As global supply chains unraveled, trade credit insurance dried up, leaving some calling for government help and others looking to move local.
By Russ Banham
Leader’s Edge magazine
Marc Wagman had never experienced anything like it before. Compared to the 2008 financial crisis, when trade credit insurance coverage terms, conditions and pricing tightened up over a period of time, the impact of COVID-19 was immediate and devastating.
“A dark cloud suddenly passed over the market,” says Wagman, managing director of credit and political risk at Gallagher. “Business stopped cold for companies without trade credit insurance that wanted it. In the 25 years I’ve been doing this, it was the first time I’d ever seen such wholesale destruction of available capacity.”
Trade credit insurance is one of those insurance products rarely in the spotlight. This specialized form of insurance protects companies from the risk of unpaid receivables. Over the past year, as global supply chains unraveled, the normal flow of business-to-business capital constricted. Industries like retail, travel, manufacturing and hospitality experienced cataclysmic drops in revenue, and suppliers to these industries found that money owed them was not being paid on time, if at all.
The average time U.S. companies took to pay their invoices, known as DPO (days payable outstanding), increased 10% from midyear 2019 to midyear 2020, according to The Hackett Group, a global strategic consultancy based in Miami. Over the same period, the average time it took for those businesses to collect payments owed them, known as DSO (days sales outstanding), increased 7%. Bear in mind these numbers include all industries, not just the aforementioned caught in the crosshairs of the pandemic.
As bills went unpaid, companies with trade credit insurance filed claims on their policies. “Normally, we might see 20 claims a day come in, but once COVID-19 struck, it went up to 40 a day in April, and by May we were looking at 70 to 80 claims daily,” says James Daly, CEO of Euler Hermes North America, one of the three largest trade credit insurers. “Clearly, the U.S. economy was contracting at an alarming rate. In response, we made some tough decisions, reducing our overall exposures by around 15%.”
From midyear 2019 to midyear 2020, the pandemic forced trade credit insurers to slash coverage by 14%. And that was for the lucky companies that had it. Insurance brokerage Lockton says nine in 10 of its clients without trade credit insurance could not buy it at any price. A case in point is the retail sector.
“Retail had been in trouble for the last three to four years, with many brand-name chains declaring bankruptcy, and then along came COVID-19,” says Jerry Paulson, a senior vice president at Lockton. Trade credit insurers did not take what Paulson calls “a scalpel approach” to retail industry suppliers seeking coverage for the first time. Instead, he says, “It was a chainsaw.”
The Vital Role of Trade Credit Insurance
No one faults insurers for their disciplined underwriting stance. The risk is simply too high to provide trade credit insurance to companies without it at a time of pronounced economic uncertainty—the “you can’t buy fire insurance when the house is on fire” maxim. Nevertheless, the sheer speed of the market’s collapse stunned insurance brokers and their clients. “We had to work three times as hard to get half as much as we used to,” Paulson says.
In some cases, clients passed on the opportunity to renew their policies. Donald Caskey, trade credit account executive at Hub International, cites the example of a major shipper of almonds to Asia that had been “burned by their buyers more than once,” resulting in significant changes in policy coverages and cost. Yet the company decided these factors outweighed the value provided and passed on renewing its trade credit insurance policy.
Several brokers expressed their concerns over a “multiplier effect”—the dominoes that fall after a single company doesn’t pay its invoices, which inevitably results in its creditors not paying their invoices, and so on. As revenues dwindle, companies decide to conserve cash by holding back payments to customers, and, as a result, customers then experience revenue problems, forcing them to do the same thing. And so on. As companies hunker down to protect their cash supply, less liquidity forces banks to become more conservative, reducing their credit lines to businesses. Trade credit insurance is designed to keep cash and liquidity flowing.
Approximately $600 billion in business-to-business transactions in the United States is covered each year by trade credit insurance, protecting businesses and jobs. “Without this safety net, companies would not be able to sustain production levels or expand their sales, resulting in supply chain disruption and significant damage to the U.S. economy,” says Daly.
