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Export Credit
Insurance: An Analysis
by Manoj Kumar
CPCU,
ACII, ARe, ARM, FIII, MBA
manoj@einsuranceprofessional.com
Export credit insurance has truly proven to be
one of today's greatest hidden keys to global growth and export
success. As barriers fall, and the world truly becomes a much
smaller place, export businesses come as a rare growth opportunity
for all businesses alike. This growth potential abroad, and
competitive pressures to secure market share are two key forces
pushing more and more companies into the export arena. However, it
also brings many inherent risks of the trade including the
unexpected customer defaults.
The risk of an unexpected customer default is a
driving reason why lenders limit advances on pledged receivables.
Prudent lending practices dictate that lenders extend themselves
only to a certain point, since the potential for default in the
receivable base can place an undue repayment burden on the borrower.
Obviously, this limits the amount of working capital available from
a given group of accounts.
A more cost-effective alternative is to hedge
the risk in pledged receivables, allowing a safe increase in the
advance rate. A financial instrument known as accounts receivable
insurance, which is commonly used in Europe and in the United States
for over 100 years, can be used to transfer the risk of unexpected
credit losses from the company's books. By eliminating this
potential for loss, it is possible to more fully leverage the
pledged receivables and increase advance rates by a beneficial
percentage.
As an example, a company with $15 million of
pledged receivables is currently allowed to advance 80%, providing
$12 million in available working capital. Assume additional growth
opportunities require an additional $4 million. By insuring the
receivables against unexpected customer insolvencies and protracted
default, the advance rate can safely be increased to 85%. This
provides an additional $750,000 of working capital. As the
receivables turn, say six times for this example that increased
availability provides additional working capital at every turn,
resulting in $4.5 million in additional funds accessible to the
company. Further, by guaranteeing payment on the receivables, the
lender enjoys the benefit of advancing against a "riskless
asset".
The end result is an immediate increase in
working capital, increased sales, and increased future sales
revenue, while the company preserves remaining assets for future
financing needs. This approach is a win-win opportunity for the
company and their lender.
According to the latest figures from the
Association of British Insurers (ABI), UK domestic and export sales
amounting to 18% of gross domestic product were supported by credit
insurance. British credit insurers supported £188bn ($290.5bn)
worth of trade worldwide in 1998. Another estimate is that credit
insurance covers about 25 percent of total exports in Europe,
compared with 1 percent of US exports.
Export Credit Insurance has two basic components
- Commercial risk and Political risk protection. While economic
risks remain significant and encompass insolvency, bankruptcy and
protracted default; political risks have not declined either despite
the end of the Cold War. On the contrary frequent political
upheavals have created an atmosphere of uncertainty in the minds of
the potential exporters.
Insolvency: Its True cost
Consider a situation. The customer is insolvent
or bankrupt with no hope of recovery. Either way (depending upon his
specific credit policy and procedure) the next step would suggest
that the account balance be written off to bad debts and life goes
on. Unfortunately, removing the principal amount owing from the
ledger does not always represent the true cost of the bad debt when
one considers the impact on other aspects of the business.
With the advent of just in time delivery, many
suppliers perform an essential customer service by ordering or
manufacturing, in advance, products specifically required by the
customer. If these products are customer specific, they will
ultimately have to be written down as obsolete or sold at
considerably less than market value. This is often accounted for
differently and never really tagged as part of the bad debt,
although it arguably could be.
Annual budgets look ahead and sales forecasts
cascade down to individual customers. Product sales and margins are
predicated on the retention and growth of these identified
customers. A bad debt removes this opportunity from the mix and the
void must be filled from among the existing accounts or a concerted
prospecting effort must be undertaken to find a volume/margin
replacement. If neither is found, these lost sales become very
measurable.
Bad debts are financed out of a bank line. The
reduction of bank availability because of this loss would mean
funding for specific projects, like new product development.
Programs may have to be curtailed. Companies need to continue to
advance and remain competitive. The impact of not having access to
these resources will have a much longer-term effect on the overall
business.
While bad debts typically fall within the domain
of the credit department, the true cost of losing a customer has
both short and long-term consequences for the company. Therefore,
recording the principal loss is in reality an understatement, if
these others factors are not recognized in some form or another. In
a competitive situation, this may make the difference between
securing the contract or losing the business.
Even in more developed nations, financial
security can be a real problem. There were about 200,000
bankruptcies in Western Europe last year, Bankruptcies in Italy
surged to nearly 19,000 in 1994 from 14,000 in 1993, while in
Germany, they jumped from 20,000 to 25,000 in the same period. A
country can be both politically stable and economically uncertain.
Political Risks
Export credit insurance often is marketed in
tandem with political risk insurance, which covers payment risks
related to the country of the buyer. This encompasses non-payment by
the buyers due to transfer difficulties, government moratorium,
contract frustration, war, currency inconvertibility, asset
expropriation, political violence and so on.
