The use of insurance as a risk management tool is common place. Some of the insurances may be required by law and others optional but can form part of a company’s risk management strategy and balance sheet protection. We have seen a significant increase in the amount of interest in trade credit insurance as a means to de-risk counterparty risk particularly in the trading of commodities; selling of product/produce; and, investment/financing facilities. The effect of de-risking transactions and investments can also lower the cost of monetary lending for example, thereby securing much needed investment for projects.
Trade credit insurance – what is it?
The right trade credit insurance policy has the ability of reducing a company’s global trading risk and exposures. It is a product which provides protection to a company or bank (the policyholder) in respect of certain events which affect the ability of customers/counterparties to pay invoices or meet their financial commitments.
Commonly trade credit policies provide cover for:
- The protracted default of a customer/counterparty: this occurs on the non-payment of all or part of an undisputed invoice. The trigger for payment will usually occur on the expiry of what is called “the waiting period”. This is a period of time agreed with the insurer after which the non payment triggers policy cover. The waiting period is often around 90 days from the date the invoice falls due for payment.
- The insolvency of a customer/counterparty: often insurance policies specify the scenarios that constitute “insolvency” under the policy and which will trigger cover.
- A political risk event: this is an event that prevents payment or meeting of a financial commitment by a customer/counterparty. Trade credit policies will usually define the scenarios that come within the meaning of the political risk cover provided. Scenarios can include general moratoriums decreed by a government in the customer’s counterparty’s country, economic difficulties in the customer’s/counterparty’s country, currency shortages, administrative measures or new legislation in the customer’s/counterparty’s country which prevents payment.
As with all insurance policies, if the right terms are obtained and the right procedures are followed by the policyholder the risk transfer can work well. However, we have been involved on a significant number of trade credit insurance disputes in relation to both national and international losses and we set out below a number of the issues that have arisen and a few thoughts on prevention procedures to minimise the risk of insurance disputes.
It is usual in trade credit policies for there to be conditions which the policyholder needs to comply with to ensure that the sale or transaction comes within the terms of the policies. These are conditions which, if not complied with, will provide an insurer with the opportunity to refuse to indemnify a loss or at least to negotiate down the amount of indemnity that should be paid to a policyholder. Pre-qualifying requirements can include the following:
- Credit limits: it is usual in trade credit insurance policies for the insurer to set credit limits for particular customers/counterparties. This effectively limits the insurance provided for transactions with a particular customer/counterparty and therefore if that credit limit is exceeded, the insurer will only provide cover up to the amount of the credit limit. Policyholders need to be aware that insurers can often withdraw or vary credit limits, usually only with prior consultation with the policyholder. However, such notice periods can be short and can catch policyholders out. As a result policyholders need to regularly review the credit limits and compare them against the amount of business being undertaken with a particular customer/counterparty to ensure there is no risk of uninsured exposures.
- Retention of title clauses: invariably there will be a requirement for the policyholder to include retention of title clauses in their contracts with their customers/counterparties. On a commercial level this can cause difficulties where a customer/counterparty is in a country in which it may be difficult to enforce such clauses. Policyholders may want to consider negotiating with insurers that this requirement is taken out of the policy completely or only for certain customers/counterparties, although such agreement may require the payment of an increased premium to reflect the heightened risk to insurers.
- Invoicing: it is not unusual for policies to require a set time by which invoices need to be rendered to customers/counterparties.
- Geographical limitations to the cover: for global businesses or businesses trading internationally there are usually limitations and exclusions in relation to providing services or the selling of goods to customers/counterparties in certain territories.
These are only a few examples of the kinds of pre-qualifying requirements in trade credit policies to illustrate the importance of ensuring that a policyholder’s practices comply globally with such requirements in order to ensure maximum cover under the policy. The requirements may vary slightly depending upon the policyholder’s business and the nature of the transaction being covered but ideally risk managers and treasury departments should be aware of all the obligations.
Trade credit policies contain onerous reporting obligations. For example, in protracted default situations there is often the requirement to notify insurers that payments are overdue by a certain time-often 90 days and invariably before “the waiting period” expires. Whilst this may not at first appear to be a difficult process to manage, when managing the payment of invoices on a global scale across various global business units, obtaining the information in order to comply with tight notifications and reporting obligations can cause difficulties. In this respect all the business units nationally and throughout the world, if applicable, need to be complying with the policy requirements and this will often require a uniform business/systems protocol to ensure that the relevant department making the notifications and reporting to insurers has all the information available to them in good time in order to ensure that no reporting conditions of the insurance policy are breached.
Obligation to prevent the minimised loss
Invariably there will be obligations upon the policyholder to prevent and/or minimise losses. The requirement to do so is for the policyholder to take “all reasonable steps” and what may constitute“reasonable” often depends upon the country in which those steps are being taken and the availability of legal remedies against the customer. In recent years we have seen a number of disputes between insurers and policy holders regarding what is “reasonable”. There is case law in the English law jurisdiction (Euler Hermes Plc v. Apple Computer BV1) which supports the argument that a policyholder can take into account their commercial interests when deciding if a certain step is “reasonable” to prevent/minimise loss.
In addition, the policy often does provide that the insurers can contribute to the policyholder’s costs in taking reasonable preventative or mitigating action. However, often such a contribution is dependent upon insurers providing their consent to the loss prevention/minimisation actions in the first place and even then is usually at the discretion of the insurer.
Care should be taken when deciding what steps to take, for example, the strategy of reissuing invoices or agreements agreeing a lesser amounts and then attempting a claim under the policy for the remaining amount. This strategy can provide insurers with the argument that the reissuing of an invoice or amending of an agreement is an acceptance by the policyholder of a price/payment reduction and there is no debt or sum due because the customer/counterparty has paid the amount stated on the reissued invoice or agreement, therefore there is no loss.
Policyholders should also stay away from accepting reduced amounts in full and final settlement of a due amount. Again, this is because a policy will often require that a policyholder preserves all subrogation rights against third parties and by agreeing to a full and final settlement a policyholder is not preserving rights against those third parties. If the intention is to agree to a full and final settlement with a customer/counterparty, this should be agreed with insurers first.
Other coverage issues
Other issues which may arise and which policyholders need to be aware of include:
- Disputed receivables: insurers will often not pay out where there is a dispute over the invoice or the services provided. The insurers will only indemnify the policyholder once the dispute is resolved.
- Collation and provision of documents to support claim: there are often deadlines within the policy by which the policyholder is required to provide documents to support their claim if requested to do so by the insurer. Policyholders need to ensure that their internal procedures are consistent nationally and, if applicable, globally to ensure that all their business units retain and correctly file relevant documentation so that it can be easily sent to the relevant department liaising with insurers.
- Insured loss: the policy will usually set out how the insured loss is calculated. This is normally by reference to a particular date by which the loss will crystallise. The date at which the losses crystallise can have marked effects on the insured loss under the policy and clauses in the policy may vary as to how recoveries are dealt with that post date the crystallisation of the loss.
What has been evident from the disputes we have been involved with in the last few years is that there is often a disconnect between how the policyholder and the insurer considers the policy to operate. It is essential that the policyholder understands all the clauses in the policy to ensure they know what cover they are buying, what their obligations under the policy are, and to ensure that their business units nationally and around the world are operating the same protocol and procedure to ensure that the conditions in the insurance policy can be complied with.