What Is Credit Insurance?

Mr. Stephen Lo is Business Development Manager in Trade Credit Department - Gerling General Asia Ltd.

When was the last time you lend a thousand dollar to a complete stranger?

The answer would probably be no or never. In other words, those who can pick a grand out of your pocket are usually someone that you know of. The same can be applied to credit management. Those who are capable of obtaining a high credit limit from you are often established customers, someone that you know of. In this sense, no customer is completely safe!

"Are you insured?"

One of the main difficulties of credit management is to spread and minimize risks on credit exposures. Just as shipping managers minimize their risks through marine and cargo insurance, credit managers can spread their credit risks through credit insurance.

Compare with other types of insurance, credit insurance is a relatively young field. While credit emerged soon after the invention of money, the first practical attempts to insure credit took place in the 18th and 19th century. In general, the idea of credit insurance first caught on after the Second World War in Europe and has since become ever important as a key tool for minimizing the risks on credit exposures.

Basically, credit insurance protects the policyholder from non-payment by customers for goods supplied or services rendered. Indemnifications can be up to 90% of the insured debts.

The benefits of credit insurance are the reduction of credit risk and the provision of financing facilities. That means the insurance company will pay for the loss of an insured debt when it is unpaid and becomes a bad debt. On the other hand, there is a growing trend of using the credit insurance policy as a security to obtain short-term financing from financial institutions.

Generally speaking, credit insurance operates on a whole turnover basis, which means the policyholder must insured their whole turnover based on credit sales. When calculating the premium, the insurance company will take out all the cash sales, inter-company and letter of credit transactions from the prospect's sales turnover, the remaining sales figures would then be of credit sales. This will become the "insurable turnover" from which the insurance premium would be calculated.

Although the credit insurance policy covers all the credit sales transactions, the policyholder will not be required to report to the insurance company every credit sales transactions. However, the credit insurance company will place a credit limits on the policyholder's customers on what can be insured without its further approval.

The risks covered by credit insurance are insolvency of buyers and protracted default. Protracted default happens when the buyer accepts the goods and failed to pay upon the expiry of the "waiting period" set in the general conditions of the insurance policy. In addition to the general coverage, most credit insurance companies also offer political risk coverage. That would protect the holders from political events such as currency inconvertibility, war, import restrictions imposed by the government etc.

However, it is worth noting that there are also risks that are not covered by credit insurance. If the non-payment arises because of a trade dispute, then it is not covered. On the other hand, the insurance company may also refuse to entertain a claim if the holder did not comply with the general conditions of the insurance policy. An example of this would be the failure of the policyholder to notify the insurance company on late payments concerning their buyers.

Credit insurance helps to minimize credit risks. Apart from providing cover against potential bad debt losses, the insurance company also assesses the creditworthiness of the policyholder's new customers and monitors the existing customers through the approval of credit limits.

With a credit insurance policy, the policyholder can hedge their credit risks. Since insurance is not a guarantee, the policyholder will not get 100% coverage on potential losses. However, credit insurance does reduce credit losses and makes sales income more predictable. That is why there is a growing popularity on the integration of credit insurance into the overall credit management system.

As with all types of insurance, credit insurance comes in different terms and conditions from different insurers. It is, therefore, the credit manager's duty to make sure that the insurance policy is cost-effective and the coverage is suitable..