Reprinted with permission from The Secured Lender – March/April 1998
By Victor Sandy and Craig J. Bonnell
Credit insurance is a financial tool that offers tremendous competitive advantages for asset based lenders who understand how to use it. If you haven’t heard of it before, or if you think you may have heard all there is to hear about it, following are a few new approaches you may not have considered.
In a competitive environment, or in situations where you are simply searching for ways to meet your client’s increasing capital requirements, we have found credit insurance consistently provides the optimum solution to safely putting more capital in the client’s hands. Maximizing capital availability will win you the deal every time. The real trick is doing this without compromising your internal credit underwriting guidelines. In all of the competitive situations we have encountered, the lender who used credit insurance to increase availability ultimately offered the client a more attractive program and won the deal.
As a firm that specializes in all forms of domestic and export credit insurance and political risk insurance, we help lenders use these programs to solve several very specific risk issues when structuring receivables based borrowing arrangements for their clients. In addition to the obvious basic credit risk mitigation benefits the policy offers, credit insurance also provides an added layer of expert due diligence and ongoing monitoring of covered accounts to further strengthen the client’s credit practice and protect the lender’s interests. Many of the carriers also provide collections and bankruptcy litigation support at rates lower than the typical cost.
Even if you are comfortable with the risk profile of a client’s customer base, there are still a few deal breaking issues that can impact a transaction. Here’s how you can use credit insurance to resolve them:
In many industries, like automotive or project oriented business sectors, it is not uncommon for a fair percentage of total accounts to fall beyond the standard 60 or 90 day eligible window. This may result in a reduction of available working capital of 20% to 40% or more. Receivables that extend beyond the window are not included in the borrowing base, and the client loses access to the capital tied up in these accounts.
Credit insurance can be structured to protect accounts from protracted default (past due) problems up to 180 days from invoice date. This protection allows lenders to keep accounts in the borrowing base for a much longer period of time, with obvious benefit to the client. Should the covered accounts ultimately default, the carrier will reimburse the loss according to the terms of the policy.
Purchase Order Protection
Most lenders have difficulty providing advances against purchase orders. While credit insurance does not address any performance issues you may have with your client, assuming you are confident in their ability to do their work and deliver, credit insurance can provide protection to advance against the initial contract. We have met several companies operating well below capacity, and turning away orders because they lacked the capital to fund the jobs upfront.
Credit insurance can be structured to protect the client and lender against default by a customer on a custom prepared product or service even before the work is complete and the customer invoiced. This purchase order protection is an ideal way to hedge the risk of taking a loss on an account that has not yet been converted into a receivable. It also provides your client with capital right when they need it most- when they get a new contract.
Advance Rate Increases
Because of the potential for bad debt losses possible in any given account portfolio, advance rates are limited. We regularly use credit insurance to protect lenders who wish to increase their advance rates. As an example, a policy with a simple 10% coinsurance, where the carrier agrees to pay .90 on the dollar for all eligible losses, enables the lender to increase the advance rate to 90% and still be covered for their full exposure. The client retains 10% of the risk, and the carrier absorbs the remaining 90%. Considering that the typical advance rates in a good deal average just 80%, the extra available capital from even a 10% advance rate increase can be substantial. Credit insurance can allow advance rate increases that make a marginal deal good and a good deal great, in the client’s eyes.
Cost of Funds
The natural reaction when considering credit insurance is that it will add another cost burden to a deal where price is always a key issue. What we have found is that for a cost averaging just 10 to 30 basis points on covered annual sales, the premium for credit insurance does not add measurably to the cost of the transaction. Further, the rates required for the lender to properly price for the risk is greater than the policy premium and lower cost of funds possible with the coverage. In several instances, we have structured policies for lenders competing against non credit insured offers. The program utilizing credit insurance provided greater eligibles and advance rates resulting in more capital, and the lender’s cost of funds did not have to include a premium for the credit risk, so the total cost, even with the policy, was lower. This makes for an easy decision on the client’s part.
A slight basis point reduction in the cost of funds will more than offset the policy premium, and as the receivables turn and the portfolio is leveraged multiple times during the year, the cost of credit insurance is spread extremely thin. The client’s return on the additional funds employed, provides a substantial return on the premium investment.
With the right policy structure behind your deal, you can bring tremendous value to your clients, while increasing your loan portfolio and reducing your exposure to potential losses.
