What is Credit Insurance?

Credit insurance is an insurance policy that pays a seller if a buyer does not pay an invoice. In effect, the risk of incurring a bad debt is shifted from the seller to the insurer. The insurer should be willing to provide coverage against customer nonpayment if a proposed customer clears its internal review process.

Advantages of Credit Insurance

Credit insurance offers multiple benefits. First, a company may be able to increase the credit levels offered to its customers, thereby potentially increasing revenue. Second, an international sale might normally be delayed while the parties arrange a letter of credit, but can be completed faster with credit insurance. Third, the insurance can cover the shipment of custom-made products, in case customers cancel their orders prior to delivery. And finally, credit insurance essentially shifts risk away from a business, so it is especially beneficial in companies that have an understaffed credit department that cannot adequately keep track of customer credit levels.

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Disadvantages of Credit Insurance

Credit insurance, while beneficial in many scenarios, has several disadvantages. Here is a list of potential drawbacks:

Cost. Credit insurance can be expensive, especially for businesses with a high volume of accounts receivable. Premiums may significantly reduce your profit margins.
Limited coverage. Policies often exclude certain types of risks or customers, such as high-risk buyers or industries.
Complex terms. Credit insurance policies can be complex and difficult to understand, with terms and conditions that may limit claims. Further, ambiguities in policy language can lead to disputes over what qualifies for a claim.
Administrative burden. Managing credit insurance requires ongoing monitoring of customers' creditworthiness and compliance with policy terms. Businesses may need to report regularly on their accounts receivable, which adds to their administrative overhead.
Deductibles. Most policies have deductibles, meaning the insured party must bear part of the loss, reducing the overall financial protection.
Dependence on insurer’s decision. Insurers may decline coverage for certain buyers or transactions if they deem them too risky. This can limit a business's ability to work with high-risk but potentially profitable clients.
Delayed claims processing. Claims might take time to process, causing cash flow issues if the insured party relies heavily on the insurance payout. Further, insurers may require extensive documentation and evidence, which delays settlements.
Encourages risk aversion. Businesses might become overly reliant on insurance to assess customer risk, reducing their incentive to develop strong credit management practices.
Not always necessary. For businesses with strong credit management systems or limited exposure to credit risk, credit insurance may not provide sufficient value to justify the expense.

Understanding these disadvantages can help you make informed decisions about whether credit insurance is a suitable tool for your organization’s financial risk management strategy.

Credit Insurance Best Practices

It may be possible to offload the cost of credit insurance to customers by adding it to customer invoices. This is most likely to be acceptable for international deals, where a customer would otherwise be forced to obtain a letter of credit to pay for a purchase. In this case, the customer will incur a lower cost by paying for the credit insurance. As is the case with all insurance policies, be sure to examine the terms of a credit insurance agreement for exclusions, to see what the insurer will not cover.