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Trade credit insurance - why you need it, how to choose the right cover and how to make it work for you

From 2000 to 2010, six of the world's 10 fastest growing economies were from the Sub Saharan Africa (SSA) region. The African Development Bank has handed out over US$1 billion in the past two years with the explicit aim of boosting intra-Africa trade. The message from the Africa 2016 CEO Forum which took place recently in Cote d'Ivoire was that there needed to be a focus on infrastructure development.

Recent forecasts place SSA economic growth at just 2.9% this year and the IMF is expected to revise its 2016 growth forecast for the region. That is not to say there are no opportunities as the figures reflect the slowing growth in the Nigerian and South African economies which have a significant impact on the economic growth figures for the SSA region. There are SSA countries where reasonable growth is expected, for example, Ghana, Cote d'Ivoire and Kenya.

It is widely recognised that African economies need to create a more robust economy by diversifying. Whilst there are a number of barriers for intra-Africa trade, such as inconsistencies in tariffs between countries, the single major issue which is discussed repeatedly as holding back trade (whether intra-Africa, or with countries around the globe) is the lack of infrastructure. Air transportation is expensive, many products are not suitable for ship or road transportation due to their relatively short perishable lives and in any event there is often a shortage of road systems and transportation routes to transportation hubs, such as ports. Furthermore, rail transportation is often not an option, again because of the lack of rail infrastructure, although in some jurisdictions in SSA large projects are ongoing to establish a rail network, or in the first instance rail links between commercial hubs.

The African Development Bank Group has assessed that Africa's infrastructure financing needs are estimated at US$95 billion per annum. The annual investment currently being made into the African continent is estimated at US$45 billion providing a significant financing gap of US$50 billion.

Insurance and reinsurance can have a significant influence on a number of vital components required to boost commerce: the availability of financing; the de-risking of the large projects required to develop infrastructure networks; and, the development of trade and commerce around the continent (as well as globally). Recently we have seen deals signed between UK Export Finance (UKEF), an export credit agency, and African Trade Insurance (ATI) to boost exports to Kenya. The aim is for UKEF to share risk with other ATI-member countries in order to increase risk capacity for projects in African countries sourcing goods and services from the UK. Whilst this is an example of the continued growing interest in the African continent internationally, there also needs to be a focus on trade in the reverse direction, i.e. from Africa to countries around the globe. Again, insurance and reinsurance can play a key role.

From the investment perspective, lenders will often require insurance to be taken out to safeguard their investment. Projects need an array of insurance products to protect property, the risk of delays leading to delayed completion and profits, and public/environmental risks.

Insurance is a key management tool for trade and commerce, enabling businesses to pursue ambitious business strategies by lowering the risk of counterparty default. By reducing the risk of a particular transaction or investment, insurance is a tool which can help drive forward business strategy for those engaging in intra-Africa trade as well as enable international businesses to further their commercial ambitions, for example by expanding their trading reach to the African continent or further developing an existing strategy within the continent.

When considering insurance products relevant to trade and commerce, a few products come to mind, such as cargo, political risk, trade credit insurance. This briefing specifically considers trade credit insurance. There are a number of variations to this type of insurance product which can be utilised to map into specific risk requirements. It can insure against the likes of protracted defaults; insolvency of customer; defaulting letters of credit; defaulting counterparties; political risk; pre-export finance; export finance cover; and, contract frustration.

How does trade credit insurance benefit policyholders? Not only does it provide balance sheet protection (especially cash flow) against counterparty default, it promotes corporate governance as well as importantly supporting the business in seizing new opportunities. Furthermore, trade credit insurance can also improve financing terms of investment.

For many years the only products available were off-the-shelf, standard trade credit insurance products which did not necessarily accurately reflect a policyholder's risk profile. However the growing capacity in developed insurance/reinsurance hubs has presented the more traditional insurance products on offer with competition. A surplus of capacity in the London market has meant that insurers have had to adapt in order to compete. This in turn has had a significant effect on the development of policy wordings. Insurers are now far more sophisticated and prepared to offer bespoke wordings which map into the risks of businesses.

