Bad debt insurance can help cut losses

By Robert E. Parmelee Senior Vice President American Credit Indemnity Co. Baltimore, Md.

lN THIS era of prolonged I economic sluggishness, protecting working capital from bad debts is a must. The possibility of a sizable bad debtwrite-off currently is greater than in any period since the depression of the 1930s. And the building industry is especially prone as it is an activity characterized as cyclical and presently in a slump in which extraordinarily high interest rates on mortgage financing and borrowing are serious problems.

A large bad debt write-off can cut sharply into cash flow and create cash need and borrowing need. Sometimes it can fatally damage a supplier/seller's capital base. The inability to collect trade receivables is a major cause of business failures, as the American economv is now witnessing.

One saf'eguard for the wholesaler and retailer of building products is to insure the business receivables.

Basically, bad debt insurance safeguards the supplier/seller's working capital from abnormal or excessive credit losses which can occur through failure of one or more large accounts, or a number of failures due to changing economic conditions. Credit extensions are guaranteed to the extent that they are insurable financial risks. The insured is reimbursed for credit losses in excess of the deductible, or normal expectancy. The "normal" losses from bad debts, or loss levels considered to be affordable, become the deductible. Typically, the premium expense ranges from 1/5 to l/3 of l9o of covered gross revenues or sales.

Credit insurance policies are flexible. My company, for instance, can provide monthly premium payment plans. Reinsurance facilities are arranged to facilitate covering very large risk exposures.

Businesses carry insurance on assets because these are company owned. Bad debt insurance of accounts receivable is actually insurance on inventory after the title passes to the purchaser. A new entity is created-an account receivable. When that has a guaranteed value, cash invested in the products is assured a return into working capital.

Properly used, bad debt insurance is an effective management planning and selling tool. When the supplier/seller of building products is assured of collecting, he can plan for production, inventory, cash flow, cash need and borrowing needs more efficiently. Additionally, the sales and credit functions can collaborate more effectively. Marketing efforts can be directed toward the guaranteed level of financial coverage surrounding the receivables.

Story at a Glance

Working capital is not tied up in seriously delinquent accounts. Turnover of working capital is enhanced. The policyholder's collections are strengthened. A better salvage of insolvent accounts is attainable. The supplier/seller's financial status is stronger because receivables have a known, guaranteed value.

Borrowing ability is strengthened, because the bank lender knows that receivables have a guaranteed level. Because loan security is enhanced, the bank credit line may be enlarged or interest rates lowered. The insurer's opinion is available on the creditworthiness of a particular account.

Some companies have a greater need for credit insurance because of vulnerability to abnormal credit losses. Theymay include those which: o Do business primarily in one region. o Confine marketing to a few customer accounts. o Are active in a significant specialty business. o Sell to companies engaged in one line of business. o Deal in seasonal products. o Are overly sensitive to an economic slump, or to an inflationary cost-pricing squeeze.

. Accept greater risks in order to maintain sales volume.

Baddebt insurance has been referred to as "sleeping insurance" because it promotes peace of mind when the credits guarantor is watching over the policyholder's accounts receivable and is ready to pick up the pieces if the worst should happen. It is better to have it and not need it, than to need it and not have it in an industry which is vulnerable to credit risks.