Solve Your Automotive Supplier’s Request For Additional Working Capital
Case Study #1
Automotive Supplier – Selling The “Big Three” and Tier I & II Suppliers
Middle market company selling into a changing industry. While the company was experiencing tremendous growth prospects, more and more of the actual “production” costs were being transferred to their balance sheet. Buyers were taking up to 180 days to pay on invoices causing a great deal of accounts receivable to extend beyond the eligible time window of 90 days. This resulted in a major strain to working capital – supplier was not able to employ the funds. The company was concerned that they would not be able to fund future growth opportunities.
Projected Annual Sales: $20 million, Average Receivable Balance: $4.4 million, Turns Per Year: 4.5, Gross Profit Margin: 31.0%, Bank Cost of Funds: Prime + 1%.
Implement a credit insurance program that eliminates the lenders risk on the pledged accounts receivable, and also on “work-in-progress” – before an invoice is created.
With reduced risk, the lender agreed to “open” the eligibility window on aged receivables – increasing the eligibility time window from 90 days to 180 days. Also, the lender allowed to increase the advance rate on inventory (“wip”) because the “purchase order” was insured. The credit insurance program was projected to “free up” approximately $700,000 of additional working capital immediately, as follows:
|Before Credit Insurance||After Credit Insurance|
|Average A/R Balance||$4.4 million||$4.4 million|
|A/R over 90 days||$900,000||$900,000|
|Eligible A/R||$3.5 million||$4.4 million|
|Funds Available – Eligible||$2.8 million||$3.52 million|
|Additional Funds Available||N/A||$720,000|
Profit / Payout
Cost of Credit Insurance Program: $40,000
(+) Additional Interest Cost: $60,000 (toward your goals)
(=) Total Added Costs: $100,000
(/) Gross Profit Margin: 31%
(=) Incremental Woking Capital: $322,580 – break-even point Required Over Year
Additional Working Capital Provided: $720,000
(=) Additional Capital to Employ in Operations: $3,240,000
(x) Gross Profit Margin: 31%
(=) Incremental Profit Opportunity: $1,004,400
(/) Total Added Cost with Credit Insurance: $100,000
(=) Return on Investment / Credit Insurance: 1,000%
Solve Your Client’s Need for Working Capital to Fund Work In Process
Case Study #2
Assembly line equipment manufacturer selling primarily to OEMs and top tier suppliers in the transportation industry.
The company sells assembly line metal processing equipment globally, facing an estimated 20-40 direct competitors depending on the country they sell into. The equipment they manufacture is custom designed for each assembly line location, and takes approximately three to six months to build and deliver once an order is approved. All export transactions are done on letter of credit terms. The company operates below capacity, but is forced to turn down orders due to a lack of working capital to fill the orders. A large automotive supplier requested shipment of a custom built machine into Mexico, and demanded open credit terms. The company contemplated turning down the opportunity in spite of their long standing relationship with the customer.
Years in business: 75, Current senior management experience: 25 years, Operating capacity: 75% est. Average transaction size: $100,000 to $400,000 large projects can reach $2 million Order turnaround time: 3-9 months Current order under consideration: $500,000
Structure a credit insurance “contract cover” policy that would provide a firm guarantee of payment on the contract, should any commercial or political risk loss occur at any point after the order is accepted. The policy would be designed to cover the costs incurred up to the point when the loss event occurs. The policy would name the client’s lender as beneficiary, which would permit the loan officer to initiate a claims filing, and the bank to be a party to loss payments from the carrier.
A contract cover policy was issued that permitted the client to take advantage of the sales opportunity, better utilize their available capacity and maintain a long standing client relationship, without putting their working capital and earnings at risk. The policy protected the client and their lender against commercial and political risks, and assured recovery of losses incurred up to the time of the loss event. This program permitted the lender to structure an advance on the insured purchase order that allowed the project to be funded without disrupting existing orders, or affecting existing working capital.
Order amount: $500,000
Gross margin: 30%
Advance rate: 70% (provided only with credit insurance coverage in place)
Insurance premium: $10,000
Incremental working capital: $350,000 (additional borrowings credited to loan officer’s goals)
Incremental profit to client: $140,000 (before cost of funds)
Review a Related Case Scenario: Borrowing Enhancement