As many clients of the BBH Commodities & Logistics group are well aware, recent consolidation among commodity consumers – particularly in the soft commodity sector (e.g., coffee, cocoa and sugar) – has created pressure on merchants to lengthen payment terms for many of their larger customers. The result has been greater counterparty exposures, increased working capital financing needs for commodity traders, and pressure on commodity financiers to increase accounts receivable limits to certain customers. An important role of a merchant in the supply chain has long been to provide liquidity and credit in the marketplace, which has recently been accentuated as large, multinational players lean on small and midsize merchants for unsecured financing. This dynamic has been driven in part by the leverage taken on by these multinational companies, which are in many ways leaning on trade vendors for funding.
In response to this market phenomenon, market stakeholders – including merchants, banks, insurers, and supply chain technology and software providers – are working together to develop risk mitigation solutions. Fortunately, there are instruments today to help alleviate counterparty risk including trade credit insurance and accounts receivable finance. This article summarizes some of the pros and cons of these two different solutions.
Trade Credit Insurance
Let’s first look at the trade credit insurance marketplace, which is generally bifurcated into two types of insurance providers:
Monoline insurance carriers provide a single type of insurance coverage, principally underwriting cancelable trade credit insurance policies, otherwise known as “whole turnover” or “ground-up” coverage. Ground-up programs comprise roughly 80% of the global trade credit insurance market, and this segment of monoline trade credit insurers is dominated by the “big three” carriers: Coface, Atradius, and Euler Hermes.1 Under ground-up programs, these insurers set credit limits for counterparties, but if the carrier perceives the condition of a covered counterparty to have deteriorated, it is able to amend or cancel coverage altogether on a particular name, while preexisting credit exposure remains covered.
Monoline insurers underwrite risk across the full spectrum of industry participants, from small and medium-sized businesses to the very largest multinational enterprises. As noted, their policies often feature whole turnover or ground-up coverage, which insures a policyholder’s entire customer base, with per-debtor credit limits preapproved for larger accounts and a discretionary limit covering smaller accounts.
Cancelable trade credit insurance buyers often view the insurer’s ongoing credit risk monitoring of debtors as additive to their own internal risk management function, as it can serve as a virtual outsourced credit department. Monoline carriers have vast databases that afford them the ability to monitor entire industry sectors and counterparties in ways that most individual merchants cannot match. Action by a monoline insurer can provide a warning sign in the event of a decline in a counterparty’s creditworthiness. This type of insurance can be particularly helpful to smaller commodity traders that seek to augment or largely outsource their in-house credit monitoring functions.
The cancelation feature of these policies is especially important to a monoline insurer given that risk is positively correlated across its business, as the carrier is only insuring trade credit risk. This was especially pronounced during the 2008 global financial crisis when insurers with cancelable coverage exercised their option to cancel credit limits, albeit at a time when many policyholders most needed the coverage.
Property and Casualty (P&C) Insurance
Property and casualty (P&C) insurance carriers underwrite a variety of insurance policy types covering accident and health, directors and officers liability insurance (D&O) and professional liability, property and casualty, surety, and credit risk. “Credit risk” for most P&C insurers includes trade credit – which covers the typical commercial and political risks found in most trade credit insurance policies – as well as structured credit. Credit insurance typically comprises a small percentage of a P&C insurer’s overall book of business; however, it is often disproportionately important to the carrier given its role in diversifying the insurer’s risk. P&C insurers generally find credit insurance attractive, as the risks are uncorrelated to those inherent in their larger lines of business.
Most P&C insurers underwrite non-cancelable, non-payment insurance policies. Non-cancelable policies generally comprise roughly 20% of the total trade credit insurance market.1 These insurers include ACE, AIG, Equinox, FCIA, HCC, QBE, XL, and Zurich, while Atradius and Euler also offer a similar program in addition to their traditional ground-up coverage. For non-payment insurance policies, once a counterparty is approved for coverage, the insurer cannot cancel coverage for the duration of the credit limit period.
Since the 2008 financial crisis, in response to many insurers exercising their right to cancel credit limits under cancelable trade credit policies, purchasers are increasingly choosing policies with non-cancelable credit limits to protect themselves against adverse action by the insurer. The offset to this type of committed coverage is that the self-insurance in the form of a deductible is higher than a ground-up program, and the insurer will not be able to provide the insured party with the same level of detail on the customer portfolio. In addition, providers of non-cancelable, non-payment insurance policies tend to be more selective than monoline carriers in whom they insure and the policy types they offer. For example, medium- and large-sized companies seeking trade credit protection are often offered coverage not for their entire account debtor base, but rather for specific catastrophic account debtor risk.
