State of the market - Trade Credit Insurance and managing claims for customer payment default

In brief - Insureds should consider how to manage their trade credit risk and be aware of the issues around trade credit insurance cover

Recent reports in the financial press suggest that there may be emerging coverage limitations for underwriting trade credit risk as insurers address potential fallout from the coronavirus crisis.

This issue brings into stark relief the insurance infrastructure that underpins cash flow and the securing supply chain for many businesses, and the potential for major flow-on effects for the Australian economy if cover is adversely affected.

Trade credit insurance is a niche product that protects businesses against the risk that customers fail to pay invoices and credit coverage is often a condition for securing supply chains and trade finance in order to protect cash flow for many businesses. 

Withdrawal of cover would mean that it would be difficult for SMEs to secure cash flow credit without trade credit insurance as many suppliers cannot afford to sell on credit without trade credit insurance.

What is Trade Credit and when is it activated?

Trade credit insurance covers a supplier of goods and services against the risk of non-payment by its customers because of wilful default or insolvency.

Trade credit coverage can be bought to cover single customers or the entire customer base.

Trade credit insurance responds once a default is officially declared.

Current state of the market

A higher volume of claims under trade credit coverage is likely to arise under the pandemic as a result of the coalescence of the following factors:

• a liquidity crunch in the economy

• major disruptions in the supply chain

• suppliers experiencing increased default by buyers

• the lack of consumer demand

As a trade credit insurance policy responds to the proximate cause of the loss, which is default or non-payment of a supply invoice, the coverage does not consider the underlying cause of the loss.

That is, non-payment or default is covered unless the policy terms exclude a particular risk or event.

Potential solutions

In managing trade credit risk, the following steps should be considered:

Making a claim under a Trade Credit Insurance Policy

Subject to the specific policy terms, insureds are likely to be able to make a valid claim for losses related to COVID-19 under a trade credit policy provided that:

• there is compliance with any policy conditions, and

• there are no exclusions relating to the risk

ASIC has indicated that during the pandemic phase it expects insurers to ensure:

• fair and efficient insurance claims handling

• clear and accurate communication to customers and policyholders about their cover recognising the changing circumstances affecting them

Business continuity risk mitigation 

Business continuity risk mitigation actions to ensure a business is more resilient to COVID-19’s economic effects such as:

• customer onboarding and credit assessment procedures

• inclusion of protective contractual provisions in supply contracts

PPSR

The PPSR and trade credit insurance work together to provide multiple layers of security against customer default and insolvency. Whilst some insurance companies may insist on PPS compliance in order to qualify for cover, PPSR registration is a useful backstop.

SME Guarantee Scheme

Consider if a business will qualify for the SME Guarantee Scheme.

The Federal Government, Reserve Bank of Australia and the Australian Prudential Regulation Authority have taken coordinated action to support the flow of credit in the Australian economy, in particular for small and medium enterprises (SMEs).

Under the SME Guarantee Scheme, the Government will provide a guarantee of 50 per cent to small and medium enterprise (SME) lenders for new unsecured loans to be used for working capital. This initiative endeavours to enhance a lenders’ willingness and ability to provide credit, with the objective of SMEs being able to access additional funding to help support them through the upcoming months. 

Managing Trade Credit Cover and claims going forward

Even if an insurer decides to continue to write trade credit insurance, close attention must be paid to the policy exclusions.

Most policies are likely to contain two critical exclusions for losses caused by or connected with:

1. a natural disaster, and

2. a government decree

Pandemic related trade credit losses occurring at this stage could fall into either or both exclusions. 

We are anecdotally aware that some insurers have adopted an approach that current events are not characterisable as a natural disaster (and that may be the case in Australia, although events in other countries that cause a buyer to default to an Australian creditor might fall into that description). However, it cannot be guaranteed that any insurer adopting this position will continue with it if things worsen. 

Depending on the circumstances, statements made by an insurer upon which an insured relies in entering into an insurance policy are probably binding. However, if you already have a policy entered into before current events such statements would likely not assist.

In any event, the government decree exclusion is critical. Given the way that state governments are closing down entire categories of businesses in Australia, every insurer will consider whether the loss under a trade credit policy has been caused by government decree and hence excluded from cover.

The only effective insurance solution to this latter exclusion is political risk cover, which is an exotic Lloyds' based cover (or government backing, eg, EFIC or the US Exim bank) that insures against government decree and confiscation. It is naturally expensive, complex and we suspect becoming hard to obtain at commercial prices in the current market.

We are also anecdotally aware of insurers imposing manuscript exclusions for identified suppliers, which likely reflects insurers' wish to seek to model and control their risk profile.

Insureds should very carefully check their policy terms before applying for cover.

Once cover is obtained, it is critical that an insured review the required procedures under the policy carefully and establish internal procedures so that it can effectively comply with the various reporting and recording obligations required by a trade credit insurer.

Such procedures might include:

• reporting a state of default to the insurer within the time periods required

• determining whether the insured is permitted to postpone a due date without the insurer's consent

• maintaining accurate turnover information on an insurer's online information system

• setting permitted limits, and

• making a claim by filing a claim/collection form 

This will be likely to assist in saving delays and hurdles if a claim arises. 

Under section 54 of the Insurance Contracts Act, failure by an insured to comply with a contractual term does not entitle an insurer to decline to cover the claim. However, it does entitle the insurer to reduce its liability to reflect any prejudice the insurer has suffered as a result of the insured's failure to comply with a contractual term or condition (if the insurer can prove such detriment). 

For example, if an insured neglected to report a state of default within the required time, but only did it some time later, with the result that the loss deteriorated, then the insurer would be able to reduce its liability to the loss that would have occurred had the insured complied with the reporting obligation time limit. 

Neglecting to comply with policy conditions will also lead to disputes with insurers and delays in payment by the insurer, which could have a significant impact upon the insured's cash flow.