How Credit Insurance Affects Your Payroll Funding, Factoring, or Banking Relationships
Steve Capper – Flexible Funding - July 17, 2017
It’s exciting to land a new account that is large enough for you to make some real money. At the same time, it can be a bit frightening to know that if the same account ever turns into a bad debt loss, it can kill your net profit of the entire year, or even put you out of business. Accounts receivables credit insurance was invented to protect you from that scenario, but many have
learned that it comes with certain frustrations and limitations.
In many industries other than staffing, accounts receivables represent, on average, over 40% of a company’s assets portfolio. In the case of staffing companies, receivables represents the largest portion of the company’s assets–generally half to two thirds of total assets. So it makes sense that there would be some interest in knowing when and how to best utilize credit insurance.
CREDIT INSURANCE –PRODUCT CHALLENGES
Credit insurance policies are typically lengthy documents. It takes a credit insurer anywhere from a dozen to 20+ plus pages to say they will take on credit risk, and under what circumstances. A common restriction is the exclusion of all non-payment circumstances except insolvency. In other words, if somebody doesn’t pay solely because of insolvency, the insurance company will pay. It’s basically a guaranty. A policy can be twenty one pages–excluding the declarations page and excluding all the endorsements. Add those common elements and the policy now becomes twenty eight pages. Why does it take them twenty eight pages? Some knowledgeable people say “it is because they are determined not to pay you.” How many pages are there to make sure you get paid? Not many. As a result, many consider credit insurance a fragile product.
Consider a large company’s experience with filing a credit insurance claim. The process of getting the claim filed with the insurance company in a way that complied with the policy was difficult. This was a company with people who are careful, intelligent, and resourceful. They had resources of secretarial staff and analysts. The task was to get a claim on file; they spent a tremendous amount of time reading through the long boring policy line-by-line to comply with all of the deadlines and notices, keeping the insurance company apprised of every phone call and email with the debtor. Then, the debtor filed bankruptcy and they had to keep the credit insurer fully informed of that. It was all consuming just to get a claim on file, and here the debtor was insolvent and didn’t dispute anything–everything was by the book. Senior management had to review every report, every letter, every word of every e mail just to file a claim– they lived in fear of not meeting every fine detail of compliance. All along, they felt,”you should not have to live in fear… that is not what business is about –and it’s the opposite of what insurance should be about!”
A key problem with credit insurance is that the credit insurers pay you for losses related to credit (ie. inability to pay, insolvency, bankruptcy); they do not pay you anything at all on accounts with any invoices, even one invoice, that are disputed. Take note here–they will not pay you anything on the ENTIRE account, even all the good undisputed invoices for that account. We see dozens of disputed invoices every year, and the reasons for disputes are many and varied; conflicts about overtime pay amounts, minor travel expenses, work not performed perfectly in the subjective opinion of the staffing agency customer, minor property damage supposedly caused by the temp, erroneous workers compensation insurance classification codes, etc. The list goes on and on, and customers can get quite creative.
If you have twenty unpaid invoices outstanding with one customer and the customer will not pay one of them because of dispute, and, the credit insurer gets the hint that there is a dispute, counterclaim, possible right of offset–then the credit insurer will pay you nothing. You would think and hope that you could say to the credit insurer, “I don’t care about that one invoice, so let’s just set that one aside and you can pay me on the rest of the invoices.” Sorry, it doesn’t work that way. They will pay you nothing on anything with that account. The disputed portions may be very small, such as a hundred dollars, and yet it can hold up insurance payment on tens of thousands of dollars. What you might have to do is take a shortcut– sue your customer account to get the one invoice cleared up, or motivate the account to settle, so that the credit insurer will pay you on the rest. Unfortunately, court is rarely inexpensive or quick.
The BASIC credit insurance policy is for insolvency. If the account debtor becomes insolvent and unable to pay their debts AS DEFINED IN THE POLICY, then there’s coverage. If the debtor just closes it’s doors or disappears, then there’s no coverage.
Insolvency requires that the debtor admit in writing their inability to pay their debts, or a bankruptcy case, or an assignment for the benefit of creditors, or the court appointment of a receiver; there must be an overt objective act(s) of insolvency. Credit insurance does not always cover going out of business, closing doors, going dark–which often happens–when there are no overt acts of insolvency. Overt acts give you insolvency coverage, but what if there are no overt acts? One solution is that in some states you can start a lawsuit and have a receiver appointed to the business–in which case you have created the overt act.
When considering insurance, a credit insurance salesperson may offer, or you should ask for, something called “protracted default.” It increases the coverage to include mere non payment for slow pay reasons (ie. not paying you for X number of days–such as 90 days.) If all you have is an unpaid invoice for 90 days– no bankruptcy or other overt acts–you submit that and you get paid.
