Accounts receivable insurance can provide a measure of protection against catastrophic customer defaults, as well as potentially increase your access to capital, boost your competitiveness, and more. Here are the basics on this financial tool.
Reprinted with permission from Scrap – September/October 1997
By Craig Bonnell and Victor Sandy, Vice Presidents
Global Commercial Credit – Bingham Farms, MI.
The scrap recycling industry has long subscribed to the philosophy that a customer’s word is its bond. It’s not unusual , for instance, for processors to ship material on open credit, relying on nothing more than the customer’s promise to pay.
As the pace of business increases, and the risk of customer default grows along with it, recyclers need to balance the risks and rewards of doing business on open credit terms. If a customer lives up to its promise, all is well. If the customer defaults, however, the result could be fatal. Such credit risk is an ever-present threat to the survival and profitability of scrap companies.
Fortunately there’s a tool-accounts receivable insurance-that can protect processors from the financial effects of catastrophic customer defaults.
Dealing with the Unexpected
While recyclers wouldn’t dream of operating without insurance on most aspects of their business, it’s ironic that few insure their receivables, which often represent their single largest asset and the greatest concentration of their resources, encompassing their materials, production, profit, and more.
Most recyclers attempt to ensure the reliability of their receivables by conducting due diligence credit checks on customers in deciding to whom to sell and how much credit to extend.
They often don’t take into account or adequately address the layer of unexpected credit risk that’s just as real and typically much harder to evaluate. Unexpected risk is the threat of uncontrollable, unpredictable events that could effect a customer’s ability or willingness to pay. Examples of such risk include fraud, class action lawsuits, natural disasters, and financial deals and structures that cause the customer to have short-or long-term liquidity problems. These events can leave recyclers with little recourse, despite the customer’s best intentions.
To address these unexpected risks, many companies fall back on the capital structure of their business or margins in the transactions themselves. Letters of credit, personal guarantees, and other instruments are used in an attempt to ensure payment. Yet none of these standard approaches affords any true guarantee.
While competitive pressures and market opportunities encourage companies to extend aggressive open credit terms to their customers, many aren’t in a position to absorb the potential losses that could occur.
As an example, a company with a small group of accounts representing 80% of it’s sales could face defaults well into six or seven figures. Let’s assume the company suffers a loss of $200,000. If the firm operates on a 20% gross margin, an additional $1 million in sales would be needed to make up for that lost revenue. Looked at another way, a loss of this magnitude essentially means that the company’s next $1 million in sales is made at zero profit. If its margins are lower, the impact will be even more dramatic.
The Effects of Credit Risk
In day-to-day business, credit risk acts as an obstacle to increase sales and profits-and in some cases survival. The limitations it imposes are manifested in several ways.
For starters, the potential for loses when selling on open credit terms can prompt companies to limit credit to certain customers or refuse to extend credit at all. This practice can lead them to lose revenue from opportunities with accounts that would have paid, or take risk on marginal accounts and suffer losses.
Credit risk can also have a bearing on a company’s competitiveness in the marketplace. The specter of credit risk, for example, can cause one firm to be less aggressive in its open credit policies, which can mean lost revenue opportunities and put the firm at a disadvantage to competitors with better, more aggressive credit risk management practices.
Managing credit risk is also a customer service issue. Companies willing to offer the level of credit necessary to meet all the purchasing needs of customers obviously hold a competitive advantage. The more aggressive a firm’s credit terms, the more it’s customers will be able to buy at their desired level. Giving customers all the credit they need can, in fact, help them reduce the number of outside suppliers they need to use, enabling them to consolidate their purchasing with one supplier and achieve greater operational efficiencies.
