If your business extends credit to commercial trade partners, you could be faced with a default on a substantial loan. This could happen if a buyer-borrower becomes insolvent, has a serious liquidity crisis or declares bankruptcy. Where would that leave your company? Could you absorb the loss or delay in payment?
Trade credit insurance protects against loan defaults by business clients who owe your company and can’t pay. It covers certain types of unpaid debt for any client named in the policy, up to the policy limit.
Trade credit insurance is sometimes used as a catch-all term for related coverages that insure debt owed to your business. Those include accounts receivable insurance, export credit insurance and credit insurance for financial institutions.
Many insurers also offer extensions of trade credit coverage for a single client, key customers, global partners, and specific loan duration or location needs. In all cases, the insurance provides a financial safety net for the lender should a customer fail to pay on a debt.
Establishing a trade credit insurance policy
Businesses of any size can purchase a trade credit policy for international or domestic trade. When establishing coverage, your insurance professional will review your credit portfolio, type of business, location, level of risk represented by each client or type of debt, and loan repayment terms.
You can tailor the coverage to your needs and acceptable risk profile. You do not need to insure every debt. You may choose to protect only certain debts assigned to a particular type of client or industry, customers above a chosen debt threshold, or clients considered especially risky or who account for a large percentage of your debt portfolio.
Each customer the policy covers will typically be assigned its own limit of coverage based on its creditworthiness, although some policies allow you to set the limit yourself based on your history with the client. Once limits are set, any debt a named customer assumes will be covered for the current policy year, up to the terms outlined.
Your premiums will be based on your level of debt at risk, but the cost is usually less than 1% of your sales volume. Some trade credit policies also offer secondary coverage that kicks in only when a submitted claim exceeds the primary policy limit. This may make it possible to protect against excessively large claims while achieving a lower overall premium.
Each trade credit insurance policy will specify allowable reasons for debt reimbursement, which can include client bankruptcy or insolvency, certain natural disasters, government-declared emergencies, changes in monetary value, new client ownerships or bad faith actions by clients. Some policies will also cover nonpayment due to government-related events, such as trade embargos, economic collapse or political unrest.
However, if these circumstances are not expressly included in the insurance policy you are considering, you might need to add a political risk insurance policy. This is especially important if you have customers in volatile areas or you sell to multinational companies. While it’s easier to imagine some of these risks if your clients operate in unstable territories, never underestimate the potential for an unexpected credit default, regardless of the customer's location or history.
Trade credit policies typically reimburse the original credit loss in full or up to a certain percentage, such as 85-95%. They also cover associated costs, such as interest payments or collection services.
Benefits of trade credit insurance
The most obvious benefit of trade credit coverage is protection against bad debt. However, there are some other reasons you may want to add this type of policy to your insurance portfolio.
- It can make you more comfortable with extending credit to new customers or improving the terms of a business offer, such as 0% down or delayed payment following purchase. These kinds of sales incentives can prove particularly helpful if you operate in a very competitive market or industry or are trying to break into an already established market.
- It allows you to entice buyers to purchase more based on economies of scale while protecting your assets against a larger volume of credit exposure.
- It helps you maintain strong relationships with your suppliers and employees because you’ll still have the cash flow necessary to pay your own bills, even if customers fail to pay back their loans.
- It can lead to an improved credit rating for your business, which may make it possible to secure a new loan or gain more favorable financing rates from a lender.
- It can help you fulfill the risk management expectations of key stakeholders or board members.
Limitations of trade credit insurance
When obtaining your trade credit policy, look beyond the premium amount. While it may be tempting to select a larger deductible or adjust the percentage of loss paid to lower your annual premium, consider the risk you’re assuming per claim.
Your insurance professional can help you with this type of analysis. But as an example, if you agreed to a deductible of $25,000 and repayment at 75%, then had a $100,000 loss from one client, you would receive only $56,250 on your claim.
While you may be willing to accept a lower repayment level, especially if you have some cash flow or credit available for self-insuring a bulk of your losses, you should fully understand how your payout limits and deductibles work. Some companies decide to self-insure losses up to a certain amount, then insure the rest. It all depends on your willingness to take on risk and your ability to afford a loss.
Another factor to consider with trade credit insurance is the repayment timeline. Even approved claims take time to process, so make sure you have the liquidity to stay in business until you receive your claim check.
An insurance professional who specializes in trade credit risk can help you coordinate your insurance policies to protect your business against serious customer debt defaults.