Regardless of the size of the insured party, in the event a P&C insurer does offer non-cancelable coverage on an entire account debtor base or the majority thereof, the policy will likely feature a significant “discretionary credit limit” that allows the policyholder to use its own judgment in extending credit to customers up to an agreed amount per counterparty. In these instances, the insurer will place particular emphasis on the underwriting of the insured’s in-house credit procedures. As a result, these types of non-cancelable trade credit policies are often best suited for merchants with a well-developed, structured approach to credit risk management.
While terms vary widely across the market depending on the carrier, some of the most common features of a trade credit insurance policy include:
- Cancelable or non-cancelable country and counterparty limit(s)
- Single or multi-debtor policy
- Definition of risks covered
- Policy or per-counterparty deductible
- Credit limit for each counterparty
- Aggregate credit limit across all counterparties (for multi-debtor policies)
- Coverage provided per loss
- Discretionary credit limit per buyer
- Policy term – usually 12 to 24 months
- Premium – charged monthly or annually and calculated as a percentage of sales to or receivables due from insured debtors
- Reporting – including annual renewal of buyer limits, declaration of turnover report with a specific period’s total sales to a debtor (used for premium calculation purposes), past due receivable reporting, and receivable aging reports
Accounts Receivable Finance
While trade credit insurance is the most common way for commodity merchants to mitigate their counterparty and customer credit risk, the amount of coverage available has, in certain cases, proven to be insufficient in light of the trends discussed in this article. As a result, banks and, increasingly, capital markets investors have begun to show a keen interest in financing the accounts receivable of these parties through the creation of short-term paper. The trend toward receivable disintermediation has only accelerated as a result of more stringent capital requirements for banks and increasing investor demand for yield in today’s low interest rate environment. While low commodity prices have reduced utilization rates on credit facilities – perhaps slowing the trend of increasing usage of capital markets – this trend is likely to continue longer term.
Accounts receivable financing is typically executed through the outright sale of an accounts receivable to a third party. As soon as a company books a receivable from its customer and that receivable is confirmed by the customer, the receivable is sold at a slight discount to a third-party purchaser. The discount reflects an imputed interest rate that provides the return to the investor. These transactions provide immediate cash to the seller of the receivable rather than having to wait the full payment period provided to its customer. In many cases, the seller receives a higher percentage of the receivable value than it might in a typical asset-backed or commodity-based lending structure. The universe of third-party receivable buyers ranges from traditional commercial banks to formal asset-backed securities vehicles with capital provided by fixed income investors, who are looking for current yield with minimal duration risk.
Regardless of which structure a merchant pursues, a key consideration for the seller of the receivable is determining whether it is executing on a recourse, limited recourse, or non-recourse basis. In a recourse or limited recourse structure, the buyer of the receivable has rights to the seller’s balance sheet in the event that the purchased receivable is not fully collected because of obligor insolvency or otherwise. This is typically preferable to investors, given the additional layer of risk protection derived from the seller’s balance sheet, but is suboptimal for the seller. In contrast, in a non-recourse transaction, the seller of the receivable avoids the assumption of direct or contingent debt on its balance sheet since the receivable is sold outright and there is no recourse to the seller if the obligor defaults. How many receivables a company chooses to sell depends on its business need and could vary from one to all of its receivables.
Receivable finance programs are offered by third-party trade finance providers in addition to some commercial banks. The structures can range from less formal arrangements with banks in which receivables are sold on a case-by-case basis, to more formal securitizations with specific terms and guidelines for eligible collateral. The securitized notes are then sold to fixed income investors. For example, a large commodity trader recently issued $300 million in public notes to investors backed by trade receivables, which included two tranches of floating rate notes at a spread over one-month LIBOR of 95 and 225 basis points, respectively.
Critical to distinguishing which receivable finance provider works best for a company is the provider’s flexibility in developing and implementing a suitable trade finance program and the provider’s ability to fund these programs.
The importance of managing liquidity and counterparty risk is essential for companies to remain healthy and able to pursue new business opportunities; however, certain factors exist that are making it harder, especially for small and midsize merchants, to comfortably manage these risks. Fortunately, there are resources available to help reduce pressure on merchants and support working capital needs and credit risk mitigation.
For more information on trade credit insurance or receivable finance programs, please contact your BBH relationship manager or Alice Birnbaum (Alice.Birnbaum@bbh.com or 212-493-8920).
Some information provided by Marsh USA.
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1 Source: Marsh USA