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One casualty of a recession is trust. In better times, you're confident longtime customers will pay their bills. But for businesses dealing with rising inventories and account defaults, once-solid partnerships can suddenly seem risky.
Last fall, Paramount Products Group, a Van Nuys (Calif.) distributor of wireless electronics, found itself struggling to keep doing business with Dyscern, a $9 million electronics reseller and one of Paramount's long-standing retail partners. Dyscern, like many of Paramount's customers, had seen its line of credit dry up and was suddenly short on working capital. But Paramount itself has razor-thin margins, and as a cash-and-carry operation it needed to settle invoices on the spot. Paramount couldn't offer Dyscern payment terms of even 30 days, never mind 60 or 90.
With its business facing a potential standstill, Paramount, with $18 million in sales, turned to something called trade credit insurance. The little-known risk management tool protects companies in the event their customers can't pay. Although it's not unusual for receivables to represent more than 40% of a business' assets, less than 3% of U.S. companies currently hold trade credit insurance policies.
Trade credit insurance is not for everyone. Some industries are simply too risky to insure. Today that includes anything related to autos, housing, furniture, or jewelry. You can't wait too long to start coverage—insurers are unlikely to offer policies against customers that are already evincing the telltale signs of failure. For some companies, the cost of holding a policy may surpass their actual bad-debt expense.
A business can purchase trade credit insurance for individual customers or as a blanket policy, covering a percentage of its receivables. Within a blanket policy, key accounts are identified for coverage. Once a policy is approved, the insurer sets a credit limit for each account and monitors them closely using proprietary risk management tools. If a customer appears to be in trouble, the insurer notifies the policyholder and will usually either reduce the credit limit or tighten the credit terms. In the event of a default, most policies provide full payout, minus a 10% deductible.
You can buy a policy on any qualified customer that has a Dun & Bradstreet (DNB) record. Insurer Euler Hermes specializes in working with smaller companies, but Atradius, Coface, and FCIA Management are other choices. Premiums can run from less than 1% to 2%-3% of the amount you're insuring, depending on the creditworthiness of your customers and the size of the deductible.
While the most obvious reason to buy trade credit insurance is to avoid large unpaid invoices, there are other benefits. Banks love trade credit insurance, and some even require the policies for new loan applications.
After buying an $80,000 policy against its Dyscern receivables, Paramount felt comfortable offering its retailing partner a 60-day credit window. In exchange, Dyscern was only too happy to pay a tad more to help offset the cost of the insurance. For Paramount, says CEO Ezra Soumekh, "the cost is worth the peace of mind." Now might be the time to consider it for your business, too.
Monica Mehta is managing principal of New York-based investment firm Seventh Capital.