Besides the basic trade receivables policy, there are custom policies available that will insure for additional events such as economic downturns, seasonal business cycles, natural disasters, geopolitical events, defaulted payments due to change of ownership, damage to the accounts receivable records, etc. But as with protracted default policies, the more you purchase the more you must pay for.
In most of these policies there are other limitations one must be aware of:
- Understand that if you are insured and there is a covered bad debt loss, they will not be reimbursing you for 100% of the loss. More typically, they will be insuring you for 90% of the original loss A/R amount after a 60 day collection period. In addition, a small percentage of collected monies may apply IF anything is ever collected.
- Credit insurance polices usually have an annual deductible, and a per loss deductible or co-payment.
- There may be a minimum loss level under the policy….there can be an exclusion for losses below a certain dollar amount.
- Insurer reimbursements for losses can be fast, or slow, depending on the fine print of the policy. An insurer could pay within 30 days when a customer files for bankruptcy. Or there can be a lengthy delay period for a bankruptcy court to go through its processes and render it’s verdict before you get paid.
- Amounts outstanding before the effective date of the policy will not be covered.
- There will be a deadline for filing a claim, such as 240 days after the due date.
PAYROLL FUNDING AS A COMPONENT OF CREDIT INSURANCE
There are three reasons you would have a credit insurance policy on your debtor accounts. First is that you just went out and bought it yourself. You would purchase it on your own directly from a credit insurance company or through a credit insurance broker.
The second reason is that your payroll funding company, bank, or lender required it of you, and the lender required you to name them as a loss payee under the policy. If the funding company is a loss payee and the insurance company says they must pay somebody on the loss, they will pay the funding company. Being a loss payee gives the lender no rights against the insurance company. It may give them limited rights to be notified if the policy is amended or terminated. Or, the payroll funding company could be named under some credit insurance company endorsement that says they have a “factoring endorsement,” in which case the funding company will have all of the rights of the insured under the policy.
Anytime there is a payroll funding or lending relationship (whether you buy the insurance for the first reason or the second reason) the A/R insurance company should be informed whether your accounts receivable funding is on a recourse basis or a non-recourse basis. When the funding is on a recourse basis the funding company charges a price for the time it takes for the customer to pay, but if the customer does not pay it is charged back to the funding company customer–you the staffing agency. In non- recourse funding, there is no recourse to the staffing company when the staffing company’s customer account doesn’t pay–the funding company ends up taking the loss. These distinctions can make a difference in how the policy is written.
The third reason you would be covered by credit insurance is that your lender has bought a policy on the accounts (where you and they are effectively insured.) In the third case, you may not even know you are covered in any way.
Accounts receivables credit insurance can affect or modify your relationship with your bank, payroll funding company, or factor in a number of different ways.
- It may increase your available loan amount with the lender when you have a large concentration customer in your customer base. A bank for instance may only fund a portion of your receivables from an account debtor, or completely eliminate that account debtor from availability, as soon as that customer represents 20% or more of your entire customer base. With credit insurance in place they may agree to increase the concentration level to 30%, or some other higher level
- If you take a significant bad debt loss, it might be that you violate one or more of the loan covenants/rules in the payroll funding/financing agreement, in which case you go into default and lose ALL of your funding on everything. Or, you may have to pay a much higher rate to the funding company while on some type of default probation. So, insurance may improve some terms of violation and default.
- Insurance can allow you to sign up new customers that you would not normally take on. In funding programs where the availability is regulated primarily by the amount of credit worthy invoices, and the funding company has a higher level of comfort because of the insurance policy, it may provide a larger borrowing base. Regarding the existing customer account debtors that you already have, the reduction of risk provided by an insurance policy may motivate your lender to allow a larger advance rate on them or allow accounts to be outstanding for a longer period of time before charging it back to you.
- A lot of companies effectively self-insure against bad debt losses by keeping a bad debt reserve on their balance sheet in recognition of the fact that at some time in the future a customer will default on payment or declare bankruptcy. Banks often require that a bad debt reserve be kept on the company balance sheet. When an accounts receivables insurance policy is purchased, the company may be able to significantly reduce, but not eliminate, it’s bad debt reserve. When determining how much the bad debt loss reserve can be reduced, keep in mind that some account debtors will not qualify for the amount of coverage requested and others will not be approved at all. Also, a company may elect to only protect a portion of their accounts receivables. For example, in a “key buyer” policy, the coverage is extended to a single business entity rather than insuring an entire pool of accounts receivables (known as multi-buyer insurance).
If you purchase the credit insurance yourself and don’t tell your funding company, or tell them after the fact that you have purchased a policy, you may miss out on some of the above funding company benefits or concessions. On the other hand, a funding company may provide no benefits at all because of all the previously discussed compliance difficulties.
