Trade credit insurance protects sellers of goods and services on credit against the risk of customer non-payment due to customer insolvency, protracted default, political events, or acts of war that prevent contract performance.
The market is growing rapidly, especially in the Asia-Pacific region. After reaching a value of US$10.9 billion in 2021, the global trade credit insurance market is expected to see a compound annual growth rate (CAGR) of 9.12% from 2022 to 2027 and reach US$18.1 billion by 2027. Much of the recent surge in demand for trade credit insurance stems from the COVID-19 pandemic, which created global trade uncertainty and raised supply chain and payment default risk concerns for businesses. India, for example, saw a 30% year-over-year increase in demand in the second quarter of 2021 as businesses became more aware about various pandemic-related risks around the globe.
WHAT IS TRADE CREDIT INSURANCE?
Trade credit insurance, or debtor insurance, is a financial risk management tool that protects businesses from non-payment or default risk that supply goods or services on credit. Simply, it covers the risk of the buyer not paying to the seller. In this arrangement, the businesses can insure a portfolio of buyers and an agreed percentage of an invoice or receivables that remain unpaid are paid for covered perils, including commercial and political risk.
Commercial risk coverage includes insolvency of the buyer or protracted default, such as if the buyer is unable to pay within the pre-defined period, calculated from the due date of payment of premium.
Political risk coverage is important for buyers trading internationally, as it protects against risks arising from a moratorium on payment by the government of buyer’s country; cancellation of import licenses; political events; economic difficulties; legislative or administrative measures preventing payment; military or civil war; revolution, riot or insurrection; non-payment by government buyers; and government decisions that prevent performance.
Insurers consider many risk factors to determine premium rates, including size of the trade, past due records, claims history, and the trade sector of the insured. Based on these factors, insurers set a credit limit for each buyer designating what they will pay to the insured business in case of buyer default.
When purchasing the trade credit insurance, buyers should be aware of the exclusions under the policy. These exclusions include any nuclear risk or contamination due to a radioactive substance; disputes with the buyer that may result in withholding of partial or full payments by the buyer; costs involved in resolving these disputes between the insured and the buyer; any penalties that the buyer is expected to pay; any interest amount that gets accrued after the original due payment date; any amount owed by any government entity that cannot be declared insolvent; currency fluctuations; reverse factoring policies; pre-shipment risks; buyers under direct or indirect control; sales contracts made with the private individuals; and banking costs unless agreed to as part of the amount owed by the buyer.
CHANGING MARKET CONDITIONS
As a result of Ukraine-Russia war, the risk of credit defaults has been heightened by the barrage of financial sanctions imposed on Russian companies. These sanctions include exclusion from the SWIFT international payment system, which elevates default risk if companies cannot execute international financial transactions. This has caused many insurers and reinsurers to exit the Russian market to limit their exposure. The financial crisis in Sri Lanka, which caused the nation to default on its debt in May, has also had an impact, prompting the Export Credit Guarantee Corporation of India to change Sri Lanka’s cover category from open to restricted. This will lead to revolving limits that will be approved on a case-by-case basis, but has not yet resulted in increased the premiums.
These instances demonstrate the importance of monitoring country default risk—according to Bloomberg, the countries that are most likely to default on their debt obligations in 2022 are El Salvador, Ghana, Tunisia, Pakistan, Egypt, Kenya, Argentina, Ukraine, Bahrain and Namibia.
In response to changing market conditions and evolving risks, the Insurance Regulatory & Development Authority of India (IRDAI) issued revised guidelines in November 2021, to cover the non-payment risk of SMEs, MSMEs, banks, factoring companies and other financial institutions. As per these guidelines, trade credit insurance must cover the loss from non-receipt of payment from a buyer due to commercial or political risks and trade-related transactions other than loan default of seller. A trade credit insurance policy will not cover reverse factoring; government buyers, except for political risks in export transactions; financial guarantees in any form; any other risk coverage as specified by the IRDAI.
IMPROVING BUSINESS RESILIENCE
Businesses of all sizes can benefit from having trade credit insurance coverage. For small businesses, it is especially important. If even a single buyer defaults, this can have a huge impact on the company’s finances and can hamper their growth and future. Even large businesses that may be in a better position to sustain smaller losses may not be able to absorb the impact in case of multiple buyer defaults, particularly in today’s volatile economic environment. Trade credit insurance can therefore improve the resilience of a business and provide it with the confidence to trade beyond their natural territories and expand internationally.