Chapter 1 – What Is Trade?
In order to write a book on Trade Credit Insurance there should be a clarification of the wording of the subject. This book starts with short descriptions of Trade and Trade Credit Insurance.
Today, the term ‘trade’ is used for transactions that involve multiple parties participating in the voluntary negotiation and exchange of one’s goods and services for desired goods and services of another party. The advent of money as a medium of exchange has allowed trade to be conducted in a manner that is much simpler and effective compared to earlier forms of trade, such as bartering, which is the act of trading goods and services between two or more parties without the use of money.
Trade has evolved considerably over time; however, the basic elements of buying and selling in some form of a market have not changed, because ultimately, trade still involves transferring the ownership of goods from one person or entity to another.
Absolute and Comparative Advantage
One of the major benefits of trade was described by Adam Smith in ‘An Inquiry into the Nature and Causes of the Wealth of Nations’. First published in 1776, this theory states that free market economies are more productive and beneficial to their societies and that nations can only benefit from one another if free trade is practised. The main argument here is that a country can produce goods or services at a lower cost per unit than the cost at which another country produces that good or service.
Later in 1817, David Ricardo described in his publication ‘On the Principles of Political Economy and Taxation’ how two countries, or any kind of different parties, can both benefit from trade if, in the absence of trade, they have different relative costs for producing the same goods. David Ricardo illustrated the importance of comparative advantage in an example involving the trade of cloth and wine between England and Portugal in order to describe how productivity levels dictate the patterns of trade.
Whilst profitable gains from absolute advantage may only be beneficial to one of the trading parties, comparative advantage explains that every country can gain from trade.
International trade allows economies to use their resources – whether labour, technology or capital – more efficiently. Because countries have different assets and natural resources, some countries may produce the same goods more efficiently and therefore sell it more cheaply than other countries. In other words, trade determines a country’s import and export structure.
The conclusion drawn is that free trade exists due to specialization of skills and division of labour in areas where different areas have the highest comparative advantage in the production of a number of tradable commodities. However, since productivity levels do not remain constant but are rather influenced by a learning process based on experience, dynamic effects of specialization on comparative advantage should not be neglected.
Trading Globally To Increase Efficiency
Trading between different regions or countries has been common for thousands of years. International trade is the exchange of goods and services across borders. If a country cannot efficiently produce an item, it can obtain the item by trading with another country that can. Without international trade, nations would be limited to those goods or services that can only be produced or provided within their own borders.
Basically, free trade has to lead to international division of labour and therefore to interdependence between countries. This type of trade gives rise to a world economy in which prices arising out of supply and demand affect and are affected by global events.
International trade not only results in increased efficiency due to comparative advantage but also allows countries to participate in a global economy, encouraging the opportunity of foreign investments. As a result and in theory, economies can grow more efficiently and become more competitive economically. In principle, countries where foreign investments are made show a rise of employment levels which eventually leads to an increase in their gross domestic product. On the other hand, investors benefit from market expansion and growth; thus translating into higher revenues.
In this sense, there is a causal connection between economic growth and international trade as the specialization of countries on its ‘core competencies’ and the exchange of goods traded internationally increase global productivity and the variety of products available for consumption.
In times where nations did not exist, international trade meant trading over long distances. In this period of history, trade was very similar to today’s concept of international trade.
Trading between different parties likely goes back to pre- historic times when goods and services were bartered before the beginning of civilization. Polished stone axes, ornaments of amber and shell, and copper or bronze implements, for example, have been assumed to be primitive valuables and have been used to infer incipient social ranking since the Neolithic Age (from 9500 BC).
In ancient times, Arabian nomads carried out long distance trade by camel caravans to the Far East bringing spice and silk to Europe. The Egyptians travelled through the Red Sea trading spices from Arabia.
In the Middle Ages it is worth mentioning the Abbasid Caliphs who used Siraf, Alexandria, Aden and Damietta as ports to travel into India as well as into Chang’an, the Chinese capital of the Tang dynasty that was regarded as the eastern depot of the Silk Road to China for the purposes of trade.
