The severe, widespread, and persistent economic downturn has featured the retrenchment of bank credit, the “drying up” of letters of credit, and the virtual disappearance of the secondary banking market. These conditions have triggered a significant rise in payment defaults and corporate failures, which in turn have been reflected in a significant increase in claims against trade credit insurance policies.
Indeed, the three major trade credit insurers all had high loss ratios for this coverage line in 2008, and the performance has worsened during the first six months of this year. As a consequence, for the past several months, credit insurers have been reviewing their exposures and reducing them with respect to industry sectors and specific countries, as well as individual buyers. Unfortunately, for businesses seeking to purchase credit insurance, this has translated into an unprecedented reduction in available credit limits.
As the size and frequency of claims rises, both insured businesses and their insurers have become increasingly burdened with claims and collections processing. Furthermore, there is no coverage available at all for certain industry sectors and businesses seeking to insure transactions in specific countries. Businesses that have had significant claims or poor recent loss history are experiencing dramatic premium increases. And, some are finding it difficult or impossible to renew their coverage at any price. Frequently, there is no alternative market once other insurers have seen the loss ratios and/or bad debt experience.
Nonetheless, the news for businesses with potential credit exposures is not completely negative. During the first two quarters of 2009, as the overall level of exposure has increased substantially, the good news is that insurers are still providing coverage albeit at higher costs. The greatest impact has been on what the insurers consider to be high-risk buyers and trades. Meanwhile, many credit insurers continue to be willing to insure businesses that have effective credit management and sound business plans. In fact, even a business in an industry sector or trade region that has had difficulty obtaining coverage in the past may be able to obtain cover if its credit management record is exceptionally strong.
On the other hand, a company with poor credit management—even in what insurers might consider a desirable trade sector—may find it difficult to obtain credit insurance. In this environment, insurance brokers and advisors can help insurers understand an individual company’s credit exposure and make informed underwriting decisions.
Given the challenges present in the traditional insurance market for trade credit insurance, some firms have been exploring alternatives such as “top-up” cover, other insurers, accounts receivable purchase agreements, and government support.
Top-up cover is insurance that sits above whatever protection might be available under a firm’s existing trade credit insurance policy, thus raising the overall amount of protection available to the firm.
While a limited number of insurance companies are willing to provide this type of coverage, it is not available to address risks in all parts of the globe. Further, top-up cover generally has very restrictive terms. Several insurers will only provide this cover if the risk is “investment grade” or better. Most insurers willing to provide the coverage do so to address capacity shortfalls while maintaining strict underwriting standards. There are also potential issues related to the sharing of salvage. Notably, if the top-up insurer doesn’t agree with the primary underwriter’s assessment of the exposure, it will limit its level of participation in the program.
Alternative markets
Smaller credit insurers generally have not recoiled from the market, primarily because they did not cut their rates prior to the credit crisis and have remained prudent in their overall risk taking. While these insurers may be helpful in certain situations, they cannot replace the capacity offered by the major insurers. In general, they tend to be more suited to isolated individual or local exposures rather than more extensive portfolios of credit risk.
With the traditional insurance market for trade credit coverage so challenging, a growing number of business are placing credit risk in their captive insurance companies with excess-of-loss reinsurance provided by multi-line credit insurers. A captive program tends to work well when the insured business has sophisticated credit and collections procedures and is willing to retain a sufficient amount of risk in the form of an aggregate deductible.
There is also a developing market for specific approaches for one-off risks, known as structured trade credit. Although this market is currently dominated by financial institutions seeking to insure trade financings, other large corporations have been able to obtain coverage for certain risks in emerging markets. However, given a recent spike in claims, insurers have become more selective and their premium rates have increased significantly in step with bank loan margins.
Neither the top-up cover nor the structured trade credit market will provide a solution in situations where credit limits have been withdrawn because the business seeking to obtain coverage represents a poor (or declining) risk. Underwriters are being extremely cautious and will avoid any risks they deem to be potentially volatile or unprofitable.
Export Credit Agencies (ECAs)
ECAs appear more pragmatic and are less inclined to reduce their coverage limits than the private sector. By and large, many ECAs have a different mandate than their counterparts in the private sector. Specifically, they must support or help to facilitate exports and, as a result, may tend to be less concerned about an individual risk. In addition, because of government support, they often can taker a longer-term view. ECAs may be useful alternatives for businesses that are exporters and have exposures that are limited to a handful or fewer international markets.
Government support
Some national governments have been willing to provide some degree of support for companies operating in their domestic markets. However, for the most part, these credit facilities have been focused on small and mid-sized enterprises, limited in scope and capacity and expensive in some countries.
Generally, it appears unlikely that these facilities will develop quickly enough to address the challenges faced by large, global companies that have seen significant reductions in their trade credit insurance limits. Many governments appear wary of the open-ended commitment that may be required to support larger domestic insurance limits.
Finding a solution
While no readily available pool of trade credit insurance exists to underwrite marginal and problematic risks declined by the major credit insurers, businesses should try to work more closely with current insurance markets to appeal limit reductions and policy non-renewals. It is worth noting that some limit reductions arise not from specific concerns about individual buyers, but from general concerns about the trade, country, or requirements from shareholders or reinsurers to reduce the level of trade credit exposure across an insurer’s overall risk portfolio.
Insurers can be part of the solution by improving their risk assessment capabilities and providing reinsurers with adequate returns on their credit risk. This will enable them to attract sufficient risk capital in the future.
While the reinsurers’ appetite for credit risk eventually may return to historic levels, it is currently hard to predict when that might happen. In the interim, businesses with trade credit exposures need to work with their insurance brokers and risk advisors to assess all potential solutions for risk transfer and risk mitigation, including those outside of insurance.
In this environment multinational businesses can take a number of steps to assess and manage their receivable risks, including the following:
Negotiations with insurers
If trading experience is excellent, explore appealing for a reduced or withdrawn credit limit.
This appeal will have to be supported with specific information, such as up-to-date accounts.
The older the accounts, the more important other information becomes, such as management accounts.
Other “underwriting type” controls should be examined; these will include stock and sales returns, a forward order statement, regular aging returns (trading experience) to the underwriter, and retention of title, for example.
Given the downturn, the limit may no longer be required at the same level; this needs to be investigated, as some businesses treat the retention of limits almost as a non-negotiable requirement even if they are not used.
If a shorter credit period can be negotiated, a lower limit may suffice.
Claims management
Make sure claims are filed promptly and within the parameters of the policy.
Engage your claims brokers and insurers as soon as a potential loss is discovered so that proper filing procedures can be followed.
Alternative products
All available insurance markets should be fully explored.
For certain firms that qualify, the “Accounts Receivable Put Option” market may be a viable option if your company’s profit margins can support the high premium cost.
For businesses with strong credit and collections management, and the ability to retain risk, the use of captive insurance companies should be explored. It is possible to combine a third-party credit management system with an excess-of-loss captive program.
Single-risk accounts that are financially viable but too large for the current insurer might choose to explore either top-up cover (where available) or indications from the structured trade market, potentially on a syndicated basis.
In short, the takeaway for businesses with trade credit insurance is that while these challenging insurance market conditions persist for this coverage—and even beyond—they need to be working closely with their insurance brokers and advisors to forge stronger relationships with their current insurers and others providing various forms of trade credit coverage. This will help maximize coverage opportunities or options in this environment. Meanwhile, insurance companies will need to improve communication with their trading partners and consider alternative underwriting and pricing models to help reduce the likelihood of a repeat of the challenges associated with trade credit coverage that have occurred during the current global economic downturn.
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