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Spurred in part by globalization, a seldom-used Civil War-era financing tool may finally go mainstream.
Marie Leone, CFO.com | US
September 29, 2005
In September 2002, Skyworks Solutions Inc. was in a quandary. Sales of its semiconductors were soaring, and the company was eager to boost capacity as well as research and development. But the chipmaker's balance sheet was weak and debt-laden after a recent merger. That meant that traditional borrowing based on cash flow was costly, and in some cases unavailable, according to vice president of finance Paul Vincent.
To make matters worse, Vincent was having problems arranging for asset-backed loans — often used by undercapitalized companies — since lenders were wary of the quality of the foreign receivables he wanted to use as collateral. The banks were especially spooked by the political and economic risks in China, Korea, and other Asian countries where Motorola, Nokia, Ericsson, and the company's other blue-chip customers operated.
Yet by July 2003, Skyworks managed to get a $50 million credit line by securitizing its receivables with Wachovia Bank, says Vincent. The company was able to achieve that by strengthening the creditworthiness of its receivables with a seldom used, and somewhat misunderstood, financing tool: trade-credit insurance.
The Woburn, Massachusetts chipmaker bought a policy from Atradius Trade Credit Insurance Inc. to cover about $60 million of its $94.4 million in receivables, effectively guaranteeing that the amount would be paid to Skyworks even if a customer failed to pay its bill or significantly delayed payment, Vincent explains.
The company placed its receivables in a special-purpose entity, which is fully consolidated with Skyworks' financials for accounting purposes, and sold them to the bank. Skyworks collects the receivables or files claims in the event of non-payment; the bank is named as the policy beneficiary.
Today, Skyworks is a key player in the specialty-chip market for cell phones and other hand-held communication devices. Revenues have nearly doubled in the last three years, to $785 million in 2004. And Skyworks is profitable, earning $22.4 million last year. "The trade-credit insurance allowed us to unleash cash at a time when we needed to feed growth," Vincent says.
The company hasn't been alone in that. Trade-credit insurance, in fact, has been used in the United States since the last of the tall-masted ships were hauling cargo between Europe and the New World in the early 1860s. But its use here never spread beyond a small number of companies that operated in volatile markets, like retail and lumber.
Currently, only between 5 percent and 6 percent of U.S. companies buy it, according to the Credit Research Foundation, a non-profit research group in Baltimore. In contrast, 40 percent of European companies buy trade-credit insurance, says Neil Leary, chief executive officer and president of Atradius.
Why the discrepancy between the Americans and the Europeans? Tradition and culture. Although cross-border trade has been a fact of business life for centuries in Europe, many executives there harbor a mistrust of foreign receivables. Europeans also tend to have a lower tolerance for risk than Americans, adds Leary.
In the United States, CFOs have historically used other methods to reduce the risk associated with receivables. Some companies self-insure against bad debt. Others lessen their exposures by structuring stringent sales agreements or requiring customers to pay in advance or provide cash on delivery. Still others may be asked for a letter of credit. But as competition heightens and rivals battle for market share, many companies are reluctant to force customers to tie up their own capital to close a sale.
Nevertheless, insurers foresee a growing market for the product in the United States. The Credit Research Foundation expects double-digit growth in the policies over the next few years. Basing their estimates on several economic and market factors — not the least of which is globalization — most vendors predict growth will reach 15 percent annually.
Half of the companies that use trade-credit insurance buy it to expand their available collateral base, says Michael Ferrante, president of Coface N.A., another carrier. The other half use it mainly as a risk management tool, deploying the coverage to protect them against the loss of receivables from customers in unstable or economically immature regions.
Further, insurance clients use it as protection against high customer concentration. In such cases, in which a big customer like Wal-Mart or Kmart accounts for the bulk of a policyholder's sales, trade-credit insurance helps curb the risk of financial catastrophe if the customer declares bankruptcy, says Rich Matusz, a senior vice president at Wachovia.
Matusz also points out that bankers favor the use of trade-credit insurance because it enables them to write more asset-backed loans. "We like to lend money — that's how we make money," the banker says.
