What is credit insurance?

Business owners are often bombarded with different types of insurance without having the basics explained. Atradius' Mark Hoppe outlines exactly what credit insurance is and why it can be useful for SMEs.

Australian businesses are under enough pressure from outside forces. Having to deal with non-payment of invoices is something these businesses just don’t need.

Many businesses may never recover from unpaid debts, but business owners can easily and affordably protect themselves against these risks.

Credit insurance is a first line of defence against customer insolvency and payment default risks. Businesses with a policy are guaranteed payment, regardless of why the customer cannot pay.

Many businesses mistakenly think of credit insurance as a large expense, and so choose not to take out cover. This can leave them exposed to unnecessary risk.

However, policies can be tailored to the business’ needs and only make up a small percentage of overall costs. The expense is reasonable when you consider that taking out cover can save the business from insolvency.

A sign that says CREDITBusinesses in all industries can benefit from credit insurance protection. Between January and May this year, the construction industry was the hardest hit by insolvencies, with 625 insolvencies recorded in Australia.

However, start-ups and small businesses are also feeling the pinch. SMEs with assets under $100,000 make up 85 per cent of collapses in this category.

Businesses that benefit from external market influences like foreign exchange rate fluctuation or changes in public policy can just as easily suffer from them.

Unnecessary trading risks can emerge without warning for businesses that have not invested in credit insurance.

Currency volatility and political events are just two of the many factors that can result in businesses down the supply chain failing to pay bills on time, leaving upstream organisations with cash flow troubles.

Cash flow will also suffer if a customer’s business fails, if market performance is sluggish or if economic cycles behave unpredictably.

When businesses trade on credit terms, substantial amounts of working capital are tied up in accounts receivable, which can also lead to cash flow risks if customers don’t pay their invoices on time. As soon as a business sells its goods to a buyer on credit, it puts itself at risk.

However, a credit insurance policy tailored to an organisation’s business requirements by a trusted provider can mitigate the risks involved with trading domestically and internationally, regardless of the external factors.

There are many reasons a customer might not be able to pay an invoice on time, or at all.

Regardless of the reason, it is important to safeguard cash flow from bad debt, which can damage profitability and business-supplier relationships.

Credit insurance can provide an effective safety net to protect against bad debt. Credit insurers can follow up bad debts on a business’ behalf and cover losses.

There are four key business risks that can be substantially mitigated by credit insurance:

1. Trading with unqualified partners

Buyer ratings, which rank buyer portfolios against specific default criteria determined by country and industry sector, can help businesses identify and steer clear of suspicious customer prospects. Unqualified business partners can pose a threat for unwary organisations.

Without visibility into a customer’s financial stability, businesses can unknowingly trade with high-risk partners.

Credit insurance companies not only provide ongoing advice on the financial risks of trading partners, letting businesses make better-informed trading decisions, they can also implement a credit insurance policy that can help cover the losses for a business that has been unwittingly hit by a high-risk partner.

2. Environmental and political threats

Customers can fail to pay invoices due to reasons beyond their control, such as government policy changes, unexpected market sluggishness or even natural disasters, which can force affected businesses to shut down while waiting for insurance payouts to help cover their debts.

Credit insurance covers organisations for losses incurred as a result of non-payment, providing the continued liquidity a business needs to remain in the black.

While many external influences can be predicted before they hit, many can come as a surprise. Credit insurance is fail-safe fallback measure in any circumstance.

3. International market risk

A jigsaw puzzle, with an empty space, which reads RISKBusinesses trading internationally rely on the stability of foreign markets. Factors such as regulatory changes, goods confiscation and civil unrest pose risks to businesses making cross-border transactions.

Fluctuations in international currency markets can hit businesses hardest of all. A weaker US dollar might be good news for Australians travelling to the States, but it can be bad news for trading companies, as volatile currency markets can upset the finely balanced profit margins offered by established currency differences.

While foreign currency fluctuations can see companies fail to pay their bills on time, credit insurers can provide cover and advise businesses on country-specific risks.

4. Reduced cash flow

Buyers who cannot pay at the agreed time or are unable to pay at all can restrict an organisation’s cash flow. This can cripple the organisation and damage relationships with other trading partners.

When a primary buyer or multiple buyers can’t pay, companies are exposed to a heightened risk of insolvency. Insufficient liquidity resulting from reduced cash flow can stunt business growth.

However, credit insurance can provide liquid funds that enable a business to continue operating by maintaining its cash flow.

While most businesses can take steps to prepare for external market factors that have the potential to affect cash flow, such as seasonal market trends and long-term business cycles, many other external factors are likely to be entirely unexpected.

In the absence of firm information to help businesses prepare for crises, credit insurance provides a dependable solution.

Mark Hoppe is the managing director, Australia and New Zealand, of Atradius.

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