From our experience of acting and advising on insurance and reinsurance matters, including trade credit insurance, the following are, in our view, the key considerations when purchasing a trade credit product:

What kind of risk are you seeking to insure?

If you are seeking the traditional, whole turnover cover then a standard off-the-shelf product may be sufficient. However, if you are seeking to insure a complex, one off large transaction, or your business transactions vary from the norm you may need to consider a bespoke policy with the terms mapped into the specific, unique risks faced.

Are there any pre-qualifying requirements?

In trade credit policies policyholders often need to comply with conditions which ensure that the sale or transaction comes within the terms of the policy. Non-compliance with these conditions will provide an insurer with the opportunity to refuse to indemnify a loss. Pre-qualifying requirements can include the following:

  • Credit limits

    In the more usual whole turnover policies, credit limits will be set for particular customers/counterparties. This effectively limits the insurance provided for transactions with a particular customer. If the credit limit is exceeded, the policy will only provide cover up to the amount of the credit limit. Credit limits can often be withdrawn or varied at short notice so policyholders should regularly review the credit limits and compare them against the amount of business being transacted with a particular customer to ensure that there is no risk of uninsured exposures.

  • Retention of title clauses

    There could be a requirement for policyholders to include retention of title clauses in their contracts with their customers/counterparties. On a commercial level this can cause difficulties where a counterparty is based in a jurisdiction in which it may be difficult to enforce such clauses. Policyholders may want to consider negotiating with insurers to have this requirement removed or a watered down obligation included in the policy or for the obligation to apply for certain customers/counterparties. However this may require the payment of an increased premium to reflect the heightened risk to insurers.

  • Geographical limitations to the cover

    Trade credit policies usually contain limitations and exclusions in relation to providing services or the selling of goods to counterparties in certain territories. A policyholder needs to be alive to such limitations and exclusions. Sufficient due diligence on the transaction and parties in question is essential to minimise breaches of such exclusions or being caught out by such restrictions.

  • Pre-qualifying warranties

    There are often warranties in the policy that have to be complied with in order for a risk to attach. In one dispute we advised on, the requirement in question was a warranty confirming that the debt could be pursued against the counterparty in their jurisdiction. When faced with such warranties an insured needs to be aware of the local laws in the counterparty's jurisdiction and, where required, should obtain a legal opinion confirming what recovery options are available before agreeing to provide such confirmation. Where a counterparty is affiliated to or is part of a government entity (or is a government entity) consideration needs to be given as to whether that entity is immune from prosecution in their jurisdiction.

The above are only a few examples of the kinds of pre-qualifying requirements which might be found in trade credit insurance policies. They illustrate the importance of ensuring that a policyholder's business practices comply globally with its insurance requirements in order to ensure maximum cover under the policy.

What are the reporting obligations?

Trade credit policies can often require the policyholder to adhere to onerous reporting and notification obligations. For example, in protracted default situations there is often the requirement to notify insurers that payments are overdue by a certain time – often 90 days and invariably before "the waiting period" expires. Whilst this may not at first appear to be a difficult process to manage, when managing the payment of invoices on a broader scale, say nationally or across jurisdictions with various counterparties, obtaining the correct information in good time in order to comply with tight notification and reporting obligations can cause difficulties in maintaining insurance cover.

Other reporting triggers can include the policyholder becoming aware, or suspecting, that a counterparty cannot perform their terms of the contract. In addition a policyholder can be required to report to insurers as soon as they become aware of unfavourable information concerning a counterparty, be it financial or reputational.

Where requirements are vague or uncertain, a policyholder should clarify what exactly is meant by them. Coverage disputes can be minimised if both the policyholder and insurer know from the outset what is expected or meant by a particular provision.

When considering reporting obligations, a key question is whose knowledge triggers the obligation to report? The policy should specify this and a policyholder should ensure that it fits with its business practices to ensure it has sufficient time to notify within the terms of the policy and with sufficient detail as may be required.