Over the past year, this safety net has come undone. The cutbacks in trade credit insurance are creating a drag on economic activity. Without available trade credit insurance, companies must confront the prospect of not being paid by other companies that buy their goods. As cash flow constricts and banks tighten their credit lines, they’re forced to preserve the cash they have instead of spending it on growth. This causes them to pull back on hiring and production. Approximately $46 billion in U.S. production gains will be squandered in 2020, as will an additional 155,000 U.S. jobs, according to a report by Euler Hermes and two other large trade credit insurance markets, Coface and Atradius.
Without trade credit insurance, a company’s growth capital prospects also are affected, since banks more favorably treat businesses whose receivables are insured. “Banks will typically advance 70 percent to 80 percent toward domestic receivables,” according to the report. “When covered by trade credit insurance, they will loan up to 90 percent [of the] indemnity amount, due to the carrier bearing the risk of the asset.”
“On a million-dollar line of credit,” Daly says, “this means a business has access to as much as $100,000 in additional working capital—funds that can make the difference between laying off workers or continued growth.”
Robert Hartwig, a clinical associate professor of finance at the University of South Carolina’s Darla Moore School of Business, says the trade credit insurance market plays a crucial economic role.
“The global economy is projected to shrink 3.3% in 2020, which doesn’t sound like a lot but actually is,” Hartwig says. “Among advanced economies, where most trade takes place, it’s projected to shrink 6.1%.”
Behind these figures is a tale of supply chain upheaval, he says. “An astonishing 97% of companies say their supply chains were disrupted by COVID-19,” Hartwig says. “Obviously, if virtually every supply chain on the planet is disrupted, that adds up to an enormous amount of stress in the credit markets. What underpins this credit is trade credit insurance, emphasizing its pivotal function.”
Trade Credit’s Evolution
The first trade credit insurance policies originated in the United States in the 1860s, when investor Johns Hopkins charged a 5% premium on the notes provided to creditworthy clients, making it easier for the bearers to later sell the note to a bank or another firm.
More formal trade credit insurance policies were developed in Western Europe between the First and Second World Wars. Policies initially covered export accounts receivable and later domestic receivables. “Trade credit insurance is a buffer when cash flow constricts,” says Daly, of Euler Hermes, which is celebrating its 125th year in business, making it one of the first providers of the insurance in the United States.
Paulson, who worked at Euler Hermes before joining Lockton in 2016, shares this view. “Trade credit insurance is really more about liquidity than risk transfer in the customary sense,” he says. “Much of a company’s working capital is actually trade receivables and payables. When that shrinks and companies have to pay in advance for a product, they need to get debt from a bank. Going to a bank and trying to get liquidity without trade credit insurance has little hope of success.”
COVID-19 took this comfort away for many companies. “Unlike traditional recessions generated when demand drops out of the supply chain and people don’t buy products they normally buy, the pandemic produced something we very rarely see—a supply-driven recession,” Daly says. “Governments shut down their economies, which we only see during times of war, when normal trade and commerce pause and people go off to fight the adversary. In a matter of weeks, supply constricted out of the system, resulting in the unemployment of 30 million people” in the United States.
Trade credit insurers were aware of these possibilities before they emerged. “Our antennas started to rise in January when the story broke about a new virus at a wet market in China,” says Mills Ramsay, vice president and credit risk underwriting manager at global insurer QBE North America. “The revelation launched a series of ‘what ifs’ for us, like, ‘What if retailers can’t get shipments?’”
By late February, “things got real,” Ramsay says. “For example, we have clients selling goods to buyers located in China. In one instance, a Chinese airline was not responding to emails and phone calls from our clients, because the country was on lockdown. That was the first sign that something serious was brewing.”
Brokers were inundated with worrisome calls from clients without trade credit insurance. “We experienced a substantial uptick in clients suddenly wanting it, but there was little we could do since the insurance had become unavailable,” Paulson says. “They were in shock. Looking back, their CFOs should have known better.” Wagman agrees. “Clients without the insurance realized overnight their receivables had become their largest uninsured assets,” he says. “That cash was their lifeblood, but underwriters had gone into a protective mode.”
Renewals Require Realism
For companies with trade credit insurance, as their policy renewals approached, brokers warned the process would be painful. “We were dogged about making sure our clients understood the market appetite and the changing coverage terms and conditions,” Caskey says. “We had to paint a picture about their forward-looking demand, which required them to be transparent about their customers.”
