What it means
At its simplest, credit default insurance transfers the risk of non-payment from the business that extended credit to an insurer. If the customer or borrower goes bust or simply refuses to pay, the insurer compensates the policyholder for an agreed share of the loss.
Businesses use it because a single large unpaid invoice can wipe out a year of profit. A company selling goods on 60-day terms is effectively lending money to every customer, and credit default insurance puts a ceiling on how badly that lending can go wrong.
Lenders and banks also like it because insured receivables are easier to borrow against. Policies usually cover a percentage of each insured debt, often somewhere between 80% and 95%, rather than the whole amount.
The insurer also sets a credit limit for each named customer, and sales above that limit are not covered. Insurers monitor the financial health of the customers they cover, so the policy can double as an early warning system when a buyer starts to look shaky.
In capital markets the same idea appears as a credit default swap, where an investor pays a periodic fee to another party who promises to cover losses if a bond issuer defaults. Although it works like insurance, a swap can be bought by someone who does not own the underlying debt, which is why regulators treat it differently from a standard insurance policy.
Cost depends on the riskiness of the customers, the industries involved and the total sales covered. Premiums are commonly quoted as a small percentage of insured sales, and a business should weigh that cost against the bad debts it has historically suffered.
In practice
Real-world examples.
Example
A furniture manufacturer sells to department stores on 90-day terms and insures its receivables. When one retail chain enters administration owing $350,000, the insurer pays 90% of the claim and the manufacturer avoids a cash crisis.
Example
A software reseller wants to expand into a new region where it knows little about local customers. It buys a policy so the insurer vets each new buyer and sets a credit limit, which lets the reseller grow sales without guessing who will pay.
Example
A pension fund holds $5,000,000 of bonds issued by a mid-sized airline and worries about the sector. It buys a credit default swap on the airline's debt, paying a quarterly fee in exchange for compensation if the airline defaults.
Formula
Calculation
Premium = Insured sales x Premium rate
Claim payout = Unpaid debt x Coverage percentage
Worked example: a wholesaler insures $2,000,000 of annual sales at a premium rate of 0.4%, with cover of 90% on each debt.
Premium = $2,000,000 x 0.4% = $8,000 per year.
A customer then collapses owing $200,000, which is within its approved credit limit.
Claim payout = $200,000 x 90% = $180,000.
The wholesaler absorbs the remaining $20,000 ($200,000 - $180,000). Its net position on this event is a $180,000 recovery against $8,000 of premium paid that year, so the policy has clearly earned its keep.Case study
Seen in the real world.
Harbourline Foods is a fictional supplier of frozen produce to supermarkets, and this story is purely illustrative. About 40% of its sales went to three large retail customers, and the finance director worried that one failure could sink the business.
The company bought a trade credit policy with 90% cover and agreed credit limits for each buyer. Eighteen months later one of the three customers collapsed with $420,000 outstanding. Because the debt was within its limit, the insurer paid $378,000, and Harbourline carried on trading with only a modest dent in its profit.
The finance director later pointed out that the real benefit was earlier than the claim. When the insurer reduced the customer's limit a few months before the collapse, Harbourline tightened its own terms and shipped less on credit, which reduced the eventual loss.
Watch out
Common mistakes.
- Assuming the policy covers 100% of every unpaid invoice, when most policies pay a stated percentage and exclude sales above the approved credit limit.
- Ignoring the policy conditions, such as reporting overdue accounts promptly, which can lead an insurer to reject a claim.
- Treating credit default insurance and a credit default swap as identical, when swaps can be bought without owning the debt and are regulated differently.
Questions
People also ask.
Is credit default insurance the same as bad debt provision?
No. A provision is an accounting estimate of losses you expect to bear yourself, while insurance moves part of the loss to a third party.
Who typically buys it?
Exporters, wholesalers, manufacturers and lenders that extend credit to many customers, as well as investors who want protection on bonds they hold.
Can the premium be reduced?
Often yes, by insuring only the riskiest customers, accepting a higher excess (the amount you absorb before cover applies) or showing a strong collections record.
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