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CREDIT INSURANCE

– RISK COVER OPTIONS FOR EMERGING MARKETS -

RON  WELLS   CCE


CONTENTS:

PREAMBLE

FINITE RISK INSURANCE (FRI)

INTERNAL GROUP BASED ARRANGEMENT

POST LOSS FUNDING CREDIT INSURANCE


PREAMBLE


The challenge for many companies operating in Eastern Europe is how to adapt traditionally risk averse credit policies to the realities of the situation, without abandoning control altogether.

Traditional credit policies which call for ‘the analysis of "audited financial statements conforming to International Accounting Standards (or GAAP) covering three years"’ as a prerequisite for the granting of credit are frankly no use in a region where only the largest enterprises have barely started to meet this requirement.

Credit policies which go on to require the buyer to provide full security or payment-in-advance as the only alternative to meeting the former requirement are only effective as long as competitors take a similar stance. Therein lies the weakness of such a credit policy; that is it encourages competitors to find ways to give credit and thus to provide a competitive edge for their sales forces.

The company that fails to meet its competitors’ credit conditions will not succeed in the market.

Conversely the company which betters its competitors’ credit conditions will be a winner.

 

POSSIBLE SOLUTIONS RELATED TO CREDIT INSURANCE


In addition to the usual credit insurance arrangements and techniques some companies have set aside cash funds, taken out of current profit, in order to create a liquid reserve to cover potential bad debts. This has enabled the companies to relax credit policies and thereby to become more competitive, while insuring financial survival. Two alternatives are described, namely;

  1. an external arrangement called "Finite Risk Insurance" and
  2. an internal arrangement managed within a group of companies.

 

1. FINITE RISK INSURANCE (FRI)


FRI is based on an investment policy that is reinforced with a credit insurance policy; to cover any loss incurred before sufficient funds have been accumulated.

 

EXAMPLE FINITE RISK INSURANCE ARRANGEMENT:


Given that a company decides that it wishes to;

accumulate $15 million in cash reserves,
over a five year period,
to cover potential receivable losses;
with immediate availability of credit insurance protection up to $15 million.


A Finite Risk Insurance package will provide the company with:

  1. An investment policy designed to accumulate $15 million after five years, given fixed annual contributions (of say $2,600,000 on the first day of each year) plus retained, compound investment income.
  2. A linked insurance policy which would provide cash to cover the difference between (a) the amount of any qualified receivable lost and (b) the amount (if less) of the accumulated fund at the time of loss; up to an aggregate of $15 million. Any such amount paid under the insurance policy would be repaid to the insurance company as future annual contributions are paid. Any investment income not earned/accumulated, as a result of a claim, would be a loss carried by the insurance company. Hence in this example the maximum at risk for the insurance company would be $2 million. This ‘Timing and Investment Risk’ is the difference between the total contributions of $2.6 million times 5 (=$13 million) and the FRI limit of $15 million. The insurance company would charge an appropriate premium, rolled into the annual contribution, for this cover.


Such an FRI arrangement would only cover losses up to a maximum aggregate amount of $15 million. If the full amount were to be lost on the first day of the arrangement, the insurance element would pay out immediately in full but the fund would have to be reimbursed over five years. The company would not enjoy any further ‘protection’ from that particular arrangement but would have to continue making annual contributions for five years.

Conversely any amount not needed to cover bad debts could be returned to the company at the end of the five-year period.

 

NOTE: Information about FRI and the example quoted was gleaned from a presentation given by Ranjini PILLAY and Christophe LETONDOT of AIG EUROPE (Paris Office, France) given at the FCIB Workshop held in Amsterdam, the Netherlands, on January 27, 1998.

Telephone: +33 1 49 02 43 09. Fax: +33 1 49 02 44 94.

 

2. INTERNAL GROUP BASED ARRANGEMENT


An internal ‘credit insurance’ solution based on a corporate group could work as follows, for example:

The Group Credit Manager, based in Corporate Headquarters, would operate a voluntary scheme for his business units. He would offer a credit insurance policy to his business unit managers - more simply worded than the usual commercial contract but covering the same ground. He would offer to cover 90% of commercial and country risk on all of the business unit's receivables for which he has approved limits and which are managed within the limits approved. In some cases he would stipulate security which must be obtained before cover would be effective. He would charge a 'premium' based on normal commercial rates. He would simply ask a credit insurance company for a ballpark figure and use that to satisfy tax managers that the arrangement is not a 'transfer of profit' scam. The policies offered would be of the 'turnover' type, which cover the majority of receivables and stipulate a premium based on a percentage of total sales.

In due course the Group Credit Manager would receive claims when debts turned bad, he would pay out 90% (if a claim was valid in terms of the 'policy') so only 10% would go to the bottom line of the business unit, at the time a receivable was written off. He would use premiums received to accumulate a fund to enable him to cover any losses. This is not envisaged as a tax scheme, so the funds would simply accumulate on the corporate balance sheet and would be invested in the usual way by the Group Treasury department.

If the Group Credit Manager had some surplus funds available he could do 'one off' special deals on specific higher risk customers. In these cases he could write a policy to cover one account, on specific conditions and charge a separate premium.

He would have different criteria for credit management in each business unit depending on the individual strengths of each unit. Some may have functioning credit departments with acceptable policies in place. In these cases he would review the credit policies and loss records and set criteria and premiums accordingly. In other cases he himself would set credit limits and conditions for all customers i.e. when only a small number of customers were involved. Accounts, which were not managed within the agreed criteria, would not be covered; he would refuse to cover losses in cases where, for example, limits were exceeded or security was not obtained. In such cases 100% of any loss would go to the business unit bottom line, when the loss occurred.

The key - for the Accountants and Tax Managers - is to develop a scheme which is equivalent to buying external credit insurance. In other words to use normal policy type language in the internal agreements and to charge market rates of premium.


It is recommended that Tax and International Commercial Law advice should be obtained before such a structure is utilised.


© R K WELLS (1998)

PS: Read about Post Loss Funding Credit Insurance.

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Last Updated:  January 02, 2017 17:14 -0000