It was also during the Late Middle Ages that the Hanseatic League secured trading privileges and market rights in England for goods from the League’s trading cities in 1157.
In early modern times the Portuguese established trade routes from Europe to India and Japan and Vasco da Gama became one of the major figures in the history of international trade. It was also in this Age of Discovery, in 1602, that the Dutch East India Company was established to carry out trade in Asia.
As time went on, the development of international trade continued to progress. More and more countries were involved in trading networks and eventually in the 19th century the first trade agreements were signed between different nations. The Free Trade Agreement sealed between Britain and France in 1860 set off successive agreements between other countries in Europe.
The further liberalization of international trade may be characterized by the formation of Free Trading Areas (FTA), customs unions, common markets or economic integrated regions.
In 1958 the European Economic Community (EEC) was established with a common commercial policy, and thus this was the first example of both a common and a single market in the 20th century. Although in earlier centuries there had been predecessors such as the United States of America and the Latin Monetary Union, the EEC additionally had a customs union.
The World Trade Organization
In 1947 following the end of World War II, 23 countries agreed to the General Agreement on Tariffs and Trade (GATT) to guarantee free trade.
In 1955 the World Trade Organization (WTO) officially replaced the GATT. The WTO is an organization that offers a stable system for governments to achieve their goals in trade by supervising and liberalizing global trade.
The main functions of the WTO consist of the implementation, administration and operation of the voted agreements. It serves as a platform for negotiations and settlement of disputes and provides assistance for developing, least developed and low-income countries to adjust to WTO policies and regulations.
The WTO cooperates closely with the two other components of the ‘Bretton Woods’ system, the IMF and the World Bank. More information on the WTO is available on www.wto.org.
Fair Trade, started as an alternative to free trade, focused on dialogue, solidarity and transparency with the objective of promoting greater equity in international trade. It contributes to sustainable development by offering better trading conditions to and securing the rights of companies in developing and less developed countries. Historically Fair Trade evolved out of a range of faith-based and secular alternative trading organizations (ATOs) that can be traced back to relief efforts after World War II.
International trade has tripled since the year 2000. This significant growth is primarily due to various political and technological developments of our age. The political rise of countries like Brazil, Russia, India and China has influenced worldwide markets. At the same time, technological changes such as the Internet have decreased information asymmetry and lowered costs for logistic services accelerating the development of global trade.
Organizations like the WTO have helped the liberalization and deregulation of international markets. In summary, international trade opens up the opportunity for specialization and more efficient use of resources and therefore has the potential to maximize a country’s capacity to produce and acquire goods.
Chapter 2 – What Is Trade Credit Insurance?
No matter how transparent an international trade transaction may be, it is not completed until payment is received. Businesses usually trade on open credit terms as an alternative payment instead of immediate cash payment to provide time for buyers to generate revenue from sales to pay for the delivery of goods and the performance of work or services. For those businesses this ‘account receivable’ is unsecured invested capital due to the commercial or political risk of non-payment or any payment delay.
History, Nature And Importance of Trade Credit Insurance
The first hints of modern trade credit insurance came at the end of the 18th century. In 1766, a Prussian professor Wurms proposed to authorities a type of insurance to cover maritime risks in order to reduce losses caused to merchants.
In 1839, an Italian, Bonajuto Paris Sanguinetti, published his work: ‘Essai d’une nouvelle théorie pour appliquer le système des assurances aux dommages des faillites’ (‘Essay of a New Theory to Apply Insurance to the Losses Caused by Bankruptcies’). He is considered the founder of Credit Insurance in a defined approach.
In 1849 the Banque Mallet Frères et Cie in France was the first to cover trade credit risks, an example quickly followed by four other banks in Paris. After an initial great success these banks had to stop their credit insurance activities because of difficulties with the strict separation between banking and insurance. By supporting overdue buyers of their insureds, they sustained many losses and decided to cease writing credit insurance in France.
