Compulsory insurance isn’t a new concept. In the UK, drivers have been obliged to take out motor insurance since 1930, while companies require employers liability insurance to cover workplace accidents. Given the massive risks that businesses face in 2020, should trade credit insurance (TCI) also be made mandatory?
It’s an intriguing prospect, raised by Nimbla CEO Flemming Bengtsen in our latest episode of The Ledger (listen in here.)
Trade Credit Insurance – a term often interchangeable with ‘Bad Debt Protection’ – gets cash into the hands of companies who might otherwise be left unpaid by their customers. Creditors, suppliers and staff get paid; business goes on as usual.
In a recession, TCI isn’t only a nice-to-have for many businesses and lenders; it’s how they survive and thrive. And the benefits ripple outwards, protecting companies from insolvency, staff from unemployment and maintaining liquidity across supply chains.
So far, so essential. So shouldn’t all businesses be made to protect themselves and their economy with mandatory trade credit cover? Let’s hear the case for against.
For: Preventing disastrous domino effects
Born out of a war-torn Europe in the 1930s, the main purpose of TCI has been to inject liquidity into markets and re-spark supply chain confidence. Suppliers know they’ll be paid; creditors are happy to lend.
Without TCI, the consequences of unpaid invoices can spell disaster across supply chains, as Flemming explains: “You can end up with what people refer to as a ‘death spiral’. Companies that need trade credit don't have the working capital to purchase goods and services they need, and face collapse, and so on and so forth. Doom and gloom galore”.
We’re starting to see this effect in action in the US, where experts have drawn correlation between falling trade credit cover and the stop-start nature of the country’s economy. Each unpaid invoice has a knock-on effect, creating a chain reaction which can quickly engulf whole sectors.
TCI acts as a buffer for such an effect, shielding suppliers and ultimately sparing staff from unemployment. From this perspective, mandatory TCI looks like a no-brainer. “The availability of credit insurance is one of those unseen, unsexy things that does actually add an extra layer of protection in these sorts of systemic events”, says Flemming.
Like a vaccine, TCI is most powerful when the majority of parties are covered, helping them shield one another. But the benefits go beyond merely defending businesses. TCI can accelerate economies, too.
For: Boosting business
“Trade credit is a catalyst”, Flemming explains. “It increases the amount of business that gets done, because credit has a multiplier effect”.
This makes sense. Businesses that are guaranteed to be paid are more confident to extend credit. “It depends who you read and where you get your stats from, but my understanding is that the multiplier effective for TCI is around 1.6 or 1.7”, says Flemming.
Accelerating business and putting oomph back into economies is of utmost importance today. Following in the footsteps of our European neighbours, the UK state has therefore launched its Government Trade Credit Insurance Scheme in support of trade credit insurers – pumping £10 billion into their reserves to help underwriters boost business confidence.
It’s not the first time that this approach has worked. Following the 2008 crisis, the Government funnelled money into backing TCI then, too. As a result of this and measures such as the EU’s Solvency II regime, the trade credit industry is well-capitalized and in a solid shape to help companies.
For: Creating a buffer, like the one we needed in 2008
Flemming worked in the London Clearing House at the time of the 2008 crisis. He therefore knows first-hand how important early intervention can be in a recession.
“It's not particularly well known, but the London Clearing House and clearing as a concept saved an enormous amount of pain that could have happened because of Lehman Brothers”, Flemming explains. “It absorbed these incredible losses … such that it didn't have a domino effect and knock plenty of other banks over. In this way [trade credit insurance] is effectively a systemic risk-buffer.”
In our conversation, Flemming explored the idea of a similar institution for businesses struggling with unpaid invoices. “One of the dreams I've always had,” says Flemming, “is that you would ultimately have an invoice clearing house in a similar way for trade credit.”
If businesses had a guarantee that their invoices would be paid, one way or another, then the effects of a recession could be drastically slowed. We’d see less abrupt closures and unemployment spikes.
It’s an attractive idea; but who could organise and pay for it?
Against: A logistical nightmare
Many SMEs will be unwilling to increase their overheads to cover the cost of trade credit cover. There’s a fine line between the cost-benefits of insurance, versus keeping a rainy-day fund or insurance ‘captive’ – something we explore in the second half of our podcast.
“If you’re in a position where you’re paying £200,000 to £300,000 a year for TCI but only losing an average of £50,000 each year, you’ll quickly do the maths and decide to create a reserve fund instead,” says Flemming.
Indeed, the cost of whole-book insurance policies is one of the drivers behind Nimbla’s ‘single invoice’ insurance product. This allows businesses and lenders to cover individual invoices from as little as £5.60, removing the need for companies to spend thousands covering all their customers. We’re pleased to be working with Flemming and Nimbla to integrate this product into our own working capital operating system, making it possible for lenders and their clients to cover single invoices as part of the lending transaction.
Innovations like this could make mandatory trade credit cover more realistic for businesses. Convincing businesses to pay for cover is one thing, however: enforcing such a programme is another. Could incentivising businesses to take out cover be a more viable option?
Against: Mounting Mistrust
Logistical issues aside, today’s trade credit industry also suffers from reputational challenges that would need to be addressed before businesses adopt their policies more widely.
Bengtsen recalls when he first spoke to vendors about TCI and their well-justified, hostile reactions. “When setting up Nimbla, I started talking to people in the rag trade in the East End”, he explains. “Almost without question, the second I mentioned the product they were quite literally pushing me out of the door. They were absolutely furious about the way they'd been treated by insurers over the years and especially during the 2008 crisis. They said; ‘We paid for these products and then when we needed them most, they weren't there’. It's a very valid concern.”
A lack of faith in trade credit cover is a widespread problem. Since May, the FCA has issued a number of recommendations to insurers to ensure businesses are protected by the cover they’ve already purchased, reminding them to ensure their policies are ‘fit-for-purpose’ in a post-pandemic world.
Rejected trade credit claims create their own ‘death spiral’, whereby companies that had purchased cover then borrowed money in order to fund riskier business decisions. “If a business’ debts don’t get paid and it still has to come up with the money to repay its creditors, you have a double deficit,” explains Bengtsen. “Without cover, affected businesses have a hole to fill over there and still have to repay what they’ve borrowed”.
The verdict: TCI needs work before making it mandatory
A wise person once said that “in theory, there is no difference between theory and practice. But in practice, there is.”
This looks to be the issue with trade credit insurance today. Policy models and the sector’s reputation need an overhaul before businesses could accept being made to purchase TCI – however much it might benefit all of us. Refreshing the trade credit sector would be one giant step towards protecting businesses and employees in the current economic climate.
Happily, change is afoot. The coronavirus pandemic is shifting TCI models faster than ever before. Click here to find out four ways insurers are transforming their models in response to changing conditions.
To listen to our interview with Nimbla CEO Flemming Bengtsen, click here. To find out more about our credit insurance functionality within our working capital operating system for lenders, email firstname.lastname@example.org.