by Joe Ketzner
Credit Insurance – Understanding a Restrictive Decision and Beyond “only accept the good accounts”
The general trade credit insurance market is represented by two fundamental and distinct underwriting philosophies.
The Limit Underwriter
The “limit underwriter” (ground-up) will focus on the primary risk, the buyer. The limit underwriters typically are made up of large staffs with local presence in the markets where the buyer risks are concentrated. They invest heavily in human resources for the development of buyer information, technology, monitoring, debt management and recovery as well as claims and recovery administration. The portfolios they manage are large, diverse and complex. Companies (buyers) under review will number in the millions. Heavy reliance on analytics is employed to proactively address changing risks and effectively minimize and avoid losses. While the importance of the seller’s performance is also calibrated into the risk assessment, as well as sector, geopolitical and economic factors, the ultimate assessment is conducted at the buyer level. Policy structure tends to be “ground-up” carrying little or no annual deductible.
The Discretionary Underwriter
The “discretionary underwriter” (excess of loss) will focus on the seller’s historical performance with the application of credit and risk management capabilities being a central point of assessment. These underwriters typically are made up of smaller staffs with less global resources associated with managing buyer financial and payment performance. Their reliance for risk management and mitigation is the seller’s credit & collection policies & procedures and the resulting historic experience of bad debt performance. As a result. The underwriter will typically provide a broad discretionary credit limit to minimize the number of buyers being monitored, will maintain the credit limits for the duration of the policy term, and employ a meaningful deductible (aggregate first loss) aligned with historical performance. Policy structure tends to be “excess of loss” associated with this meaningful deductible
Both philosophies are excellent approaches to credit, risk, and accounts receivable management. However, careful consideration should be given to the seller’s credit management capabilities as well as their business strategy and needs before determining the most suitable solution. Globally an estimated 80% of all trade credit insurance is managed by a “limit underwriter”, and the balance is covered by a discretionary underwriter.
Regardless of the underwriting approach being employed, rarely does 100% of the seller’s buyer risk get accepted by the underwriter. The process of portfolio management is dynamic as buyers are added, deleted, increased/decreased throughout the policy term. Additionally, for the limit underwriter, monitoring is a key element of risk management and they retain the ability to cancel a limit during the policy term. Efforts to minimize losses through cancellation only apply to future orders and not existing balances or orders already accepted. The discretionary underwriter will not cancel a limit during the policy term although it requires the seller adherence of its defined credit & collection policies & procedures to minimize exposure to potential losses.
The Restrictive Decision
Restrictive decisions are often viewed from a negative perspective by the seller unless a comprehensive rationale of what a “no” represents is provided. When an underwriter is presented a buyer to analyze, only one of three decisions can be rendered:
- Yes, the buyer limit is accepted in full. Little rationale is presented.
- No, the buyer limit is declined for cause and presented.
- Partial approval, the buyer limit is restricted for cause and presented.
In most cases, the seller (insured) has a good understanding of his customer’s credit quality and payment capabilities. Because the seller closely monitors the buyer’s payment history as well as their purchasing and inventory assessment, only a meaningful change in behavior will trigger a deeper assessment of the buyer’s financial and credit.
For the “limit underwriter”, ongoing monitoring goes beyond the buyer’s payment pattern. Efforts to maintain current financial information, banking information, regressive trade payment experience, claim & collection data is augmented by significant economic, geo, geo-political, sector, size and risk quality assessment. Included in this dynamic assessment is the seller’s performance.
A “yes” or a “partial” decision means that the underwriter has determined that the risk is acceptable for the foreseeable future and the probability of default is low. These buyers will continue to be monitored until the seller request, they be removed from the policy, or the underwriter cancels the limit. A “no” decision means that the risk is unacceptable as the probability of default is considered high. A “no” does not mean that a default is imminent, only that it is unacceptable to the underwriter at this time when considered along with the other contributing risk factors noted earlier.
The “no” is oftentimes viewed as more beneficial than a “yes” as it provides the seller the opportunity to manage the risk more effectively through other means. (COD, LC, guarantee, etc.)
Economic Cycle Impact
Economic cycles have a significant influence on the underwriter’s acceptance rate. Logically, a positive economic cycle is characterized by low defaults. Conversely, a negative economic cycle is characterized by an increased level of defaults. By extension, the seller should anticipate a higher acceptance rate during a positive cycle and lower during a negative cycle. This has remained historically true even if the specific buyer risk and supporting information is unchanged.
An analogy would be the onset of the flu season; which type of person is the most at risk to die? Assuming all persons are equally suspectable, the most vulnerable are the elderly, young children, or those with weakened immune systems. Even if the individual’s health hasn’t changed, their mortality rate has increased as a result of increased exposure to the flu. It’s the same with commercial mortality associated with a sick economy.
Historically, the vast majority of the “no” decisions will never result in a default, but the incident of default will rise measurably. If any underwriter could accurately predict with 100% certainty which buyer would default on payment or seek shelter under bankruptcy protection, there would no longer be a need for the trade credit insurance product. The primary mission of the limit underwriter is to find the optimal balance of risk management and profitable sales.
