One of the key aspects of credit insurance is that it allows for banks to seek capital relief. Both EU and UK law stipulate that a bank must not fall below a certain threshold of held reserves. In other words, there is a limit to how much money a bank is allowed to lend. In the case of a bank offering factoring services this can be problematic for large customers. Showing that a company has credit insurance on its accounts receivable will allow a bank to release a higher percentage of its cash reserves to fund factoring.
Capital Requirements Regulation (the “EU CRR”) and the Capital Requirements Directive are the two pieces of legislation relevant to capital relief. Since Brexit the equivalent in the UK has been the UK Capital Requirements Regulation. As of 2023 there has not been any significant divergence between the EU and UK regarding this matter.
Requirements to Obtain Capital Relief
In order for a bank or funding institution to claim capital relief because credit insurance is in place the policy has to meet the following requirements:
1 Legal certainty. The policy must be legally enforceable in all relevant jurisdictions.
2. The policy must provide the bank a direct claim on the insurer. It is not enough for the financier to have loss payee status, as this status doesn’t allow the bank to make a claim in its own right under the policy. The invoice financier needs to be named as ‘sole insured’ or ‘co-insured’ on the policy.
3. The terms of the credit insurance policy must be clearly defined and incontrovertible. If there is any ambiguity in the wording of the policy then it is not deemed suitable as a way to trigger capital relief.
4. The policy must be non-cancellable. The insurer must not have the unilateral right to cancel a policy. All possible breaches of the policy must be under the control of the funder. For example, the possibility that the company seeking factoring facilities should default on an insurance premium and thus invalidate the policy must be an eventuality prevented in the terms of the policy.
5. The policy should not make it incumbent on the financial institution to exhaust all legal avenues for recovering debt from unpaid invoices before it can make an insurance claim. A bank doesn’t want the delay or expense of chasing up unpaid invoices. If there is a default on paying an invoice, they want the right to make an insurance claim promptly.
6. Covers losses in full. The bank offering factoring has to be certain that they can claim for 100% of their losses in the event of the underlying obligor not paying. If the policy stipulates that only 90% will be paid out in the event of a successful claim then the bank will adjust its prepayments accordingly to off-set the risk of being 10% down if the credit insurance is used.
Avoiding Breaches in a Credit Insurance Policy
The wording of a credit insurance policy is vital. If the policy stipulates that any breach by the insured allows the insurer to negotiate for remedies such as a reduction in the claim amount then the funder (the bank) cannot prevent an insurance pay-out shortfall. To meet the incontrovertible criterion the policy wording must place the power with the invoice financier to meet all conditions. These would include warranties and conditions precedent. In this way the financier working for the bank has control and can avoid breaches that impact insurance cover. And the financier has the option, if necessary, to apply for credit relief.
Credit insurance has become a vital part of receivables financing. It is essential that the invoice financier tasked with managing and offering factoring for a client company’s ledger of trade receivables do due diligence. This means seeking advice from insurance brokers and legal advisors as how best to use credit insurance as a risk mitigation instrument.
It also means understanding the conditions of a credit insurance policy. The policy shouldn’t allow for any situations where the policy can be invalidated by the actions of either the seller or the buyer. Being certain that the bank has the power to conform to the conditions of the policy is a vital part of due diligence.
And the reward for this due diligence is the ability of the invoice financier to increase bank exposure to debt through credit relief. This helps the invoice financier to better maintain a factoring facility and provide good levels of working capital for his or her client.