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.


Al said...

I assume that your blog pertains to Trade Credit Insurance because "Credit Insurance" is a term used to describe both Trade Credit Insurance and Credit Life Insurance. Credit Life Insurance is usually purchased by individual consumers.
If you'll research the topic of Credit Insurance further, you might stumble upon the controversy surrounding the sale of this type of insurance. In my personal experience, it is always cheaper for an individual to choose not to purchase Credit Insurance and instad choose the more "conventional" substitutes like term life insurance or disability insurance policy to cover the credit balance. To me, it all boils down to credit insurance being a guaranteed issue, no matter if a person would otherwise be insurable or not. So the rates on offer must reflect tis, and be worse than if a healthy or otherwise insurable person where to purchase coverage on their own. Does this remind you of US presidential candidate Hillary Clinton's "Improved Healthcare Package" proposals?

Vanessa said...

I'm quite familiar with the "Hillary Care" healthcare package and in my opinion it "will" only work if all - I mean all - Americans have "Lawyer IQ Levels" - i.e. 119 or higher. Is Hillary Clinton trying to cover up John Kerry's unsavory attemt at humor some time ago about Kerry's comments on the IQs of US Troops stationed in Iraq? In short under "Hillary Care", the jobs of healthcare consultants just got more secure. I just hope that "Uncle Sam" would become more enlightened and less selfish when the next US president steps in. Now back to Credit Insurance.
In practice, "conventional" term life insurance or disability insurance policies do work really well to cover an individual person's credit balance. But is this due to these "conventional" forms of insurance's incumbent "market dominance"? The prospect of Credit Insurance / Credit Life Insurance policy holders avoidance of having to pay almost any premium at all through "clever usage" seems too tempting to ignore. And this might be a very nice topic to blog about in the future.
During my research, I've also found out that there's an even more controversial practice called single premium credit insurance. Single Premium Credit Insurance is usually associated with the sub prime lending industry where the premium or costs are charged only once at the start of the loan. For example, charging US$10,000 at the time of mortgages refinance, which is totally financed or added to the total loan amount as part of the loan.
The practice of single premium credit insurance is frowned by so called "financial experts" (financial planners?) because doing this is only cheaper if one is sure that one is going to refinancing (borrow more money to pay previous / preexisting debts) once again. Woudn't one loose the benefits of the credit insurance by going through this route? To me, yes.

Mischa said...

Have you also heard of Credit Default Swap (CDS)? This "financial product" has recently become the latest scapegoat du jour as the main cause of the US credit crisis. Credit Default Swaps purportedly created the "domino effect" when US banks bought them in an attempt to hedge their risks. Sadly, the "domino effect" eventually resulted into our current global credit crunch due to US subprime mortgage exposure. Sadder still, there are no preexisting laws and legal precedents prohibiting the sale / trade of Credit Default Swaps.

Lilith Fair said...

The political debacle in the US Congress on the proposed 700 billion dollar bailout scheme will probably kill capitalism as we know it. Say goodbye to the credit market and hello to barter trade. Was Karl Marx right all along, or just eight years off? I wonder what Mr. Marx's credit rating score is?

Letiche said...

The US Congress' "reluctant" approval of the 700 billion US dollar financial bailout bill had me wondering if the American Taxpayers are the insurers of last resort. Should "We, the people..." be changed to "We, the insurance underwriters with marginal incomes..."? Will it be the end of our modern credit-based economy? How can I barter my neutron bomb making skills?

Pantaleon said...

In our modern Credit-based economy, banks that won't lend money / approve loans, consumers who won't buy and mortgages on the brink is a sure-fire recipe for a financial disaster. I too am doubtful whether the Bush Administration's 700 billion US dollar plan can really both save Wall Street and "Main Street". Never mind the two of America's largest equity loan providers Fannie Mae and Freddie Mac. It could even inadvertently transform America's free market economy into a government controlled Socialist Command Economy similar to that of 1980's Saddam Hussein controlled Iraq.

Jon said...

Credit insurance - like it's more arcane cousins credit derivatives - might be the root cause of our global economic downturn since they are operating with minimal oversight for 30 years or so.