Trade Credit Insurance: A New and Sustainable Approach To Corporate Credit Management

Credit & Financial Management Review, 2004 by van de Wall, Arjan

Abstract

Credit managers ' faith in the traditional credit control procedures used to protect against extraordinary loss has been shaken. The Kmart bankruptcy demonstrated that no one can predict who will go insolvent, and it caught many creditors by surprise. Since that time, WorldCom, United Airlines, Global Crossing and Parmalat, among many others, have further confirmed how quickly apparent gold can turn to dust. According to statistics released by the Administrative Office of the U.S. Courts, 36,785 businesses filed for bankruptcy in the 12-month period ending March 31, 2004.

The number of bankruptcies is only part of the story. The WorldCom, Enron, Global Crossing, Kmart, Adelphia and NTL, Inc. bankruptcies during 2001 and 2002 were all among the top 10 largest bankruptcies in U.S. history. The Parmalat bankruptcy in 2003 was the largest bankruptcy in European history and cost U.S. firms $2 billion.

In the past, many prospective credit insurance customers often felt confident they could judge for themselves whether customers would pay, but not anymore. Today's uncertain economic climate has many financial officers considering risk management much more seriously. Of more than 400 finance directors from the U.S. and Europe who responded to a CFO Research Services' survey, only five percent report being "very satisfied" that their current risk management approach supports their companies ' business objectives.

More and more, financial officers and managers are increasing their demand for trade credit insurance. During the last several years, spending on trade credit insurance by U.S.-based companies has been growing by approximately 15 percent annually.

The failure of Enron, and other "blue chip" companies, will drive the use of credit insurance even further as risk managers turn to it as part of an integrated program of enterprise risk management.

Market Analysis

A number of business factors are driving concern about credit risk and jeopardizing corporate futures. These include:

* High leverage

* Weak cash flow

* Unstable currency factors

* One time write-offs

* GAAP vs. Pro Forma reporting

* Domestic and foreign competition

* Excess capacity

* Major technology investments

* Merger and acquisition integration challenges

* Bankruptcy laws unique to each country

* Managing accumulation of years of growth

* Creative financing

* Complex investing strategies

Reform in the accounting profession has compelled many non-public companies to take a closer look at their financial and accounting practices. According to a recent Robert Half Management Resources survey of 1,359 CFOs from a random sample of U.S. private companies, 31% of CFOs said they have voluntarily adjusted their accounts receivable and sales processes and 29% have adjusted their credit management and collections processes since the introduction of new regulations, such as the Sarbanes-Oxley Act of 2002.

Consolidation in many industries is also increasing credit risk. Shrinking customer bases create larger concentrations with fewer buyers, which results in greater accounts receivable exposure.

Concerns About Corporate Irregularities

The Credit Research Foundation canvassed a random sampling of credit professionals to determine their views on creditors' concerns about recent corporate reporting irregularities and their attitudes surrounding the difficulties of extending credit in the current business environment. The survey revealed the following:

* 98% of credit managers surveyed believe we have not seen the last of major frauds and financial scandals among U.S. companies.

* 87% are very concerned or more concerned than in the past about accounting irregularities.

* 84% of respondents feel that major accounting firms other than Arthur Anderson will be implicated in future financial scandals.

* 72% of credit managers are somewhat concerned about the reliability of financial information they receive from clients.

* 39% of respondents think these are the most difficult time in which they have practiced credit management.

Surprisingly, only 15% of those sampled reported being "very concerned" about their customers' financial stability in light of recent events. By this measure, it is apparently "the other guy's customers" who present the real concerns - is this a paradox, or myopia?

Credit Insurance Comes Home

According to the National Association of Credit Management, the thought process among credit managers is evolving and they are now looking at the most cost-effective way to manage their entire receivables portfolio rather than primarily collecting dollars.

In the past, credit insurance has been used by many U.S. commercial credit managers mainly to cover exports because credit insurance is often far less expensive than letters of credit. Credit insurance also allows the seller to provide open credit terms to approved customers with more flexibility and less frustration, and extends longer terms due. Today many of those same managers are increasingly seeking protection for domestic business transactions and see credit insurance as a welcome back-up. In addition, fraud can strike any unsuspecting lender, and even banks are frequent victims of fraud. Credit insurance can mitigate many of these risks.