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Globalization and customer consolidation are spurring renewed interest in trade-credit insurance.
Marie Leone, CFO Magazine
November 1, 2005
Three years ago, Skyworks Solutions Inc. was in a quandary. Sales of its semiconductors were soaring and the company was eager to increase capacity and boost research and development. To finance the expansion, Skyworks wanted to tap a key asset — $60 million in receivables — to use as collateral for a line of credit, but its bankers balked. For one thing, the chipmaker was operating in the red, with a heavy burden of debt from a merger. For another, 70 percent of its receivables were from customers in China and Korea. Spooked by the unfamiliar political and economic risks in Asia, Skyworks's American bankers were reluctant to extend credit.
Skyworks found a solution in a long forgotten and little-understood finance tool: trade-credit insurance. The Woburn, Massachusetts, company bought a policy to insure its receivables, which effectively guaranteed its money if a customer failed to pay its bill or significantly delayed payment. A few months later, Wachovia Bank approved a new $50 million line of credit. Today, thanks in part to its timely financing deal, Skyworks is a significant player in specialty chips for cell phones and other handheld devices whose customers include wireless giants Nokia, Motorola, Samsung, and Siemens. 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," says Paul Vincent, vice president of finance.
Trade-credit insurance has been around since the Civil War, but it never really caught on in the United States. Now, as a result of globalization and other economic factors, CFOs are rediscovering this antique finance tool — and putting it to good use. Some use it simply to expand their available collateral base. Others want to insure receivables from far-flung customers in unstable or economically immature regions, or to reduce the risk of rapid expansion into new and untested sales territories. Still others buy it as a measure of protection in situations in which a single, large customer accounts for the bulk of their sales. Trade-credit insurance helps reduce the risk of financial catastrophe if a big customer declares bankruptcy. With more industries undergoing consolidation — think retail and telecom, to name just two — customer-concentration risk is a growing concern for many companies.
Bankers favor trade-credit insurance because it enables them to write more asset-backed loans. CFOs say trade-credit insurance is appealing in part because it buys them peace of mind at a relatively low cost. Skyworks's premium was less than 1 percent of the total amount of the receivables it used for security. (They were placed in a special-purpose entity that was fully consolidated for accounting purposes.) Skyworks's new policy enabled the company to negotiate a better interest rate than it would have gotten on an unsecured line of credit. Vincent says he has renewed the company's policy every year for the past three years, and intends to maintain the policy for years to come.
Skyworks is one of the few companies to rediscover trade-credit insurance. In the United States, fewer than 5 percent of companies buy it, according to the Credit Research Foundation, a nonprofit research group in Baltimore. In contrast, 40 percent of European companies do. Tradition and culture are key in explaining the disparity. Cross-border trade has been a fact of business life for centuries in Europe, yet many executives there harbor a deep mistrust of foreign receivables. Europeans also tend to have a lower tolerance for risk than Americans, says Neil Leary, CEO of Atradius Trade Credit Insurance Inc., the U.S. unit of Amsterdam-based Atradius NV.
A Second Set of Eyes
In the United States, finance executives historically have used other methods to reduce the risk of receivables. Some companies opt to self-insure against bad debt. Others lower risk by structuring stringent sales agreements. Some customers are required to pay in advance, provide cash on delivery, or supply a letter of credit. But as competition heightens and rivals battle for market share, some companies are reluctant to force customers to tie up their own capital to secure a sale.
So insurers anticipate a growing market for trade-credit insurance in the States. The Credit Research Foundation anticipates double-digit growth in these sorts of policies for the next few years. One reason: bankers are pressing clients to buy policies so that they qualify more readily for larger loans. That's what happened at Magellan International Trading Corp., a privately held specialty-steel distributor in Northbrook, Illinois.
At his banker's urging in the early 1990s, CFO Keith Weiss securitized the company's receivables and bought trade-credit insurance in order to qualify for a line of credit. Magellan's bankers were concerned that the distributor's customers — foreign and domestic steel fabricators — might renege on payments. Magellan's policy offers the company several advantages, Weiss notes. For one, Magellan is permitted up to an 85 percent advance rate on its line of credit. Without the policy, he says, Magellan could be financially hamstrung, limited to a far lower advance rate.
Weiss says his insurer provides another valuable service: the credit limit written into the policy works as a short-term braking system. Magellan's insurer provides "a second set of eyes to evaluate a buyer's creditworthiness," Weiss says, until his staff collects enough payment data on a new customer to make a reasoned decision. If the insurer deems a particular Magellan customer too risky to cover, Magellan may use that rejection to negotiate better terms from that customer.
Looking for Trouble
Still, relying on an insurer for key business decisions does have drawbacks. After all, an insurer does tend to be far more conservative than a growth-oriented CFO. "Atradius pulls the plug faster on a company than we do," Weiss says of his carrier, although he says that it can be beneficial to use the coverage to "help keep a tight leash on customer payments."
Like well-trained scouts on the edge of a wild frontier, insurers are intensely sensitive to the first signs of trouble. Their massive and sophisticated databases are churning continually with up-to-the-minute financial information on tens of thousands of public and private companies. Armed with data, insurers often are the first to detect even the faintest whiff of financial trouble in the market. Consider the recent experience of some policyholders of Euler Hermes, a multinational insurer based in Paris.
Six months before Enron declared bankruptcy in late 2001, Euler Hermes began advising its policyholders to reduce sales immediately to the energy giant and seek payment on receivables. At the time, Euler Hermes's clients had $120 million in receivables owed by Enron. Policyholders heeded the warning and aggressively began pressing the energy giant to pay up. By the time Enron filed bankruptcy, Euler Hermes had paid out less than $1 million in claims, says Joseph Ketzner, executive vice president at Euler Hermes ACI, a U.S. unit. "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," he says.
Trade-credit insurance is fairly broad in its coverage, but it does have some limitations. Policies typically cover instances in which customers simply can't pay their bills, such as insolvency or natural disasters. Some receivables that are 90 days past due may be covered as well, depending on circumstances. 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.
Insurers are eager to sell more policies in the United States, which could mean a bargain for some finance chiefs. Several U.S. companies, such as Chubb, have jumped into the market recently. Meanwhile, two years of minimal losses have encouraged providers to offer more insurance, in some instances at lower rates, and deductibles are falling. Still, companies doing business with telecoms, airlines, or steelmakers may find it difficult to secure trade-credit insurance because carriers may deem the risks of default on receivables too high. And carriers may set limits that fall short of what clients request.
In the end, CFOs will find trade-credit insurance a complicated business decision rather than a pure insurance play. But some policyholders say that they're hooked. "Trade-credit insurance is a habit," says Magellan's Weiss, "and not a bad one."
Marie Leone is senior editor of cfo.com.
|Watching the Receivables
Companies buy trade-credit insurance for many reasons, and tailor it to their needs.
|38% Insure major accounts*|
|33% Insure high-credit-risk sector|
|20% Insure for political or geographic risk|
|45% Insure both international and domestic receivables|
|32% Insure only domestic receivables|
|23% Insure only foreign receivables|
|*Defined as representing 20% of a company's sales
Source: Trade Credit Foundation