The credit line is generally considered to have originated in the United Kingdom, where property and casualty insurers were already covering credit business in the middle of the 19th century, and from where credit insurance spread to continental Europe around the end of the 19th century.
The oldest specialized credit insurer still operating today was founded in 1893 in the USA, but credit insurance never really took hold in the USA during the next 100 years. Only since about the turn of the millennium has credit insurance in the USA been undergoing a noticeable upswing, albeit still low in comparison to Europe.
In 1918 England was the first country to develop, a public (government-backed) guarantee scheme to cover transactional risks. This example was followed by Belgium in 1921, Denmark in 1922, the Netherlands in 1923 and many other countries in the years to come. At that time some emblematic companies were created, being still active today, namely, Hermes founded in Germany in 1917, Trade Indemnity in UK in 1918 and NCM in the Netherlands in 1925. Four years later, SFAC was introduced in France and Compagnie Belge d ́Assurance Credit in Belgium. Each of these companies considered trade credit insurance as a new activity and were able to overcome the 1929 economic crisis.
For many decades and until today European countries have been generating by far the largest part of the global credit insurance premium volume. In the 1990s credit insurance spread rapidly around the world with high growth rates, though in some regions from a low baseline. However, there are still some regions where trade credit insurance is virtually unknown, if it exists at all, such as Africa outside South Africa, in the Arab world, in large parts of Asia, some countries in South America and in most of Eastern Europe.
Even in the established markets of Europe the market penetration lies between only about 10% and 25% (measured in terms of potential market volume), depending on the country and the definition of insurable markets. The total value of the underlying business covered world-wide is more than a thousand billion (trillion) euros and the global annual premium volume is estimated at around €6 billion – with a rising trend. Since 1990 a strong concentration process has led to the formation of large corporate groups with global operations – alongside a several independent providers – the three market leaders account for a share of about 80% world-wide. Nearly all private credit insurers are members of the International Credit Insurance & Surety Association (ICISA).
Trade credit insurance (also named delcredere insurance, credit insurance, business credit insurance or export credit insurance) is the insurance product that businesses purchase to protect themselves against the risk that a buyer defaults on a payment obligation. By purchasing a trade credit insurance policy, businesses are able to extend insured credits to their customers and simultaneously reduce the risk of payment default.
The insurer is the company providing insurance cover that underwrites a risk of payment default, whereas the insured is the party purchasing an insurance policy that assumes the rights and obligations of the policy.
Trade credit insurance is usually classified into commercial and political risks.
Commercial risk is associated with the insured’s customers and their ability to pay for the delivery of goods and or performance of works or services provided to the seller; i.e. the insured.
Political risk refers to the buyer’s country and includes losses arising from political events such as (outbreak of ) war, promulgation of laws, embargos or other governmental measures that either limit or interfere with the trade of the free disposal of the contractual consideration to which the insured is entitled.
Whereas for decades the political export credit risk was borne almost exclusively by the public sector Export Credit Agencies (ECAs), since the turn of the millennium most private credit insurers have been offering both commercial domestic and international cover and also political cover, often in a single (comprehensive) policy.
Trade credit insurance is based on the principle of a bilateral relationship between the insured and the insurance company where both parties agree to obligations towards one another.
To distinguish trade credits from purely financial credits not related to an underlying trade transaction, receivables are only insurable if they relate to goods supplied, services rendered or work performed under a contract (trade credit) in the course of the normal business operations of the party to whom the receivables are due.
It covers the payment risk resulting from the insured’s delivery of goods and performance of works or services to their customers on open credit terms. In other words, trade credit insurance is purchased by business entities to insure their accounts receivable from losses due to unpaid invoices as a result of protracted default, insolvency or bankruptcy of buyers.
