Suhail Karim Beg, Business Development Specialist, Small Business Group
If it’s possible to substantially mitigate the risk of nonpayment associated with open account trades using export credit insurance, why aren’t more US businesses doing so? The five most common reasons cited are: low risk of our largest export markets, financial institution familiarity with and perception of trade finance, availability, high costs and misconceptions about coverage. This blog will attempt to address each in turn.
Trade Credit Insurance – You Don’t Need it…Until You Do!
Buyer nonpayment is both a financial and operational threat and is the single biggest cause of business failures in the US. Accounts receivable can represent 40 percent of a small business’s assets; every dollar in accounts receivables is a dollar less in cash. Booming sales can place strains on your working capital to the point you are unable to meet operational expenses. It sometimes takes only one unexpected default to drive a small business exporter out of business. One thing is for sure, getting assurance of payment will require a secure payment mechanism in place prior to shipment.
Today, up to 80 percent of global trade is supported by some sort of trade finance or credit insurance covering transactions on open account terms. About half of European exporters routinely use trade credit insurance to cover transactions but only 10 percent of US exporters do. US small business exporters have traditionally opted for cash-in-advance or costly letters of credit when selling to buyers in high or intermediate risk markets or on larger contract sales. Foreign buyers often demand favorable open account terms and the long term trend in global trade is toward sale on open account. Additionally, the World Trade Organization reports that foreign companies offered open account terms will buy on average 40 percent more!
The Challenge – Under-appreciation of Risk
What often differentiates success from failure in international markets is the courage to make an honest assessment of risk factors, analyze the costs of mitigation and then implement active risk management strategies. Trade credit insurance is more than just insurance; it’s a front-end risk management and credit enhancement tool in addition to a being a sales tool. It could also be more cost effective than bad debt provisioning or letters of credit if multiple buyers default.
The reason for underutilization of export credit insurance often tendered is that US exporters shipping primarily to Canada, Mexico and Europe view the up-front costs of credit insurance are greater than risk of nonpayment. Yet, today’s markets are more vulnerable to global financial shocks than ever, economies are fragile and political risks are on the rise. A lot can happen while your shipment is on route to the buyer: logistical delays, currency devaluations and political events—all could interrupt payment.
5 Reasons to Re-Consider Trade Credit Insurance
Here are five reasons cited for underutilization, primarily drawn from observations offered by a private sector broker dealer, Arthur J. Gallagher & Co and some counter-arguments on why you should consider taking up credit insurance.
- US Export Markets: Political and commercial risks with counterparties across multiple borders is not a particular concern for the US small to medium-sized exporter shipping primarily to Canada, Mexico or Europe.
The growth in world trade necessitates US businesses follow the markets if they want to maintain market share. The level of global trade will nearly quadruple from 19.3 trillion US dollars of goods traded annually in 2015 to a projected 68.5 trillion US dollars by 2050. This trade will be dominated primarily by emerging markets in the Far East and in Africa, not to the North and South of our borders. These countries present different logistical and country risk profiles requiring new approaches to risk mitigation. Additionally, US exporters should not be too sanguine about financial risks with our largest markets as commodity driven volatility is widespread.
- US Financial Institutions: US firms and financial institutions are not as familiar with trade credit finance instruments as their international competitors and domestic finance is characterized by an open business culture within a single border and adequate bankruptcy laws. Furthermore, trade credit insurance is a low margin business.
This may have held true prior to the revocation of Glass Steagall, separating US commercial and investment banking, when US financial institutions did not have as much experience cross-selling. Yet, the past twenty years has seen growth in trade finance as US exports have grown. Capacity in the market has also increased with new entrants and consolidation in the global trade finance industry by major European players to deriving domestic competition. More and more banks are viewing credit insurance not only as a means to increase capital adequacy requirements and improve lending terms but also secure long term relationships with new customers.
- Availability of Trade Finance: Small and medium-sized businesses account for about 53 percent of all rejected trade finance transactions, making this group most likely to be impacted by lending/working capital access, according to the most recent ICC Global Survey on Trade Finance.
Regulations, such as Know Your Customer (KYC) and Anti-Money Laundering (AML), are cited as the primary reason for declined transactions. On top of added costs of compliance, unfamiliarity with some at-risk markets have led banks to pull country coverage altogether. Lack of coverage may also be due to small transaction size or unfamiliarity with a particular buyer. If you are a small business exporter and unable to obtain trade finance, the Export-Import Bank of the United States, the official US export credit agency, can help. We empower US small businesses by absorbing “non-marketable risks” or those risks that the private sector is unable or unwilling to cover. No transaction is too small.
- High Cost: A variety of factors go into determining the cost of a policy, but the high-up front cost of the premium is often cited, trimming profit margins on sales to buyers that have never defaulted. Besides the premium, there are other costs such as underwriting fees, credit reports on buyers and time expenditure of gathering references and financial information.
The 2015 ICC Survey reported a widespread expectation for increases in trade finance fees, partly based on compliance costs but also associated with institution’s capacity and appetite for that risk. In fact, fierce competition in global trade finance in 2016 is driving down premiums as greater liquidity balances against lower volumes due to higher risks in Russia, Brazil, China and a drop in oil producing countries imports. Additionally, export credit insurance can pay for itself if you consider the lower interest expenses for improved collateral, reduced costs for credit monitoring and collections, not to mention the potential boost to international sales with improved terms.
- Misinterpretation of Coverage: There is a history of misconceptions, both on the part of financial institutions and policy holders, about what risks are being assumed and what coverage may afford. The difference is often in understanding what risks fall outside coverage especially in cases of political risks which are different from non-payment.
Trade credit insurance is just that: insurance, not a guarantee. A claims process can be significantly delayed if complicated by buyer “disputes” which are not “nonpayment” per se; neither are fraud or improper documentation. On the political risk side, the Argentine crisis in the 1990’s and early 2000’s left many insureds without a claim as devaluation risk is not covered.
Are You Being Served – The Export-Import Bank of the United States (EXIM Bank)
Risk mitigation is vital for the small business exporter as the financial impact of default can have much greater impact if a loss is suffered. If you need solid credit expertise, transactional experience and the surety of balance sheet strength and are being priced out or are unable to obtain short-term export credit insurance—EXIM Bank can help.
EXIM Bank’s Express Multi-Buyer insurance policy is designed for US small businesses that have an average of less than $7,500,000 in export credit sales over the last three years, and have at least a three year operating history. There is no policy issuance fee, and no first-loss deductible. Coverage is for 95 percent of the invoice with terms up to 180 days. There are no policy start-up costs; you only pay a premium when you ship.
To find out how your firm can insure your risk of non-payment with EXIM Bank, contact Marianne Hughes, EXIM Bank West Region (Marianne.Hughes@exim.gov) Tel: 949-660-0603.
Marianne Hughes is a Regional Director with Ex-Im Bank’s Western Regional Office for the State of Arizona. She has experience in international trade and marketing, trade finance, international credit procedures, and export credit insurance.