Obligations to prevent and minimise loss

Invariably there will be obligations requiring a policyholder to prevent and/or minimise loss. Often the requirement is for the policyholder to take "reasonable steps". In recent years we have seen a number of disputes between insurers and policyholders regarding what is "reasonable". This often depends upon the jurisdiction in which those steps are being undertaken and the availability of legal remedies against the counterparties. Under English law, for example, a policyholder may take into account its own commercial interests when deciding if a step is "reasonable" to prevent/minimise loss.

Trade credit insurers are often prepared to contribute to the policyholder's costs of taking reasonable preventative or mitigating action. However, they will usually require advance notice of what steps are contemplated. Therefore policyholders should always consider whether insurers need to be informed or their consent obtained before any action is taken. A strategy of re-issuing invoices or accepting the payment of lesser amounts in satisfaction of the whole debt can cause coverage issues. The re-issuing of an invoice can have the effect of taking it out of a protracted default situation thereby not triggering any conditions/insuring clauses in the policy required to be met before an insurance claim can be made. Accepting a price/payment reduction in satisfaction for the original debt means that there is no debt and therefore no loss for the insurance to indemnify.

Policyholders should also be wary of waiving any rights and ensure that they preserve all subrogation rights against third parties. If there is an intention to agree to a full and final settlement with a customer/counterparty, this should be agreed with insurers first.

Other coverage issues

Other issues which may arise and which need to be borne in mind include:

  • Disputed receivables

    Cover under trade credit policies will often be suspended for a particular loss pending the resolution of a dispute over an invoice, the services provided or the products provided (for example if there is a dispute over whether a product is defective or not).

  • Collation and provision of documents to support a claim

    There are often deadlines within the policy by which the policyholder is required to provide documents to support its claim. Policyholders need to ensure that their internal procedures are consistent, nationally and internationally as well as across business units, to enable the obligation to report to insurers to be met and to ensure all relevant documentation can be provided in time.

  • Insured loss

    The policy usually sets out how the insured loss is to be calculated. This can be by reference to a particular date on which the loss will crystallise. The date at which the loss crystallises can have a significant impact on the amount of the loss to be indemnified under the policy. Also, clauses in the policy may vary as to how recoveries that post date the crystallisation of the loss are dealt with.

  • The Insurance Act 2015

    If your insurance or reinsurance contracts are governed by English law, then you cannot ignore the effect of this legislation which comes into law on 12 August 2016. I first commented on the effects of this legislation in my briefing note "The importance of risk transfer and reinsurance" which was posted to the Group back in February. We will of course provide a more detailed briefing closer to August 2016 but if you do have any queries now please do contact me (graham.denny@hfw.com).

Comment/Practical Considerations

Trade credit insurance can be used holistically, alongside other insurances such as political risk and cargo insurance to provide a business with seamless protection.

In handling policy disputes and undertaking policy reviews for clients, it has become evident to us that there is often a disconnect between how the policyholder thinks the policy operates and what the insurer intended. It is far better to address any queries and inconsistencies in the policy wording prior to inception to limit the chances of coverage disputes and in order to provide contract certainty and clarity.

Trade credit insurance is an extremely useful product and can be used to support a business' ambitions whether that is to lower the cost of financing; reduce counterparty default risk and thereby allow a business to increase its trading capacity; or allow a business to focus on new, less well known markets which may deliver greater profitability without the degree of risk which might accompany those markets. Whatever the focus or use to which you wish to put a trade credit policy, it is essential that the policyholder understands all the clauses in the policy to ensure they know what cover they are buying and what their obligations under the policy are. Importantly, the department purchasing the cover needs to ensure that the business or company's internal procedures enable it to comply with its obligations in the policy. Business units, whether national or international, need to be operating to the same procedures to ensure that notification or reporting obligations can be met.

For more information, please contact Graham Denny, Partner on +44 (0)20 7264 8387.

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