The insurer compensates the insured for losses of insured receivables from a portfolio of buyers that occur during the insurance period of insurance. In exchange for insurance cover, the insurer charges the insured a premium amount. The premium is usually calculated as a percentage of all outstanding receivables, the total of credit limits underwritten or the insured’s insurable turnover. Theoretically, the premium rate used for calculating the premium should reflect the average credit risk of the insured portfolio of buyers.
Trade credit insurance policies provide for maximum liabilities which restrict the total compensation payable by the insurer for losses from political or commercial risks occurring within one single policy year. These amounts are limited usually to either a fixed amount or to a multiple of the annual premium paid during the same policy year.
Trade credit insurance compensates the insured for losses arising out of the payment risk of other companies but not of private individuals.
Trade credit insurance policies often combine domestic and export sales with an indemnity level up to 90 per cent. Receivables shall be insured if and insofar as the insurer has evaluated the creditworthiness of the insured’s buyers and stipulated a sum insured and a credit limit for each buyer. By investigating the financial position of prospective buyers, the insurer evaluates whether or not particular transactions constitute acceptable risks.
In order to perform the assessment of risks, the insurer uses an extensive information network with trade reference and collection agencies, banks and rating agencies just to name a few. In case of aggravation of risk, the insurer has the right to reduce or cancel credit limits of a certain buyer.
Apart from credit limits assessed and issued by the insurer, trade credit insurance policies may allow cover under a discretionary limit. For those buyers insured under the discretionary limit, the granting of credit must typically be justified on the basis of written information provided by an approved credit agency and/or a positive payment history where the buyer has obtained goods or services from the insured for which the buyer has made due and proper payment.
In this case, the insurer will issue a policy with a limit of discretion (i.e. insureds that invoice buyers up to a designated, fixed limit do not need to have these amounts previously approved by the insurer). If a specific credit limit (usually in excess of the discretionary limit) is required, the insured will have to submit a specific credit limit application to the insurer. This process involves the insurer’s risk assessment of underwriting information (credit reports, financials, management accounts, etc.).
In addition, in cases of buyers who default in payment, insurers also conduct recoveries through a network of solicitors and collecting agents. Insurance cover is available on either a single-transaction or buyer portfolio basis.
In most policies, the insurer is provided with the right of subrogation that grants the insurer the contractual right to collect compensation directly from the buyer who has failed, or take legal actions against him. In such cases, all claims of the insured against the buyer and all ancillary rights are subrogated to the insurer in the amount of compensation paid.
Exclusions from coverage include failure to comply with policy obligations such as the non-reporting of adverse information regarding the financial standing of a specific buyer, non-payment of premium or non-payment due to disputes.
Benefits of Trade Credit Insurance
It has become essential to businesses to evaluate and manage future risks in challenging economic times. It is estimated that, depending on the type of a company, 20%–40% of a company’s assets are in the form of trade receivables and it is very difficult for a company to predict which buyer will default on payment. The costs of non-payment can be considerable to a business. Whilst loss rates vary in different industrial sectors and countries, every business is susceptible to non-payment of a trade debt or insolvency.
Concerning this issue, insurance companies play an important role in risk management by offering several benefits. The main benefit of trade credit insurance consists in the management and in the protection of a company’s accounts receivables by compensating the insured in the event of non-payment.
In addition, trade credit insurance also helps an insured compete more effectively. Credit terms offered to buyers have become an important component of competitive strategy. Credit insurance allows the insured to gain competitive advantages through extended open terms, higher credit limit values and expansion into new markets.
In summary, further benefits of trade credit insurance are:
- profit and cash flow liquidity protection;
- risk avoidance by focusing on credit control upon problem
- information services when making commercial decisions to
promote sales growth;
- access to the financial history and credit worthiness of
- enhancement of credit management procedures as cash flow
improves and ‘days sales outstanding’ (DSO) are reduced;
- borrowings and other lines of finance are made more
accessible due to increased bank security;
- bad debt reserves can be reduced therefore freeing up capital;
- longer terms of payment can be offered.