How much are poor credit risks costing you each
year? There are ways to determine the tangible portion
of this loss, through a cost analysis of your accounts
receivable. But there is no way, through an analysis
of your accounts receivable, that you can determine the
intangible losses that you may incur through poor
credit risks. Tangible losses can be measured in
dollars when a retailer account defaults or goes
insolvent. This first and most obvious loss is the
actual dollar loss of the goods that were sold. The
second loss is the profit that you expected to make
from the sales. The third cost is that of your
collection efforts now that the account is in default.
The fourth cost is the decrease in the value of your
accounts receivable as collateral, which will either
decrease the amount of loan capital that is available
to you, or increase the interest rate that you are
charged because of this over-all lowering of your
collateral value (or both).
The intangible cost is much more difficult to
determine, although it might be just as costly as the
tangible cost: It is the dollar volume of business
that you lose through retailer accounts that you never
obtain because they are classed as marginal credit
risks.
Much of the tangible cost of bad credit risks can
be charged to your collection department. And because
your primary business is manufacturing or distributing
merchandise, your collection department does not,
unfortunately, operate as efficiently as, say your
order department.
Insurance companies are now recognizing that the
inherent risk of maintaining an accounts receivable,
which, because of the nature of the
wholesale/manufacturing business, can run into
considerable sums of money, is as much a casualty risk
as the threat of property damage, or the liability of
employee health and accident risks. The insurance that
is designed to fill this void that other casualty
insurances do not is called commercial credit
insurance.
Commercial credit insurance is intended to
indemnify the insured, who can only be a manufacturer,
wholesaler, or distributor, for losses incurred when a
retailer account fails to pay its credit obligations.
With this type of casualty insurance, you may recover a
large portion of both your tangible and intangible
costs of doing a credit business. In essence, the
insurance company serves two functions: (1) it acts,
initially, as your collection agency, and (2) if it
fails in the collection of the debt, it indemnifies
you, the insured, in accordance with the terms of the
policy.
The usual commercial credit insurance policy is
written with a deductible clause, which is based on the
premise that an insurance company will only insure
against unexpected or catastrophic losses, not those
losses that are normal and expected. In effect this
means that the insured self-insures for the amount of
normal and expected losses, thereby lowering his
premium costs (if he doesn't elect the deductible, he
simply ends up swapping dollars with the insurance
company). This deductible figure is initially
expressed as a percentage of gross sales, and is based
upon the bad debt loss of the average business firm in
your business's classification. The figure is then
modified to reflect your own historical losses through
bad debts, as well as any irregularities in the bad
debt loss caused by businesses insolvencies That might
have been due to local, regional, or national economic
recessions. In any year, the insurance company will
indemnify you only for amounts that are in excess of
the deductible.
The usual period of coverage for a commercial
credit policy is one year, with no cancellation
privilege for the insurance company. The upper limit
of coverage under the policy is determined by the
insurance company through an analysis of your
customer's credit ratings, which should show the loss
risk of your accounts receivable. Credit rating
agencies of long standing, such as Dun & Bradstreet or
TRW, are utilized to determine customers' credit
ratings.
As an example, if one of your customers had a Dun
& Bradstreet credit rating of at least 3A1, you could
extend this customer $100,000.00 of credit without
prior approval of the insurance company. If the
customer's Dun & Bradstreet rating was BA1, you could
extend him a maximum of $50,000.00 credit without prior
approval by the insurance company. If you adhere to
the guidelines set by the insurance company, but your
customer defaults on the debt, your insurance company
will act as a collection agency, and if not successful,
will indemnify you for the amount of the loss that is
in excess of the deductible.
The usual procedure for filing a bad debt loss
claim is to file the claim within twenty days after
learning of the debtor's insolvency, and before the
expiration of the policy. If the debt is past due, but
the customer is not in fact insolvent, the insurance
company will still process the claim as if he were
insolvent. Concurrently with filing the claim, you
must turn the delinquent account over to the insurance
company so that it can make an effort to collect the
debt, and during the next sixty days, the insurance
company acts as a collection agency for your business.
If it is successful in collecting the account, it will
turn the proceeds of the collection over to you,
including any amount that is in excess of your coverage
(less collection charges). Even in the case in which
it is obvious that the bad debt loss exceeds the policy
coverage, the insurance company will make an all-out
effort to collect the total debt. Failing collection,
at the expiration of sixty days, the insurance company
will indemnify you for the loss.
We can see that the insurance company's most
obvious function is to (1) recover the absolute dollar
value of the merchandise, plus (2) recover any expected
profit, thereby recovering your first and most obvious
tangible losses. Next, by using the collections
facilities of the insurance company (which may be
superior to your own), you eliminate your collection
department with its attendant personnel costs,
investigating costs, legal fees, as well as some of the
uncertainties and unpleasantness inherent in operating
a collection department.
Moreover, your accounts receivable now offer more
collateral security, because you are, in effect,
providing a guarantee that its value will be maintained
while you are repaying the loan. This should result in
a better credit rating for your business, which should
strengthen your position in the money market. This is
implemented by a special bank endorsement, which may be
attached to the commercial credit policy (this
endorsement enables the lending institution to choose
to receive indemnification directly from the insurance
company, rather than waiting for reimbursement from
you).
Just as it is difficult to determine how much
intangible loss that you may incur from bad debts, it
is difficult to determine the exact amount that
commercial credit insurance might save you in these
intangible losses. However, commercial credit
insurance does enable you to extend credit to those
marginal accounts that would otherwise be classed as
too risky. Of course, you must exercise a certain
amount of discretion in doing this, even with the
protection of insurance, as marginal accounts will
lower the over-all credit rating of your accounts
receivable, thereby raising either the deductible
amount, or the premium cost of the insurance. But,
when these factors are weighed against the prospect of
an increased dollar volume of business, you may elect
to take on more marginal accounts.
Commercial credit insurance is worthy of
consideration, because losses incurred from bad debts
are just as real as -- and in a broader sense, more
far-reaching in their implications than -- losses from
property damage or liability risks.
