Missed payments, customers defaulting on their loan obligations – they’re every merchant’s nightmare. Among other things, defaults weaken a company’s operational and investment capacity.To mitigate the risk of customer insolvency, many businesses take out credit insurance to protect their cash flow.
Some business owners say it helps them sleep better at night, knowing they have a risk management system in place. But credit insurance plans can be costly, so most businesses only take out plans that apply to their largest customers.
What happens when it’s a small customer that defaults? Accept the loss and hope it doesn't happen again?
That may be the case for large enterprises. But for smaller ones with equally small profit margins, that could be detrimental to the bottom line.
So the million-dollar question remains: Do you need credit insurance?
To help you figure that out, here’s a look at the basics of credit insurance and some possible alternatives in case you decide it’s not for you:
What is credit insurance and how does it work?
When a business applies for credit insurance, an underwriter performs a risk assessment evaluating the creditworthiness of its customers. The underwriter then assigns each customer a grade or rating to determine how much credit limit to grant. Should a customer default, the insured business can claim the equivalent of (or less than) the bad debt amount, depending on the terms of the coverage.
Underwriters consider a number of factors when calculating the credit insurance premium, such as the company’s industry, insurable turnover or amount insured, and past bad debt history.
Credit insurance policies cover domestic or international sales, single or total transactions. Additional charges may apply on top of the premium, like insurance taxes.
- Business continuity. For small businesses that depend on just a few large clients, one missed payment can signal the end of their operations. Credit insurance can keep them afloat.
- Better borrowing terms. Accounts receivables can be used as business loan collateral, but only if the amounts are insured.
- Additional capital. It frees up additional operational capital by reducing bad debt reserves.
- Stronger bonds with customers. It can build stronger relationships with the customer, as additional credit can be extended to them based on periodic evaluation by insurers during the term of the policy.
- Commercial credit insurance isn’t first-dollar coverage, meaning it doesn’t cover the whole amount on the policy. Annual deductibles, as well as per-loss deductibles, typically come with it.
- Policyholders aren’t reimbursed for disputed amounts. Unfortunately for certain businesses, some customers claim the receivable to be in dispute to prolong the collection process, and credit insurers cover the bad debt only when the dispute is resolved.
- According to trade insurance company Euler Hermes, a business generally needs an annual sales amount of at least EUR 1 million to make the program cost-effective.
I don’t want to incur any credit insurance expense, now what?
Consider credit insurance only if you’re comfortable with the payment and terms. If not, there are other available options to mitigate the risk of nonpayment, including:
- Factoring. Factoring is the process of selling receivables to a financial intermediary, where the funding source deducts an amount for commission and fees from the total value of the invoice.
- An effective credit management system. They say prevention is better than a cure. Platforms like Apruve provide an easy way for B2B ecommerce businesses to automate and simplify the way they manage customer credit. From new credit approval to customer onboarding, from end-of-month statements to digitized payment details, Apruve has built-in tools to monitor the overall health of an individual customer account or the entire credit program. Apruve even takes on the risk when offering business buyers revolving corporate credit accounts.
In sales, commercial risk is all part of doing business. Just another day at the office, as most people are inclined to say. If you choose to take the plunge and buy credit insurance, make sure you understand the terms and conditions, the exclusions and limitations, and if a refund can be obtained should you wish to cancel. Otherwise, it may be wise to consider other alternatives.