk / Single Buyer
Conventional insurers understood that they needed to find solutions for a booming market in trade. Some insurance companies had anticipated demand and were already proposing Single Risk /Single Buyer solutions. Even the most conventional credit insurance companies are now able to offer such solutions.
“Single Risk” coverage allows a debtor to cover a single transaction for a specified period. Credit insurance companies may require a copy of the sales contract before setting up the policy.
They can also provide coverage for a debtor for a period of up to 12 months. When the policy expires, the insurer will review the debtor’s situation before possibly renewing the credit limit for a new period.
The requirement of a minimum contractual premium by the insurer means that this type of insurance generally applies to large operations. Moreover, the cost of insurance in comparison to the risks involved is much higher than that of a conventional credit insurance policy because the insurer cannot spread the risk over several debtors. In some cases, it may make more financial sense to purchase an “wholel turnover” policy that covers the entire portfolio than to take out “Single Buyer” policies that cover only the largest outstanding debts.
The main advantage of single cover lies in the fact the insurer is less able to reduce or cancel credit limits. Some will agree non-cancellable limits. However, caution must be applied and careful reading of the terms of the insurance policy is recommended.
Brokers also have an all important role to play in finding Single Risk / Single Buyer solutions as there are now many companies offering this type of product. It is often fitting to use several insurers (co-insurance) for the same risk so as to ensure coverage of the whole sum. No less than 7 new credit insurance companies are set to join Lloyd’s in 2014.
However, insurers must still improve their responsiveness by rapidly replying to trading companies’ requests. Operations are often carried out in the form of tender; the trader cannot wait more than a week for the insurer’s consent.
Credit Risk Management: EXCESS OF LOSS
For larger trading companies, hedging solutions such as “Excess of loss” may also be implemented. After a preliminary analysis of the applicant’s credit management procedures, the insurer may agree to delegate the credit risk management in full. The insured company is then responsible for setting its own limits on customers in keeping with credit management guidelines.
In return, the insured company retains a significant portion of the risk in its financial statements (as set out in the insurance policy by an aggregate first loss). This way the company proves to the bank that it can protect itself against the greatest risks and in the event that one or more of its buyers should default, is able to bear the cost of its contractual duty.
With these two types of products, credit insurers are no longer at a loss when asked to meet the demands of this new clientele. As long as the debtor is known and agrees to submit its accounts, the credit insurer may implement a solution that meets with the bank’s funding requirements for trading operation.