There was a time when the risks faced by risk managers were pretty straightforward—property, casualty, liability and workers’ comp, but times are changing.
Today, the principal threat to businesses is no longer fire, flood or theft. Now the greatest risk facing companies is credit risk—the risk that a customer will go bankrupt owing a lot of money.
Credit risk, a financial risk rather than a physical risk, used to be handled by the credit department. But now, because of the magnitude of the threat, chief executive officers and chief financial officers are looking to their risk managers to take on this risk as well.
According to the American Bankruptcy Institute, more than 160,000 U.S.-based businesses have filed for bankruptcy since 2008. Reuters reports there will be 50,000 more in 2011. Bankruptcy lawyers as well are predicting 2012 will be “busy” and 2013 and 2014 will be “very busy.”
The sad truth is that many companies that fail are financially sound; it’s their customers that are not. Most American companies derive 80 percent of their business from just 20 percent of their customers. When one of those big customers fails, they often take their suppliers down with them.
There are four ways companies can address credit risk:
• Demand that customers pay cash on the barrelhead. But that’s a non-starter. Customers will just go elsewhere.
• Debt reserving – setting aside enough cash in case a customer can’t or won’t pay bills. But that ties up working capital at a time when banks are not lending.
• Factoring—selling invoices at a discount, leaving the headache of collecting to the factor. However, this cuts into profit margins and is potentially harmful to customer relationships.
• Credit insurance. Although it’s very common elsewhere in the world, many American risk managers have never even heard of it.
What is credit insurance? It’s a way for businesses to protect their accounts receivables. For an affordable premium an insurance company will assume the risk in case a customer defaults. If a customer goes bankrupt or is unable to pay, the company still gets paid. What’s more, premiums are based on the customer’s credit history.
HOW DO THEY DO IT?
Credit insurers maintain extensive credit histories for literally millions of companies around the world. They use this vast amount of data to underwrite risks posed by customers to a business. Most often they will insure an entire portfolio of customers. But if it’s preferred, they can insure the cash flow from just a segment.
While more than half of European companies use credit insurance, only about one out of 10 American companies do. But lately interest among American risk managers is way up. Inquiries for credit insurance have increased 25 percent over the past two quarters.
Why the sudden interest? There are two main reasons:
Continued unease about the economy. Not too many months ago, the business community watched as thousands of otherwise healthy companies went out of business. Of those that remain, many realize that they could have been one of those dominoes falling in an unforeseen chain of bankruptcies. Since then, from a regulatory standpoint, very little has changed. And now, the European debt crisis offers the potential of yet another global recession. From “part of doing business,” credit risk has escalated to an existential risk.
The second and more optimistic reason for the growth of credit insurance is the strong increase in U.S. exports. Especially among small and medium-sized American companies, exports are up 29 percent over the past two years. Credit insurance, also known as trade credit insurance, is by far the most cost-effective way to ensure payment from overseas customers; no export-import bank, no letters of credit, no bankers, no foreign courts.
Foreign or domestic, companies using credit insurance quickly discover additional benefits. Perhaps the most pleasing to management is a significantly improved financial profile. When a company’s accounts receivables are insured, banks are more willing to extend credit and at lower rates. In short, companies can borrow more for less.
Many companies also have found that credit insurance can help them increase their working capital. Because it does not have to reserve for bad debts, a company with credit insurance can use that cash for working capital. Moreover, insurance is tax deductible, debt reserving is not.
Credit insurance also enables companies to leverage their working capital. Most banks will advance a maximum 80 percent against an account receivable. But if the assets are insured for 90 percent, the bank can loan more without increasing its own exposure. An additional 10 percent working capital could be very useful, especially in an economy that is still critically credit constrained.
Credit insurance can also build-in some breathing room. For example, when accounts receivable fall behind and go past due, banks typically reduce a borrower’s working capital. Credit insurance can provide protracted default protection and keep those overdue accounts on the plus side of the ledger book. With the knowledge that an outstanding invoice will ultimately be paid, either by the customer or a credit insurer, many banks are willing to view an unpaid, overdue bill as an asset.
In addition to financial benefits, users of credit insurance have also found it can help with sales.
Because their accounts receivables are insured, companies can be more aggressive with the credit terms they offer—better terms usually mean larger sales. Credit insurance enables companies to take larger orders than they normally would, or seek out new customers. It also gives the sales force a competitive advantage. For overseas sales, credit insurance is replacing the letters of credit which are slow, one-time instruments that tie up customers’ credit. If something goes wrong, it’s the credit insurer’s headache, not the risk manager’s.
There is also an added benefit. Between reduced credit risk, improved financial position and increased sales, many risk managers who have bought credit insurance find themselves in an unusual position. Rather than being associated with a cost, they’re increasingly seen on the revenue side. Rather than merely buying insurance products to transfer physical risks, risk managers are using insurance tools to advance their company’s overall business strategy.
As we know all too well, the financial crisis has made doing business much more complicated. Risks are much more complex, requiring risk managers to cross over from purely physical risks to include some elements of financial risk.
While risk managers were not called on to provide those protections in the past, they certainly are now.