Reprinted with permission from Michigan Banker – November 1997
By Jerome O’Neill
BINGHAM FARMS – With offices in Detroit and Chicago, Global Commercial Credit Co. is fast becoming a force in the Midwest in terms of providing domestic and export credit insurance and political risk insurance for companies who sell to commercial accounts on so-called “open credit” terms.
The firm’s clients use credit insurance programs to eliminated the risk of unexpected customer default, improve their receivables-based borrowing arrangements, expand open credit sales, and start up export sales.
“While credit insurance is widely used in Europe, and has been in use in the U.S. for a century or more, many domestic companies still are unaware of the unique benefits this financial tool can offer their business operations,” said Victor Sandy, a VP with Global Commercial Credit.
Steven Zack, Global Commercial’s president, explains how his firm assists its clients:
“While competitive pressure and market opportunities force extension of aggressive open credit terms, many companies are not in a position to absorb the potential losses that could occur as a result,” he said. “This dictates that one of two scenarios occur. Either the company passes on the sales opportunity or forces restricted terms that limit the customer’s ability to buy, or they take the risk and face a major threat to earnings and possibly their survival.
As an example, a company with a small group of accounts representing 80% of sales may face potential defaults well into the six or seven figure range. Let’s assume a loss of $200,000 occurs. At a 20% gross margin, an additional $1 million sales would be needed to make up for the lost bottom-line revenue. In other terms, after a loss of this magnitude occurs, the next $1 million in sales is made at zero profit.
If margins are lower, the impact is even more dramatic. Even though most large account exposures are with companies considered to be ‘good as gold,’ should an unexpected loss occur, the impact on the company would be devastating. Most companies make wise credit decisions based on information and credit expertise; however, many unpredictable events can occur after the decision is made and it is too late to reduce the exposure,” Zack said.
“While letters of credit and personal guarantees are most often used, there is a financial tool available that can be used to transfer the risk of customer defaults on both domestic and export receivables, thus eliminating the threat of a catastrophic credit loss. Accounts receivable insurance is a custom-tailored product offered by several domestic carriers, and available through specialized brokers. These programs are designed to wrap around a company’s existing credit practice to provide an extra layer of protection in the event of a loss,” he continued.
“At a typical cost of 1/10 to 3/10% of covered annual sales, credit insurance has little measurable impact on profits and can assure long-term financial stability and security in spite of changes in the economy or business cycle,” Zack said. “Whatever the approach, it is more and more critical for today’s managers to be conscious of credit risk, and the tremendous impact losses could have on their business, and put safeguards in place that will reduce or eliminate losses.”
Benefits to Lenders
From a lender’s perspective, a properly structured credit insurance program provides several benefits. In addition to eliminating the risk of a large unexpected credit loss, the program provides expert credit decision support to further strengthen the borrower’s credit practice. The borrower’s accounts are underwritten at the coverage limits requested, allowing an expert industry analyst at the carrier to review and render a decision on the accounts. Once coverage has been approved and an account is insured on the policy, the carrier maintains the due diligence and on-going monitoring. Should an account deteriorate to the point of imminent default, the carrier can provide advance warning that may help the lender and borrower avoid a loss before it occurs.
By eliminating the risk of loss on pledged receivables, it is possible to provide higher advance rates at less risk, and possibly include more receivables in the borrowing base. The end result is greater working capital availability for the client, and a larger, safer loan for the lender. Often, just a small increase in the advance rate can result in significant additional working capital as the client turns their receivables and the increased advance “recycles” itself at each turn. This approach can give the lender a distinct competitive advantage by enabling them to offer more to the client. Further, with such a low incremental cost, the credit insurance program does not have a measurable impact on the fee structure of the borrowing arrangement, while offering a significant advantage.
For smaller, less sophisticated clients, the policy can actually function as an outsourced credit department, and go as far as prescreening potential customers for insurability before a sale is made. With more and more demands being placed on commercial lenders, there is often not enough time to properly monitor a borrower’s aging each month. Having a credit insurance program in place can eliminate the window of opportunity for undetected problems to occur.
A Means to Transfer Risk
A credit insurance policy also provides a means to transfer risk, when high concentrations are present. Since the 80/20 rule has proven to be true in a majority of companies, credit insurance represents a great approach to hedging large exposures, and more fully leveraging the receivables to give the borrower access to more working capital.
As a financial consideration, credit insurance can help the lender structure advances on non-traditional receivables like export accounts, and work-in-process or purchase orders. While historically, it has been difficult to advance against these exposures, by eliminating the risk of the debtor’s default, many lenders are now finding a great degree of comfort in these receivables. With credit and collectibility issues eliminated, the borrower can pledge what amounts to a riskless asset.
In addition to Zack and Sandy, other top officers of Global Commercial Credit include Thomas Purther, CEO; Scott Jacobson, board chairman; Craig Bonnell, vice president; and Chris Blain, treasurer.
Review a Related Case Scenario: Borrowing Enhancement