You know that as a CEO, you are chief steward of your company’s resources. One of your biggest, if not the biggest, asset on your balance sheet is likely to be your accounts receivable. For most companies, it typically represents about 40% of the total asset base, and in most cases, about 80% of the time, the receivables are unsecured open credit accounts.
Given that your receivables are the closest asset to cash- they represent a concentration of all of your cost and profit, it’s surprising that most companies elect not to insure them, or aren’t aware that this is possible. With A/R being the primary source of both cash flow and earnings, it makes sense to explore how to protect this valuable resource from unexpected loss.
There are also several proactive advantages to insuring your receivables. However, let’s first examine the impact a large unexpected loss can have on your business and the value insuring the exposure can provide. Take a company that does $20 million in annual sales and has an average receivables balance of about $3-4 million. It’s not uncommon to find that about 80% of the exposure is generated by the top 20% of accounts- the old 80/20 rule. They experience an unexpected customer insolvency and have $500k of unpaid A/R. At a 15% gross margin, it will take them $3.3 million in sales to recapture that lost revenue. In other terms, after a hit of this magnitude, the next $3.3 million in sales is made at $0 profit. If margins are thinner, the impact of the loss is even more dramatic.
What is worse is that the immediate hit to cash flow and their bottom line makes it difficult to continue with an aggressive, competitive credit granting posture that is needed to recapture the lost revenue. It’s a difficult trap. They can’t afford more losses, but they need the revenue. There is however, a great solution. If the company had insured their receivables against insolvency or past due default, they would have recovered a bulk of that initial loss upfront and by continuing to insure their new account sales, they can maintain their credit risk appetite and move forward with minimal disruption. Assuming they had a policy with 10% coinsurance, they would have received $450k of their total loss and more than recovered their cost in that bad deal. Carriers typically pay claims in 60 days, so there is some time value of money involved, but it is minimal.
It’s easy to see how credit insurance can be a life saver in the event of a big, unexpected loss, but as we mentioned earlier, there are a number of proactive benefits to also consider.
FINANCIAL EFFICIENCY: Unlike accrued reserves, which do nothing to cap your exposure and have no tax benefit, with credit insurance, you can trade a tax deductible premium for hard dollar coverage on your exposure. This eliminates the need for excess reserves and is a more efficient use of capital. The protection also increases the accuracy of your revenue projections and forecasts.
BORROWING ENHANCEMENT: Lenders who structure lines of credit backed by accounts receivable typically exclude export receivables, slower paying accounts and cap their advances on accounts with large exposures. They may also hold down their advance rate (the percent of eligible receivables they will lend to you) and charge a risk premium in their rate to allow for the possibility of bad debt losses. By using credit insurance, you significantly reduce or eliminate the risk of a loss impacting the line of credit. You can rope export receivables and some slower paying accounts back into the borrowing base, increase advance rates, remove concentration caps and get the best possible cost of funds. In the net, using credit insurance to support your receivables based borrowing arrangements can help you get better leverage from the existing receivables portfolio. In our previous example, if the company has about $3 million of average A/R, a 10% increase in working capital would give the company an additional $300k to employ back into their business. That increased availability comes with every turn of the receivables, so it can amount to a significant amount of working capital to put to work.
SAFE SALES EXPANSION: How often does it happen that sales wants/needs larger approved credit lines to meet a customer’s requirements? Daily? It’s just a routine part of the sales/credit process. A lot of companies use credit insurance to bridge the gap between what their risk appetite is and what the revenue opportunity promises. You can offer larger lines of credit to current customers and confidently extend credit to new accounts by using the policy to insure those exposures. Just a limited amount of new sales will more than recapture the premium to insure the whole portfolio. You then have comprehensive protection at a net zero cost. Used in this way, a credit insurance program can meaningfully enhance your bottom line paying for itself many times over.
CREDIT DECISION SUPPORT: What every company needs is objective credit decisions not impacted by internal business considerations- a pure risk driven credit review and credit limit recommendation. Under a credit insurance policy, the underwriters provide this decision support as well as ongoing monitoring of your covered accounts. Many of them maintain groups of industry and country specific underwriting teams of expert financial analysts. They have vast credit files and extensive third party information resources. While not at all financially feasible to try to recreate in-house, your company can put this top shelf, outsourced credit department to work and free your internal resources to focus on cash flow and collections.
So this all sounds fantastic, but everything comes at a price. How much does a credit insurance policy cost? The short answer, if you take advantage of the proactive benefits above, is $0. In fact, you can recapture the premium many times over, but of course there is the upfront investment, so let’s talk price. The carriers typically assess premium based on your actual insured sales to your covered accounts. You give an upfront estimate of what you think your insured sales will be for the coming 12 month policy term, and pay a minimum and deposit premium based on that estimate. At renewal time, after the year has passed, you report your actual insured sales and true-up for any volume over what you initially projected and paid for. You get economies of scale as your insured sales grow. In our earlier example, for that $20 million company to cover the entire portfolio, all factors being equal, they would likely see a premium rate around 15 to 20 basis points or 1.5/10ths of a percent to 2/10ths of a percent of insured sales (15 to 20 cents per $100 of covered sales). This equates to an annual premium of $30,000 to $40,000 for the year- an amount that is readily cost justified if you employ the policy for any of the proactive benefit mentioned above.
Credit insurance is available through a small number of specialized insurance companies. The best approach to source this custom tailored financial tool is to employ the services of a specialty broker. There are brokers who work exclusively in trade credit insurance. They have access to all of the carriers who provide this type of coverage and the relationships and service infrastructure to help clients manage their policy.
When looking for a specialty broker, keep in mind that with a limited number of markets, you should not engage more than one broker to shop for you. They all end up at the same carriers and since the carriers each only release one quote, you will have to designate who is approved to secure it for you. It’s better to screen and select your broker upfront and then put them to work. In selecting the right broker partner, you want to ask the following questions:
-Does the broker deal exclusively in credit insurance as their sole area of expertise?
-Do they work on a direct basis with all of the carriers in this niche?
-How many years of experience does their agent team have?
-Do they have experiences client service managers?
-Is there a dedicated claims and recovery specialist on staff?
-Can the broker provide support with account research- do they have financial analysts on staff and information resources to help maximize coverage?
-Do they charge any additional fees?
With the right answers to all of these questions, you should have the ideal broker to sit on your side of the table and help assure you get the best, custom tailored program for your specific needs. The right broker partner and credit insurance program can help you truly master one of your biggest and most at-risk assets and assure you are meeting your obligation as a good steward of your company’s resources.
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Author: Victor Sandy, executive vice president and managing partner, Global Commercial Credit, LLC
Image: Shia LaBeouf and Frank Langella in Wall Street: Money Never Sleeps (also known as Wall Street 2), a 2010 American drama film.