Trade receivables refers to unpaid invoices for goods or services provided. Until an invoice is paid, it is classified as a trade receivable. There is always a time lag between delivering a product or service to another company and getting paid. This time lag can cause problems, and it is for this reason that trade receivables financing is common practice. It is also the reason why credit insurance is so important. This post will take a closer look at credit insurance.
While a company waits for its customer to pay an invoice a lot could change in the world. The currency stipulated for paying an invoice could change drastically in value. The customer could go into insolvency. And, as we have seen recently, a country you trade with could become an international pariah, making receiving payment a process fraught with political attention and possible sanctions. In this context of risks, it is therefore wise to use credit insurance to mitigate against potential pitfalls.
The Benefits of Credit Insurance for Companies
There are specialised insurance policies for trade receivables. They have 3 main benefits:
- Supporting Sales Growth. A company can enter foreign markets with less trepidation that a debtor will default on the payment of an invoice if they have credit insurance. And a company will have less fear that the country they are trading with might go into a period of political and economic turmoil. Moreover, with credit insurance a company can offer longer payment terms to customers. This makes a company more competitive.
- Improving Credit Controls. In order to qualify for credit insurance on trade receivables a company must conform to certain credit control requirements. This is beneficial for a company as going forward it will have better credit controls in place.
- Better Financing Options. A company that uses credit insurance for its trade receivables has better financing options. The trade receivables can be used for factoring in order to generate cash needed for working capital. In certain instances, it can facilitate securitising trade receivables which again releases money tied up in unpaid invoices.
The Benefits of Insurance for Invoice Financiers
For banks and companies offering invoice finance services obtaining insurance has important benefits:
- A factoring company will have internal limits on the amount of money it has to buy trade receivables from any one client or from any one country. Having insurance on trade receivables can often allow these limits to be extended.
- Obtaining Capital Relief. A bank has to maintain certain levels of reserves of cash. These levels can be reduced if it enters into a credit protection arrangement such as a credit insurance policy.
The Cost of Credit Insurance
The cost for insuring trade receivables varies depending on the perceived risk of a non-payment of an invoice. The risk level is reflected in the premium paid for an insurance policy. There may also be legal fees involved to set up an insurance policy. There may also be broker commissions to pay. These fees increase the cost of trading. From the perspective of invoice finance companies, the cost of obtaining insurance will be included in the fees for providing factoring services.
There are also costs involved in maintaining a credit insurance policy. The credit insurance provider will stipulate a set of administration tasks for the holder of the policy. This will include putting in place credit control procedures and ongoing reporting of financial transactions. In the event of an insurance claim being made, the credit insurer may insist that it take control of the recoveries process. This might impact a company’s relationship with its customer.
The Role of the Insurance Broker
An insurance broker is a person who sets up and administers an insurance policy for an insurance company. The broker is the go-between for an insurance company and a company seeking insurance cover. As such the insurance broker has specialist expertise that can advise on financial matters.
A factoring company will use an insurance broker to make sure it has the correct insurance policy and to help with the legal wording on contracts.
Insurance brokers often specialise in certain sectors and certain types of insurance policies. This knowledge can be utilised by their customers.
In technical terms the broker acts on behalf of the insured. He or she will make an insurance contract legally binding by getting the insurers to stamp the policy. The broker will answer any queries that arise during the term of the insurance policy. They will also be the conduit for any negotiations regarding amending insurance cover.
Benefits of Credit Insurance
When a credit insurance policy is taken out for a seller using a factoring facility, the invoice financier in charge of the factoring facility is named in the document as the loss payee. This means that if an insurance claim is successfully made it is the invoice financier who receives the insurance pay out. This is because it is the invoice financier who has taken over the seller’s book of trade receivables, and if there is a missed payment on an unpaid invoice it is the invoice financier who is set to lose money.
However, in the event of needing to make an insurance claim, it is the company who is using factoring services NOT the factoring company that needs to apply to the insurer. Moreover, it is the company that needs to submit all the necessary documents in order to facilitate an insurance claim. If the company holding the insurance policy goes insolvent, the loss payee status of the invoice financier may not result in payment from the administrators involved in the insolvency as there might be third parties with a prior claim to the monies raised. To prevent such a scenario, a factoring firm can insert an assignment of proceeds clause into the insurance contract. This effectively puts the factoring company to the front of the queue for receiving money as a result of their client going bankrupt.
A factoring firm can be named in an assignment of proceeds as the beneficiary of any payments made arising from insurance claims. It is legally difficult to be assigned the insurance policy. However, with a co-assurance insurance policy both the factoring company and its client company are identified as the insured parties. There are effectively two insurance policies: one for the company using trade receivables finance and one for the factoring firm. However, in the event that a debtor cannot pay their invoice only one insurance claim can be made.
The main advantage of using co-assurance in an insurance policy is that the factoring firm has the power to make a claim independently of its client. This type of insurance policy structure will still leave the company, not the factoring firm, with the obligations of providing documentation and proof in order to make an insurance claim.
Another possible mitigation that a factoring company may place on a credit insurance policy, is to insert protective provisions in the factoring agreement. These provisions bind a company to comply with the terms of the insurance policy in a timely fashion.
If it is still deemed that there is a risk of a credit insurer not paying, then a factoring firm might take out its own insurance policy on the trade receivables it owns. This way it can make a direct claim in the event of a debtor defaulting on an unpaid invoice.
Where there is risk, there is the need for insurance. While a factoring company will thoroughly research an unpaid invoice before it accepts the invoice for factoring, there is still the real possibility of an invoice going unpaid. This could be because of financial mismanagement, currency fluctuations, global financial disasters, wars etc.
The best way to mitigate against risk is to take out a credit insurance policy. In the case of insuring a factoring agreement, a policy broker is used. They work on behalf of the party seeking insurance, they will negotiate the details of the policy and make sure the ensuing insurance policy is legally enforceable.
If the factoring company is not able to recover the money due from an invoice that it has bought as a result of a factoring agreement then it can request that its client (in whose name the insurance policy is registered) make an insurance claim. The factoring company will be designated as the ‘loss payee’. To mitigate the possible situation of the company that takes out credit insurance on its unpaid invoices going insolvent, an assignment of proceeds clause or a co-assurance structure can be inserted into the insurance policy. Alternatively, the factoring firm might decide to take out separate insurance.
In many instances credit insurance is not deemed necessary for factoring. About 50% of factoring is done without insurance. This is to reduce costs where risk is considered as minimal (especially with non-recourse factoring). As noted above the costs of credit insurance have to be set against the benefits of using insurance – not only does it protect against non-payment of an invoice, it can also lead to an increase in credit limits and better credit control systems.