Published in Economic Times on 7 July, 2015, Written by Kapil Mehta
Insurance is generally meant to cover accidents and risks outside the control of the insured. Generally, contractual obligations are not insurable. For example if an SMEassumes a liability – limited or unlimited – in a contract then this will not be insured. Penalties that are specified in contracts or penal interest rates are not insured. There are, however, a few exceptions notably credit defaults by customers.
What is Credit Insurance?
In credit insurance the insurer will pay you the outstanding receivable if your customer does not pay within a certain period, typically 180 days. The insurer then takes on the responsibility of recovering as much as possible from the defaulting client. Historically, this kind of an insurance was bought by exporters from ECGC to protect them from default by international buyers. Increasingly, other insurers have entered the segment and now cover defaults by domestic customers as well.
The default could take place for any reason – the buyer could be bankrupt, he may be unhappy with services or may just have a long approval time.
How does credit insurance work?
Say a company has 100 customers and it does regular transactions with them. Out of these 100, a merchant feels that 25 are most important customers for him as they do higher number of transactions. The company can then select the customers for which they want to be covered based on non-payments in past, late payments, higher amount of transactions. The Insurer will inquire about those customers and decide whether they can be covered or not. A credit limit is approved for each buyer based on a thorough financial background check. Any outstanding amount up to this limit is covered by the insurer. A pre-approved credit limit can be decided in case of several small buyers. The insurer will pay for those companies if they default on payments.
What are the benefits of the scheme to the firm?
A few defaults can wipe out an SME’s profits. Credit insurance protects companies from bad debts and losses. It helps bring certainty in cash flows. The premium is an expense for the firm and hence tax deductible.
What can be covered under Credit Insurance?
Credit insurance can cover international or domestic buyers; private or public sector companies. However, it does not cover default by government departments or the government itself. So, for example, delays in payment by a state electricity board will not be covered.
How can SMEs buy this scheme?
The premium rate of credit insurance policy is based on the insurable turnover, type of business, number of customers, credit limit, risks covered. The rate can vary significantly by customer but is generally between Rupees 3 and 6 per Rupees 1000 of sum assured.
For companies extending loans to consumers there is another different kind of credit insurance that can be bought. This is meant to cover the default risk if the customer dies. It is called credit shield and is a term insurance policy structured in a way that the sum assured mirrors the outstanding amount at any time.
The underwriting process for credit insurance is time consuming and detailed. It takes three to four weeks to place an insurance. However, this is an effort worth making.