Friday, February 8, 2008

Credit Insurance: A White Knight against Recession?

As Bond Insurers loose their “triple A” credit ratings thanks to the US economic turbulence towards the end of 2007. Can Credit Insurance providers still be counted on as recession looms?

By: Vanessa Uy

In today’s world, credit has become a vital part of our modern economy. If large credit losses occur, profits may be totally lost. Manufacturing and wholesaling firms always have that looming threat that someone to whom they extend credit may become insolvent and will be unable to meet their obligations.

Ordinarily, it is possible to estimate probable losses caused by extending credit and to add this cost to the price of the goods. It is also possible to be very cautious about extending credit. However, one large loss may upset all plans and methods for meeting the losses, and if too restricted credit practice is followed sales and thus profits will be cut even greater than credit losses. Credit insurance was developed, therefore, to protect business against undue credit losses. This insurance does not cover credit transactions between retailers and customers. Credit insurance policies do not place any serious restrictions or limitations on the cause of the debtor’s insolvency and thus contain broad coverage after the title of the goods has passed to the various debtors.

The principal kinds of credit insurance policies are general coverage policies. With the general coverage policy, all customers are included subject to the limitation of the policy. The financial standing of the customers and their credit ratings determines whether he or she is to be covered and for what limit.

The Dun & Bradstreet, Inc., mercantile agency manual is generally relied upon for information concerning customers, although there are other approved agencies. The insurance companies require that the customers have a capital and credit rating in a recognized mercantile agency because of the nature of the fluctuating hazard of credit.

The mercantile agency books show the approximate amount of net worth and the promptness of meeting obligations of the various concerns. The better firms receive high or good credit ratings and are regarded as preferred ratings. Usually the much coveted “triple A” rating badge. Other, less secure enterprises are rated as fair and limited and are considered inferior ratings. Often credit – insurance policies do not cover concerns rated as limited as these firms represent great hazards. Under such circumstances credit afforded to customers in this class is extended at the insured own risk. The liability of the insurance company on any one loss is limited in relation to the credit and financial standing of the customer.

Credit insurance does not cover loss of profits involved in a failure of the customer to pay for the goods. An amount, representing the estimated profits, generally 10 per cent, is deducted from the total of the uncollected accounts for which indemnity is provided. This deduction of a stated percentage from provable losses is known as coinsurance. By payment of an additional premium the coinsurance clause will be eliminated.

Since all concerns normally expect to suffer some credit losses every year, an amount known as the normal loss, is deducted. This is done way before any of the losses be paid by the company. Generally the amount is based upon the total sales of the insured and the ratings on which coverage is required.

So in today’s financial climate that’s fast heading into uncertainty, do credit insurers help manufacturers and wholesalers from going under? Well, if one looks our global financial system from the perspective of “enlightened self interest” the answer is a big fat yes. This is so because manufacturers and wholesalers are the main customers of credit insurance providers. And credit insurance providers are not stupid enough to sacrifice their own “cash cows” just to protect their own interests. But when bad goes to worse especially if your specific credit insurance provider can’t reimburse you because it went bust. Then, this is surely a sign that a full blown economic recession is in progress. Just hope that a full blown economic depression doesn’t come next.