When it rains, it pours. Trade credit insurance is a common arrangement to alleviate credit risk for organizations. Suppliers purchase these policies to eliminate financial losses, reduce bad debt reserves, grow sales revenue, and sustain cash flow. During the Global Financial Crisis, however, trade insurance claims rose significantly and insurers responded by pulling coverage on financially distressed companies. Today, with the prospect of heightened bankruptcy and insolvencies globally, credit professionals are actively demonstrating that they are concerned that trade insurance coverage is being withdrawn once again.
CreditRiskMonitor is a leading web-based financial risk analysis and news service designed for credit, supply chain, and other risk professionals. CreditRiskMonitor is helping professionals, including those from more than 35% of the Fortune 1000, manage and reduce financial risk during the coronavirus pandemic. The CreditRiskMonitor service provides credit report coverage on more than 56,000 public companies worldwide and the FRISK® score, which predicts bankruptcy with 96% accuracy over a subsequent 12-month period.
Rising Claims, Dropping Coverage
In April, the International Monetary Fund projected that the coronavirus pandemic will erase 3% of global GDP in 2020, marking the steepest plunge since the Great Depression. If the pandemic does not subside in short order, the IMF anticipates wide-ranging calamitous outcomes: “The pandemic may not recede in the second half of this year, leading to longer durations of containment, worsening financial conditions, and further breakdowns of global supply chains. In such cases, global GDP would fall even further: an additional 3% in 2020 if the pandemic is more protracted this year, while, if the pandemic continues into 2021, it may fall next year by an additional 8 percent compared to our baseline scenario.” Such an economic collapse will invariably lead to elevated corporate bankruptcies across many sectors.
Suppliers routinely apply trade credit insurance to their largest, highest-risk customers. For example, suppose “ABC Company” goes bankrupt and the supplier suffers a write-down of $300,000. Against a product gross margin of 20%, the supplier would need to generate another $1.5 million in revenue to make up for the lost cash flow. Insurance will often cover up to 90-100% of the potential loss, making these policies quite attractive, but typically cost 10%+ of the credit’s total value in normal time. Yet when a particular company’s likelihood of bankruptcy increases, insurers frequently hike premium, reduce the coverage amount, or even cancel the policy altogether. This retrenchment in trade insurance is already taking hold across the globe. Additionally, primary originators indicate that the state of trade credit insurance remains quite fragile: “Banks and insurance companies say trade could be squeezed even more if a key financial product used to facilitate it isn’t restored to health,” according to The Wall Street Journal.
As the coronavirus swiftly batters corporate credit quality, the European trade credit insurance industry, for example, has been adversely impacted. On Apr. 12, the European Commission approved a €10 billion guarantee to support France’s credit insurance market. Two days later, the commission permitted a backstop of €5 billion for Germany’s insurance market with a safety-net to cover up to €30 billion. In effect, governments are playing the role of reinsurer to help smooth trade flow interruptions.
Commercial banks are also tightening underwriting standards and adjusting credit agreements to risky borrowers. Secured creditors have executed amendments that reduce total loan commitments, curb seasonal increases, expand default provisions, and require intra-quarter budgeting documentation. Given that banks and insurance companies are shoring up their underwriting practices, unsecured trade creditors need to modify their processes as well.
The FRISK® Substitution
The FRISK® score will help protect your accounts receivable portfolio. The model is based on a “1” (highest risk)-to-“10” (lowest risk) scale with anything in the “1”-to-“5” category falling into the high-risk “red zone.” CreditRiskMonitor segments all trade into these tiers:
Subscribers are advised to carefully evaluate a counterparty that trends into the red zone, particularly into the lower classifications. Notice that the risk of failure becomes significant, or nearly 2x that of the average public company, starting at the “4” category. Some subscribers traditionally secure trade credit insurance for counterparties in the “1” to “4” range. Although that window closed in 2008 when insurers reduced coverage for major auto manufacturers such as General Motors Company and Ford Motor Company (their respective FRISK® scores were deep in the red zone). For context, Ford’s current FRISK® score has fallen back to a FRISK® score of “3” similar to levels observed in 2007 and 2008.
Even without insurance coverage, however, CreditRiskMonitor subscribers still leverage the FRISK® score to their tactical advantage. Often with several quarters of advanced warning, credit professionals are given the opportunity to reduce their total credit limits, lower the term (e.g. 60 days to 30 days), request cash on delivery, cash before delivery, or some other type of added security.
In the existing environment, FRISK® scores for numerous public companies have dropped from the safer “blue zone” into the red zone. The collective group of FRISK® scored red zone companies in January increased by 67% headed into April. The highest risk subsets expanded the most, as shown below:
As insurance protection diminishes on a company-by-company basis, particularly on red zone companies, subscribers need to be prepared to mitigate risk exposure in other ways. Careful monitoring of counterparty FRISK® scores, engaging in active discussions with distressed counterparties, and adjusting the terms of trade credit based on those conversations can provide comparable risk mitigation at a fraction of the cost of a trade credit insurance policy.
Bottom Line
Even with government intervention, trade credit insurance is waning at the exact time when it is needed most. The longer the coronavirus persists, the more bankruptcies will ensue, and the harder it will likely become to acquire trade insurance. Fortunately, the FRISK® score bridges that gap by providing daily updated and highly accurate bankruptcy readings on public companies. Contact us today for a risk assessment to see how many of your counterparties are trending in the FRISK® red zone.