INSURANCE CAN MINIMIZE YOUR BAD DEBT LOSSES How much are poor credit risks costing you each year? There are ways to determine the tangible portion of this loss, through a cost analysis of your accounts receivable. But there is no way, through an analysis of your accounts receivable, that you can determine the intangible losses that you may incur through poor credit risks. Tangible losses can be measured in dollars when a retailer account defaults or goes insolvent. This first and most obvious loss is the actual dollar loss of the goods that were sold. The second loss is the profit that you expected to make from the sales. The third cost is that of your collection efforts now that the account is in default. The fourth cost is the decrease in the value of your accounts receivable as collateral, which will either decrease the amount of loan capital that is available to you, or increase the interest rate that you are charged because of this over-all lowering of your collateral value (or both). The intangible cost is much more difficult to determine, although it might be just as costly as the tangible cost: It is the dollar volume of business that you lose through retailer accounts that you never obtain because they are classed as marginal credit risks. Much of the tangible cost of bad credit risks can be charged to your collection department. And because your primary business is manufacturing or distributing merchandise, your collection department does not, unfortunately, operate as efficiently as, say your order department. Insurance companies are now recognizing that the inherent risk of maintaining an accounts receivable, which, because of the nature of the wholesale/manufacturing business, can run into considerable sums of money, is as much a casualty risk as the threat of property damage, or the liability of employee health and accident risks. The insurance that is designed to fill this void that other casualty insurances do not is called commercial credit insurance. Commercial credit insurance is intended to indemnify the insured, who can only be a manufacturer, wholesaler, or distributor, for losses incurred when a retailer account fails to pay its credit obligations. With this type of casualty insurance, you may recover a large portion of both your tangible and intangible costs of doing a credit business. In essence, the insurance company serves two functions: (1) it acts, initially, as your collection agency, and (2) if it fails in the collection of the debt, it indemnifies you, the insured, in accordance with the terms of the policy. The usual commercial credit insurance policy is written with a deductible clause, which is based on the premise that an insurance company will only insure against unexpected or catastrophic losses, not those losses that are normal and expected. In effect this means that the insured self-insures for the amount of normal and expected losses, thereby lowering his premium costs (if he doesn't elect the deductible, he simply ends up swapping dollars with the insurance company). This deductible figure is initially expressed as a percentage of gross sales, and is based upon the bad debt loss of the average business firm in your business's classification. The figure is then modified to reflect your own historical losses through bad debts, as well as any irregularities in the bad debt loss caused by businesses insolvencies That might have been due to local, regional, or national economic recessions. In any year, the insurance company will indemnify you only for amounts that are in excess of the deductible. The usual period of coverage for a commercial credit policy is one year, with no cancellation privilege for the insurance company. The upper limit of coverage under the policy is determined by the insurance company through an analysis of your customer's credit ratings, which should show the loss risk of your accounts receivable. Credit rating agencies of long standing, such as Dun & Bradstreet or TRW, are utilized to determine customers' credit ratings. As an example, if one of your customers had a Dun & Bradstreet credit rating of at least 3A1, you could extend this customer $100,000.00 of credit without prior approval of the insurance company. If the customer's Dun & Bradstreet rating was BA1, you could extend him a maximum of $50,000.00 credit without prior approval by the insurance company. If you adhere to the guidelines set by the insurance company, but your customer defaults on the debt, your insurance company will act as a collection agency, and if not successful, will indemnify you for the amount of the loss that is in excess of the deductible. The usual procedure for filing a bad debt loss claim is to file the claim within twenty days after learning of the debtor's insolvency, and before the expiration of the policy. If the debt is past due, but the customer is not in fact insolvent, the insurance company will still process the claim as if he were insolvent. Concurrently with filing the claim, you must turn the delinquent account over to the insurance company so that it can make an effort to collect the debt, and during the next sixty days, the insurance company acts as a collection agency for your business. If it is successful in collecting the account, it will turn the proceeds of the collection over to you, including any amount that is in excess of your coverage (less collection charges). Even in the case in which it is obvious that the bad debt loss exceeds the policy coverage, the insurance company will make an all-out effort to collect the total debt. Failing collection, at the expiration of sixty days, the insurance company will indemnify you for the loss. We can see that the insurance company's most obvious function is to (1) recover the absolute dollar value of the merchandise, plus (2) recover any expected profit, thereby recovering your first and most obvious tangible losses. Next, by using the collections facilities of the insurance company (which may be superior to your own), you eliminate your collection department with its attendant personnel costs, investigating costs, legal fees, as well as some of the uncertainties and unpleasantness inherent in operating a collection department. Moreover, your accounts receivable now offer more collateral security, because you are, in effect, providing a guarantee that its value will be maintained while you are repaying the loan. This should result in a better credit rating for your business, which should strengthen your position in the money market. This is implemented by a special bank endorsement, which may be attached to the commercial credit policy (this endorsement enables the lending institution to choose to receive indemnification directly from the insurance company, rather than waiting for reimbursement from you). Just as it is difficult to determine how much intangible loss that you may incur from bad debts, it is difficult to determine the exact amount that commercial credit insurance might save you in these intangible losses. However, commercial credit insurance does enable you to extend credit to those marginal accounts that would otherwise be classed as too risky. Of course, you must exercise a certain amount of discretion in doing this, even with the protection of insurance, as marginal accounts will lower the over-all credit rating of your accounts receivable, thereby raising either the deductible amount, or the premium cost of the insurance. But, when these factors are weighed against the prospect of an increased dollar volume of business, you may elect to take on more marginal accounts. Commercial credit insurance is worthy of consideration, because losses incurred from bad debts are just as real as -- and in a broader sense, more far-reaching in their implications than -- losses from property damage or liability risks.