One might think that funding companies would spend huge sums on credit insurance, but they do not. Payroll funding companies gauge credit every day, therefore they get very good at it. It is their full time job. They have designated people to monitor accounts, and large budgets for reporting bureaus. As a result funding companies do not often take large hits, or losses, for credit reasons. Funding companies take greater losses for reasons of fraud, embezzlement, and criminal activities–and credit insurance does not cover any such circumstances. It would be the same if you purchase insurance on your own account–any criminal activity whatsoever and the insurer will not pay. Payroll funding companies also know how difficult it can be to get paid by a credit insurer given account debtor disputes, policy exclusions, deductibles, compliance requirements, etc.
Although a funding company may not actually insure many or any accounts receivables, they may have a client relationship with a credit insurance company, which can be useful to you. The main sources of business credit information are the credit bureaus Dun & Bradstreet and Experian Credit. But even those two sources may not be enough to safely rely on when you are risking large amounts of money and are extending credit to a concentration account. For safety, you may be inclined to purchase credit insurance.
A credit insurer may have more detailed data on a company, and more experience with an account, than D&B and Experian Credit. The first questions to the credit insurer should not be, “will you insure this account and how much will it cost, and can we have the application to apply?” The question to be asked is, “if you were to insure this particular account, how much would you insure it for?” A funding company with a credit insurance company relationship may be able to easily get this answer online from the insurer. The credit insurer may report that the account is good or insurable for 250K, even though D&B may indicate that the account is only good for 100K. At that point you are in a better position to make the call as to whether or not to purchase credit insurance. Or, whether or not you decide to insure, the information may be valuable in making the decision on how much business to do with this potential client.
ASSISTANCE IN OBTAINING CREDIT INSURANCE
It would be great if you could call up a credit insurer and say, “I have one large account for X dollars and how much would it cost to insure and how much coverage will I get?” It’s not always so easy. The paperwork that you must fill out to apply and qualify for credit insurance can take quite some time. Financial controllers, accounting or credit professionals may see at as a simple task, whereas an overloaded business owner or time-challenged office person may view it as a tedious and difficult burden. For those who might find the process of application for credit insurance overwhelming there are two possible assists. Your payroll funding company may help. If you have used the funding organization for a few years, they may already have in their database a lot of the numerical and loss information needed for the application. For some of our own customers who wished to purchase credit insurance on their own accord (not because we required it), Flexible Funding has helped put the necessary information on a silver platter for the credit insurance companies.
An experienced and hardworking credit insurance broker can help prepare and submit buyer credit applications to underwriters for review. Later down the road, they can also help guide you through the claims process for a resolution of your claim. The type of information you must provide and the type of questions that may need to be answered include:
- Client list with complete names, addresses, phone, and desired credit limit
- Annual sales, net sales, and bad debt loss information (number of bad debts and dollar amounts, names and addresses) for the past three years–current year to date, three most recent full year’s results, worst loss over the last five years
- Current summary aging (descending high to low by open balance)
- Estimated total outstanding receivables in peak months
- Forecasted net sales in the next twelve months
- Whether you factor, finance or do payroll funding
- Whether you currently have any insurance coverage or are currently negotiating for it, or whether you have had a credit insurance policy declined or cancelled in the past two years
- A/R balances for the four prior quarters
- Terms of sale going forward, Longest terms of sale
- Original terms of sale, invoice date, full account balances, amount over 60 days reasons for past due.
- Entire current accounts receivables aging details broken down in various ways; for example, listed by dollar amount ranges such as $0 to $2,500, $2,501 to $5,000, $5001 to $10,000, number of active accounts in each range, exact dollars outstanding in each range, percentage of total in each range
- Greater details on debtors with undisputed amounts more than 60 days past due under the original terms of sale, or that you have reason to believe will become 60 days past due or end up on a payment plan
- Detailed description of the services you provide
- Most recent financial statement
- Your gross profit margins
Details on your credit management policies and practices. When do you place accounts for collections with outside collection agencies? When and under what circumstances do you stop servicing an account? Does your company have formal credit and collections procedures?…(Provide written credit policies and procedures manuals.) Documentation showing how orders are received and processed… invoices, proposals and contracts. What information do you use when establishing and reviewing credit limits? At what intervals, or on what basis, are credit limits or financial information reviewed and updated? Do your make personal visits to see clients? The names, titles, and work status (full or part time) of persons in your company who are in charge of the credit management process, and others who may assist in the effort.
ACCOUNTS RECEIVABLE CREDIT INSURANCE CONCLUSION
Business consumer credit information on trade receivables credit insurance is extremely limited in that a basic web search turns up only benefits and insurance company sales pitches. It is true that this insurance can be a lifesaver for a business. Hopefully, the real-world challenges and strategies shared in this article can help you make the most of these products and provide a reality check on your expectations for them.