Buying both Coverages is prudent, especially
when dealing with companies operating in developing economies or
uncertain political climates. Some European carriers, such as
Germany’s Gerling Group and AIG, have devised dual coverage
policies. It may be wise to purchase both policies from the same
insurance carrier. You don’t want to debate with two different
carriers whether a loss was caused by a bankruptcy [requiring credit
insurance] or an insurrection [political risk insurance].
Some carriers don’t yet provide political risk
insurance, but can coordinate coverage through another insurer. CNA,
for example, arranges selective political risk coverage through
Unistrat, a New York based political risk insurer owned by French
insurer SCOR.
Limitations of Letter of Credit
Foreign buyers are not willing to commit their
working capital to back Letters of Credit like they used to. Their
position is, We’re a good risk. If you want to do business with
us, you’ll have to do it on open credit terms like everybody else.
The cost of a letter of credit can be
significant. Banks in the United Kingdom often charge 1.5 percent to
2 percent per month of the face value of the credit extended; banks
in Brazil charge as much as 6 percent. Letters of credit also have
an impact on a Company’s available credit for internal business
purposes. If a company has a $1 million credit line, and it buys
$300,000 in products on a letter of credit, its overall credit
availability is reduced considerably. Even though the company hasn’t
really used the money, it has run down its credit line and hurt it’s
ability to run its business.
Letters of credit are not headache-free for
sellers either, creating tremendous paper work and other problems.
Letters of credit are stringent about product delivery dates and
frequently specify when a product must be shipped and/or received.
If a manufacturer misses a scheduled date because of a production
glitch or other error, the letter of credit must be amended,
requiring another trip to the bank that issued the letter of credit,
and paying another fee.
Export credit insurance, on the other hand,
creates no burdens for product buyers. The seller purchases the
insurance to cover nonpayment of account receivables. Although this
creates cost for the seller, the benefits more than compensate for
the cost. If you are exporting and insisting on letters of credit as
payment, you are probably losing business to your competitors who
are offering open terms. If this is the case, you should look into
export credit insurance as an alternative to letters of credit.
Rating
Credit insurers incorporate a number of factors
in deriving the premiums they charge, including the financial
stability of product buyers and the country in which the buyer
resides. The latter is important for political considerations, which
can affect the debtor’s commercial obligations. Other underwriting
considerations include the terms of sale and credit, for instance,
net 30 days or net 90 days, and the terms of transactions involved.
The insurers also incorporate a coinsurance share on the Insured
between 15 to 25% and impose a wait period of 6 to 12 months before
the bad debts can be claimed.
Typical credit insurance program costs 1/10% to
3/10% of covered annual sales for domestic receivable policy, and
slightly more for export programs. The return on additional funds
employed in the business assures the company a sizable return on the
initial investment. In the initial paragraphs, the $4.5 million of
additional capital reinvested in the business at a 30% return on
funds employed yields as incremental return of $1,350,000, from a
premium investment of approximately $150,000. Additionally, the
policy allows the company to replace reserves with a tax-deductible
premium that places a firm guarantee of payment on the accounts, and
eliminates the need for excess reserves.
Benefits
By financing its receivables, a company enhances
its cash flow, that is, it gets cash from the bank immediately
rather than waiting for shipments to be delivered and customers to
pay their invoices. The customer also benefits. Rather than pay the
exporter, it pays the lender on favorable six-month or eight-month
terms, giving it cash flow benefits and an opportunity to establish
a relationship with his bank. The lender, meanwhile, receives
interest on the financing and monthly payments, and in the event of
default, has the credit insurance policy to back up payment of the
loan. It a "win, win, win" situation for all parties
involved.
By integrating export credit insurance into a
foreign sales strategy, exporters are provided with enormous
flexibility and creativity in how they can structure a deal. No
longer is the company out there for 90 or 120 days waiting on a
receivable. The receivable is sold to the bank at the time of
shipment, thereby moving the foreign receivable off the company’s
balance sheet. The end result is greater working capital for the
client.
Because the bank’s loan is backed by the
credit insurance, it is possible to provide higher advance rates at
less risk and perhaps include more receivables in the borrowing
base. The insurance provides comfort, making it a larger, safer loan
for the lender. From that perspective, all parties benefit.
Exporters can also use the policy to replace any
reserve against doubtful accounts. The reserve is then moved to the
bottom line, increasing profits. It helps in expanding sales due to
favorable credit terms and reduces the risk of exposure to
non-payment by your buyers. It increases borrowing power by naming
the financial institution as "loss payee" to provide the
bank with security for lending and by investing in credit insurance
thereby getting more favorable loan terms. It also stabilizes cash
flow by reducing unexpected or catastrophic bad debt losses.
Finally
Despite the existence of credit Insurance for
the last 100 years many companies are still unaware of the product's
existence. As competition in the global marketplace heats up more
and more customers demanding open credit, insurance companies are
responding to the market dynamics and many new carriers are entering
the market with a wide variety of new and improved programs that can
be customized to each situation.
Financing a company’s receivables - backed by
credit insurance - is developing as a new export strategy for many
companies.
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