Much of this work was basic “blocking and tackling”—meeting with corporate CFOs, credit managers, risk managers and salespeople to evaluate the creditworthiness of business partners. “We needed to sniff out potential issues so the insurers had a clear view of possible solvency problems,” Paulson says. “When the markets were less amenable to offering full coverage, we found alternatives.”
A case in point is a so-called “discretionary credit limit” that gives insureds with smaller credit exposures the opportunity to set credit limits for each of their customers, as opposed to a single credit limit covering all their receivables. Another alternative is the use of a put option, whereby brokers approach the capital markets to assume a customer’s bankruptcy risks.
“Unlike traditional credit insurance policies that absorb a portfolio of a client’s creditworthy customers, a put option can be customized to a single distressed customer,” Wagman says. “It’s really credit insurance by another name, the difference being a bank underwrites the risk.”
Brokers also partnered with trade credit insurance providers to assemble syndicated structures whereby multiple insurers assume layers of a client’s credit risk on a quota share basis. “This way, if one insurer decides to pull back coverage, only a portion of the policy’s insurance capacity needs to be replaced, allowing for more competitive market dynamics,” says Bryan Michels, U.S. practice leader for credit solutions at Aon.
Insurers also did their share to ease conditions for their policyholders. “We worked closely with our insureds to gain a better understanding of their business, helping us to provide flexibility in addressing their business needs,” says Harpreet Mann, head of global credit and surety at QBE North America. “For instance, we worked with insureds to extend their clients’ payment terms to deliver the agility they needed to manage through payment delays, ensuring our business relationship with them flourished and continued.”
Call for Federal Backstop
Even with the creative solutions, many businesses were left exposed to supply chain risk. According to a July report by consultant Robert Litan and economist Yong Xu, the impact of these decisions falls heavily on small to midsize companies with less than $20 million in sales. Sixty percent of these suppliers rely on trade credit insurance to offset the risk of unpaid receivables.
In response, U.S. retail groups sought a government backstop for trade credit insurance. “In normal times, suppliers can purchase trade credit insurance, but these are not normal times,” says Austen Jensen, senior vice president of government affairs at the Retail Industry Leaders Association. “To preserve their balance sheets, credit insurers have been forced to revise, reduce or cancel their insurance limits, causing dramatic cutbacks in coverage.”
The solution, according to 22 retail and consumer trade groups—Jensen’s included—is passage of the Trade Credit Insurance Act of 2020, legislation loosely based on similar federal backstop bills passed in Canada and in several countries in Europe to thaw frozen trade credit insurance markets.
The U.S. legislation would establish a temporary reinsurance program in the Treasury Department as a loss-absorbing backstop for participating insurers. The carriers would retain 10% of first-dollar claim losses, with the remainder covered by the federal reinsurance program. Paid premiums would be split along the same lines.
Although the Federal Insurance Office would assist the Treasury Department in administering the program, claims would be adjusted by participating insurers according to their policies’ coverage terms and conditions and in accordance with current claims procedures.
The retail groups had hoped the bill would be passed before the holiday season, but it wasn’t. “We went to the highest levels of government and said, ‘If you stand up a backstop on Tuesday, credit insurance will be available Wednesday, in time for the holidays,’” says Steve Lamar, president and CEO of the American Apparel & Footwear Association (another trade group lobbying for the Trade Credit Insurance Act). “Needless to say, we were disappointed.”
Nevertheless, Lamar says, with local and state authorities still shutting down businesses, the need for a temporary backstop remains. Lamar cites potential competitive ramifications. “A missed opportunity doesn’t mean this shouldn’t happen,” he says. “If a company is based in New Jersey and can’t get credit insurance, retailers will reach out to a company in France or Italy that has a backstop.”
A Warming Coming?
Nearly three in four companies plan major changes to their supply chains, due to production downtime and transportation slowdowns, according to a survey by Procurious. Nearly six in 10 companies have plans to localize their supply chains and bring manufacturing back home, where the risks are clearer.
Hartwig is optimistic the compounding miseries of 2020 will soon be in the rear-view mirror. “In this new year, we will gradually see a warming of trade relations around the world and a general economic recovery brought about in large part by COVID vaccinations,” he says. “Both will be very beneficial to the trade credit market.”
One hopes this is the case. Brokers could use the rest.
Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.