Credit in the Crisis
Trade receivables portfolios are often the largest asset on a company’s balance sheet. Yet they are frequently not considered as an asset class for captives. This is typically because credit insurance is viewed as a ‘discretionary’ rather than fundamental to a company’s operating business, like marine, property and casualty lines. Sometimes this exposure mismatch can be a problem in that the capitalisation demands on the captive outweigh any of the potential benefits. Another obstacle to covering credit insurance through a captive is that it is a cyclical risk and, therefore, slightly different to the more random hazards often covered.
Historically, credit insurance has been an administrative product, with credit limits issued on the individual buyers. It has required regular turnover declarations to determine the level of premium and on-going due diligence requirements under the underlying policy. Stuart James, Ace global head of trade credit, says: “This activity can make the product appear ‘live’ compared to other lines of insurance. In reality, the complexity is handled by the insurer and the operational companies have no additional burden.”
Evan Freely, the global head of political risk and trade credit for Marsh’s insurance practice, says that when writing credit insurance into a captive, complications include setting a large number of credit limits, the potential for noncompliance and pricing. However, putting credit insurance through a captive can benefit the company. James says: “We have seen captives used to absorb the first loss deductibles required by the insurer. This effectively transfers the risk from the line company to the captive. Where there is an existing captive programme, trade credit provides an important diversification in asset classes within the captive.”
Freely argues that captive programmes are helpful in consolidating a trade credit programme, because not only can a company push out consistent credit and claims procedures, but it can also understand pricing and charge pricing back to subsidiaries in a global programme.
Perception and knowledge
A major obstacle to this is “a lack of understanding of what the risk is and the volatile nature of credit risk or the perceived volatile nature,” Freely argues. “That’s probably amplified in the last few years given the credit crisis we’ve just gone through.”
“PREMIUM RATES WERE NOT MOVED ANNUALLY IN-LINE WITH THE EXTERNAL MARKET, THIS HELPED STABILISE RATES THAT WE WOULD CHARGE OUR BUSINESS LINES”
Simon Shaw is the building products worldwide credit manager of Pilkington, a subsidiary of NSG, one of the world’s four largest glass manufacturers. He switched the business’s credit insurance to a captive programme in 2003. He previously insured all of the company’s credit sales with external insurers: the company had a number of insurers around what used to be a European business, in the UK, Germany, Italy and France. “Premiums were significantly higher than claims and, once premiums were paid, the money flowed externally from the group. The insurers were also taking virtually all the risk of buyer default by applying policies with both low first losses and low discretionary limits. This created a large amount of administration with little added-value benefit to the group or business lines,” says Shaw.
Companies that write trade credit through their captives are generally corporates with a large receivables book. They are corporates with hundreds of millions rather than tens of millions.
They tend to have a global profile and pretty astute credit management processes and credit management teams. The receivables pool is generally part of the financing arrangement. Due to this rather niche description that has permeated the trade credit captive market, it makes covering credit insurance with a captive a rarity. Therefore many captive owners are unaware of the benefits a captive can bring.
Shaw says: “As rates have increased, because insolvencies have increased, we’ve managed to keep rates at realistic levels and allowed reserves to be accumulated and retained by the captive. When the economic crisis started to unfold in 2008, the reserves meant rates could be maintained at existing levels, at a time when business lines would otherwise have faced steep increases in premium payable.” Shaw even managed a small reduction in rates last year as reserves had been built up in the captive since 2003.
Undoubtedly, as the economy faces a tough few months predicted for the first quarter of 2012 insolvencies will increase. Andrew Child, leader of trade credit at Aon, says hybrid solutions marrying
a credit insurance policy with a captive to best suit a company’s needs are going to become more popular. “Instead of moving away from credit insurers all together and having a captive, but having catastrophe credit insurance. “They do get some insight into the credit insurers bank but at the same time shifting some of that premium away into their own captive so they can manage it,” he says.
Shaw did exactly this with his captive. He wanted to bring the risk in house and insure it with one insurer and have one underwriter to work with it all. “It was actually quite successful from 2003 up to 2008. The business was all with Atradias. There were clear advantages provided by the initial captive programme. We had more flexibility in setting premium rates so there was less fluctuation year on year. Premium rates were not moved annually in-line with the external market, this helped stabilise rates that we would charge our business lines giving them more surety when planning two to three years ahead.”
In 2009, Pilkington shifted the business from Atradias to Chartis. Shaw says: “We already had a captive in place that was providing property and asset insurance to the business lines. After several proposals were considered Atradius was selected as the external insurer to provide the catastrophe cover to the captive.”
Many companies do not have a consolidated global view on how credit should be purchased, says Charles Winter, global risk consulting leader at Aon. “It is often purchased country by country, but a captive often makes the most sense once you have a consolidated global view on a risk. Then you can start to build around that with critical mass and spread of risk for example,” he says. Freely adds that leveraging purchasing with the carriers is an issue because if you allow the carriers to price and negotiate locally they can potentially divide and conquer. He argues you need to look at the overall relationship and look at economy of scale benefits.
Pilkington’s Guernsey captive, Pilkington Insurance, was initially set up just to cover the European business, as a UK company (Pilkington plc). In 2006, Pilkington was taken over by the Japanese company, NSG. Shaw says: “Implementing the new policies into the Japanese and particularly US markets with meaningful levels of cover would have been extremely difficult and expensive given the then-prevailing economic climate. The performance of the European policy and the recognition by the insurer of NSG’s internal controls, made implementation of further policies possible at realistic rates.”
Shaw started a North American policy in mid-2009. The situation was problematic as few insurers wanted to invest in the American market. Shaw always looks for a minimum of 85% cover on the top buys. This was only achievable through the use of the captive at the time. Pilkington was outsourcing its catastrophe insurance programme to Atradias, until 2009 when it switched to Chartis. “Almost three years later and policies are now operating in Europe, Japan, North America and South East Asia, providing the business lines with buyer cover in excess of 90% of all credit risk.” Shaw has been satisfied with Chartis, but is still looking to improve the overall risk that the captive is subjected to and cost structure that’s been associated with it by implementing separate policies over three regions.
Although software for trade credit has not taken great leaps forward in the past year, Aon’s Charles Winter, says: “There now exists the technology to do the job which wasn’t there 18 months ago. It just needs the take up.” Simon Shaw of Pilkington uses Chartis’ Global Limit Manager (GLM) software, which has been implemented whenever they have been using European SAP-based systems. “GLM calculates the available insured limit based on trading experience and certain risk parameters, avoiding the continuous review of limits, useful when you have thousands of customers,” he says. “There were implementation issues but these have now been resolved and we plan to roll the system into North America this year.” Unfortunately Shaw won’t be able to implement GLM in Japan for the foreseeable future as they do not have a Japanese SLA system.