Whether its used as a financing or risk management tool, the insurance is appealing because it buys management peace of mind at a relatively low cost, says Keith Weiss, CFO of Magellan International Corp, a privately held specialty steel distributor in Northbrook, Illinois. Weiss declines to divulge how much his company pays Atradius in insurance premiums, but he does say that Magellan's policy permits the company up to get a 90 percent advance rate on its line of credit. Without the policy, he says, Magellan would be limited to a rate near 60 percent.
Skyworks' Vincent notes that the trade-credit insurance premium he pays is less than two-tenths of a percent of the total amount of the receivables portfolio used as collateral. He says the policy enabled the company to negotiate a better interest rate on the line of credit with Wachovia than it would have been able to get with an unsecured line of credit. For the last three years, Skyworks' rate on the credit line has been a competitive LIBOR plus 40 basis points, says Vincent.
Another practical advantage of using trade-credit insurance is that it "helps keep a tight leash on customer payments," says Magellan's Weiss. The company's credit manager usually responds to customer requests for expansion of their credit lines in one of two ways, he explains. One is to ask the customer to pay its invoices earlier in order to provide Magellan with more working capital. The manager's other response is to buy more credit insurance on the customer. (Trade-credit insurance is written on individual companies.)
If the insurance underwriters reject Magellan's request for more coverage because the risk is too high on that particular customer's receivables, Weiss sometimes uses the rejection as a bargaining chip to negotiate better payment terms with Magellan customers.
Weiss also uses the insurer's staff as a credit research team and the credit limit written into the policy as a gauge of how much credit to extend. That's because the company's three-person credit staff is too small to vet every new customer before approving a sale.
The hulking databases of private-company and public-company information that some carriers use to research and underwrite risk can eliminate certain credit-related blind spots. Witness the example provided by Joseph Ketzner, executive vice president for commercial business at insurer Euler Hermes ACI. He explains that six months before Enron declared bankruptcy in late 2001, Euler Hermes began advising its policyholders to cut down on sales to the energy giant immediately and seek payment on their receivables from it.
At the time, Euler Hermes clients had $120 million in receivables owed by Enron. Policyholders heeded the warning and aggressively began pressing the company to pay up. By the time Enron filed for bankruptcy, Euler Hermes paid out less than $1 million in claims, says Ketzner. "We're the guys who tap you on the shoulder while you're driving to tell you the car behind you is out of control," Ketzner says.
While trade-credit insurers tend to offer fairly broad coverage, the policies do have their limitations. The coverage typically applies to instances in which customers simply can't pay their bills, such as insolvency. Late payment — more than 90 days past due in most instances — can also trigger a valid claim. Policies also cover receivables that go unpaid because of war or currency-exchange problems. However, trade-credit insurance won't typically cover receivables that go unpaid because of business disputes over defective products or late deliveries, says Parker Freedman of ARI Global Inc., a trade-credit insurance broker in Tampa, Florida.
Further, policyholders don't always get the amount of coverage they request, says Freedman. That's because carriers set limits on how much they will underwrite on their customers' dealings with specific companies. They do that by setting a level of coverage they will provide on the risk of doing business with such corporations and then allot a piece of that coverage to each policyholder.
But there may be good news for policyholders on the horizon, says Freedman. The industry is coming off of a drop in the market's loss ratio, resulting in a softening of premium prices and deductible levels. Also, a few new carriers, including Chubb Insurance Co., have entered the market over the last few years, which means availability is set to rise. But companies doing business with the telecoms, the airlines, or the steelmakers may find it hard to secure policies, since insurers are wary industries in which the risks of default on receivables are high.
In the end, CFOs seem to view trade-credit insurance as more of a business decision than a pure insurance play. Unlike insurers, who tend to be far more conservative in their judgments of their clients' creditors than their clients are, the finance chiefs of such companies must weigh revenue goals, margin targets, and competitive pressure along with receivables risk. "Atradius pulls the plug faster on a company than we do," asserts Weiss. Nevertheless, "trade-credit insurance is a habit," he says, "and not a bad one."