One method of protecting accounts receivables against unexpected loss is to use trade credit insurance. How does it work?
Nothing is sold until it is paid for but sometimes where credit has been extended, customers are simply unable or unwilling to pay. They may have become insolvent, bankrupt or just failed to pay within the agreed terms (known as a protracted default). In some cases, circumstances beyond either party's control, such as a political event (including war, terrorism or riot), may prevent payment or the transfer of payment.
Where non-payment of a trade debt would materially impact company financials, especially its working capital, trade credit insurance may be the solution. This type of insurance covers various risks of non-payment resulting from trade both domestically and internationally. For a company wishing to insure its exports only, the cover is often referred to as Export Credit Insurance. Either way, the main requirement is that the insured risk has a direct link with an underlying trade transaction, in that it relates to the delivery of goods or services.
Policies are typically offered by insurance brokers or intermediaries, some of whom specialise in this field. Most businesses, from SMEs to multinationals, are able to take out a policy, with contracts being shaped accordingly – although usually certain operating conditions and obligations must be met by the insured. There will however be a degree of flexibility as to what is covered, from a single large transaction, single customer or group of customers, to `whole turnover cover', covering all customers. Specific use purposes include cover for supplier default, delivery guarantee and credit guarantee.
Underwriters use standard actuarial techniques to assess and price risk. They will also consider aspects such as size of trade, previous bad debt experience and the trade sector of the insured. Based on this assessment, the insurer will also set a credit limit for each buyer with whom the policyholder trades. This sets out the maximum amount that can be owed by a buyer at any one time. This may not always cover the full amount of a specific trade. As with any insurance policy, shopping around for the most appropriate coverage is advisable.