And finally, in situations where lines of credit are secured by accounts receivable, or where a factor – or asset-based lender is involved, the risk of credit losses can limit a company’s access to funds. Lenders offer advance rates based on the expected risk of loss on the receivables pledged as collateral. As a result, many accounts are excluded from the borrowing base, and of those included, a limit is placed on the amount advanced. Removing the lender’s risk of loss due to credit concerns would permit a higher advance rate on eligible receivables, as well as the inclusion of more accounts in the borrowing base. The result is more working capital available to the company.
Insurance to the Rescue
Though most processors may not know it, there’s a financial tool that can transfer the risk of customer defaults on both domestic and export receivables, thus eliminating the threat of a catastrophic credit loss. That tool is accounts receivable insurance, which guarantees payment in the event a customer becomes unable or unwilling to pay. Such insurance is commonly used in Europe and has been available in the United States for more than 100 years. It wraps around a company’s existing credit practice to provide an extra layer of protection in the event of a loss.
Among its advantages, accounts receivable insurance offers tax-deductible premiums and can be custom-tailored to insure a majority of a company’s accounts or specific accounts, segments, or industries within its customer base.
Small accounts, while representing the greatest volatility, have the least impact on the bottom line. Losses are what would be considered routine, and it’s common for companies to build the cost of these losses into their prices. There’s little value in seeking insurance to transfer the risk, as it simply results in dollar trading with the insurance carrier.
A Scrap Case Study:
Accounts receivable insurance can enable companies to extend greater credit terms to their customers, gain a competitive advantage in the marketplace, secure broader access to capital from lenders, and more. Here’s an example of how one scrap processor used accounts receivable insurance to expand its sales opportunities.
Steel Scrap Processor servicing Manufactures and Brokers
Well capitalized, established company, experiencing tremendous growth opportunities within an industry that has witnessed increased demand in addition to several consecutive raw material price increases. This caused average account exposures to double in some cases, increasing the financial risk of a potential catastrophic credit loss.
Annual Sales: $120 million, Average Accounts Receivable: $15 million, Gross Margin: 10%, Account Turns Per Year: 8, Credit Function Handled By Corporate Controller.
Prospect had a few large accounts that offered additional selling opportunities but had reached their “comfort” exposure level. They were interested in a credit risk protection program that would allow them the ability to safely increase sales with reduced risk.
Cover total customer portfolio, offering a better spread of risk to underwriting, allowing increased coverage on tougher risks.
Coverage approved on just one account generated additional gross profit that covered the total cost of the protection program – actually projected to return over 200% of the programs total annual cost!
“Comfort” Exposure: $750,000
Approved Coverage: $1 million
Sales Opportunity: $250,000
By Account Turns: 8
Incremental Annual Revenue: $2 million
By Gross Margin: 10%
Incremental Gross Profit: $200,000
Programs Annual Cost: $75,000
Midsize accounts, on the other hand, present more exposure, and the threat of loss has a potentially greater effect on earnings. In this area, insurance provides a means of sharing in the risk to reduce the effect losses could have on a company’s business. Risk sharing in this account group also enables companies to grant more aggressive credit approvals for customers, which can result in increased sales and better customer service.
With large customers, the effect of an unexpected loss can be devastating. While most large accounts are viewed as “good as gold,” the fact remains that a loss could prove fatal to a company’s business. In this account segment, insurance can be used as a low-cost hedge to effectively transfer the risk off the firm’s books, providing significant protection and, hence, peace of mind. Since most accounts in this segment are indeed highly reliable, the cost to insure them is extremely low, resulting in a cost effective risk transfer strategy.
Accounts receivable insurance policies generally run for 12 months and cover losses that occur during the policy period on goods and services provided during the period. Though the cost of the insurance varies based on several factors, a typical annual premium runs approximately · to 2% of the coverage requested or 1/10 to 3/10 % of covered annual sales.
In sum, accounts receivable insurance can give scrap processors an option to eliminate the threat of a large unexpected customer default, transfer the risk off their balance sheet, and help assure the long-term financial stability of their businesses, regardless of changes in the scrap industry or the economy.