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  • 10.3.5-RISK AND THE RELATION TO TRADE CREDIT-CREDIT INSURANCE AS A (CREDIT) RISK MANAGEMENT TOOL

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  • Credit insurance as a (credit) risk management tool

     
     
    Credit insurance is provided by specialised companies that assess the credit risk posed by an importer's (or roaster's) individual clients, particularly those requiring extended payment terms. Especially smaller companies cannot afford the risk that a client fails to pay for goods delivered whereas their own banking (overdraft) facilities may also be dependent on having adequate credit insurance in place. Credit insurers in turn place limits on the amount of credit that can be insured for each individual buyer but, particularly in times of economic uncertainty, such limits can suddenly be sharply reduced or even withdrawn altogether. In such a situation, smaller importers/wholesalers, which rely on the security of the insurance, may have to either stop supplying altogether or demand cash upfront.

    Usually, credit insurers require an importer to take out cover for all his clients - in other words: all or none. Whether to insure or not will depend on the type of business that is conducted and the premium required. If the great majority of clients are top roasting companies then the cost may not be warranted, or simply becomes too high. Cost would appear to be one reason why the use of credit insurance is not widespread in the United States coffee market although it is used in the specialty segment. In Europe it is however fairly widely used, but mostly amongst smaller companies which do not normally sell (regularly) to the majors. Usually, the cost is relatively modest whereas for many importers/traders the willingness of a credit insurer to cover a (potential) client is a good indication of that client's financial standing. This is particularly important now that many smaller roasters demand extended credit terms. *

    Why is the availability (or absence) of credit insurance important?

    Here one has to differentiate between the two value chains. Coffee is mostly retailed through two separate market segments: supermarket chains and individual outlets as coffee shops etc. Furthermore, especially for smaller operators bank finance and credit risk are irrevocably linked with most funding being conditional on having adequate credit risk insurance in place.

    Supermarket chains are mostly serviced by the major roasting companies who in turn rely largely on trade houses for their green coffee supplies. Over time the tendency on the part of supermarket chains to demand ever more credit from suppliers has notably intensified. This in turn means similar demands from major roasters. For example, instead of buying on the basis of 'cash against documents on first presentation', some of the majors now buy green coffee on the basis of 'payment on arrival', thus shifting a substantial financing burden on to their suppliers. Whilst accepting that major roasters present little or no credit risk, this shift still obliges potential suppliers to find the additional funding this necessitates. Major operators will find this easier than will their smaller counterparts, some of who may be unable to compete because they cannot raise the extended finance. **

    Smaller roasters and coffee shops (particularly specialty) are largely serviced by importers/traders and wholesalers. The provision of credit has always been an accepted way of doing business in this segment. This is particularly so in the specialty business where most small roasters expect to receive 30 or more days of credit from the date of delivery. However, when the economic climate worsens, as was the case in 2008, so does the availability of finance - even medium sized roasters started looking to their suppliers for additional credit by way of later payment, also because their own clients were seeking extended credit terms. Again, larger trade houses may deal with this more easily with this kind of situation, for example by channelling their specialty and smaller client business through separate companies that can afford to take out cover for all their clients.

    For smaller operators selling on (extended) credit is not really advisable without credit insurance, whereby the insurance company insures the risk that a buyer will not pay for goods received. This is central to the functioning of almost every retail supply chain, so also for coffee. Without access to adequate credit insurance many smaller importers/wholesalers may be unable to trade freely. And, if credit insurers experience underwriting losses then the likely reaction is to reduce exposure. At times by cancelling individual buyer coverage altogether! If that happens an importer may have to retreat from certain types of business and/or clients, irrespective of the availability of bank finance. ***

    Factoring

    Providing extended credit of course constrains one's liquidity, i.e. funds that are tied up in credit to buyers cannot be used for new trading. It is important to note here that credit insurance does not improve one's liquidity - the insurance only comes into play if a buyer defaults.

    Factoring is one way around the liquidity problems associated with extending credit. It is the selling at a discount of a company's receivables (outstanding invoices) to a third party, the factor, who advances most (but not all) of the expected proceeds immediately, and pays the balance once the buyer in question has settled the amount due. Of course this is at a cost but the availability of the released funds for new business, i.e. the improved liquidity that is generated, probably offsets most if not all.

    *It is important not to confuse credit insurance with credit lines. The first refers to insuring the risk a buyer does not pay for goods received – the second refers to the amount of credit (or overdraft facility) a commercial bank is prepared to provide to an importer or trader.
    **See topic 04.02.07 for a review of payment conditions.
    ***It is important to note that credit insurers of course do not reduce or cancel individual client limits without reason. General reductions may be linked to a deteriorating economic climate in the sector concerned whereas individual reductions may be because of information received or obtained. For example for privately held companies from annual accounts lodged with Chambers of Commerce or similar such institutions.

    NB: This text has been developed from Q&A 221 that was posted in May 2009 on www.thecoffeeguide.org.