For most companies insurance against loss due to accidents, fire, and theft is an accepted cost of doing business. But these same companies often don't consider the need for protection against what has become another significant threat to their operations: bad debt.
Part of the reason for such oversight is that there are no hard-and-fast rules for budgeting against bad debts. Some companies use percentage of debts past due, applying variable periods of 60, 90, 120 days or more. Many others use various percentages of average accounts receivable. And still others simply rely on past experience with losses to establish a specific amount of bad-debt reserves.
Companies that are exposed to major credit loss are typically those that sell to a concentrated group of large customers, to only one type of customer, or to customers in a limited geographic area. They may also be businesses with hundreds of small accounts or manufacturers of custom products which, in case of bankruptcy by one customer, have limited resale value to other customers.
Those most susceptible to the peril of bad debt include small and medium-size manufacturers, wholesalers, and service businesses. Although their sales are usually growing, such companies are often thinly or insufficiently capitalized, making them especially vulnerable to a surprise loss. Bad-debt -- or business credit -- insurance is simply a safeguard against unexpected customer default.
For a premium -- generally 0.10% to 0.25% of covered sales -- a company can guarantee that its losses from bad debts will not exceed a set amount in a given year. In addition to a basic blanket policy, the insured company can also get coverage to protect against losses from a specific customer. This is particularly effective for a business that, because of its product, has a limited customer base in which a single major loss can cost the company a large percentage of sales.
A typical example is a hardware manufacturer with annual sales of $8 million that has one very large customer -- a contractor -- weathering a slump in construction activity. The hardware company insured itself against bad-debt losses for a blanket premium of $8,000 for 1982. lts contractor-customer was considered a special risk, justifying additional coverage of $400,000 for an added premium of $4,400. While the $12,400 insurance tab seemed hefty at first, sales generated by the contractor-customer were $1.6 million, and management cites several other benefits that have made the insurance worthwhile: greater confidence in cashflow projections, ability to extend more favorable terms to customers, and approval of a larger line of credit, using the guaranteed receivables as collateral.
As standard procedure, an insurer will determine the normal losses from bad debts expected in a business or the loss levels deemed affordable. Generally, a deductible is then established above which losses are covered. This is done by examining the company statements, including accounts receivable and past payment history. The average deductible is approximately 0.20% of sales. Having the insurer review receivables is a key benefit of bad-debt coverage.
Insurers monitor credit ratings of customers and potential customers as well as the payment performance of thousands of debtors on a national basis. Information obtained from this monitoring is referred to policyholders regularly. In some cases, based on its credit reviews, an insurer may refuse to cover more receivables from a specific customer, recommending that its policyholder also stop extending credit to protect against potential losses. A typical example is a company whose sales volume is flat but whose inventory continues to grow while its most recent figures indicate unprofitable operations. In such cases, the insurer will alert its policyholder to the strong possibility of a write-down of inventory at year-end, operating losses much higher than expected, and subsequent cash-flow problems.
The severity of any credit loss, of course, depends on a company's equity position and how well its financial structure can withstand default without a serious effect on cash flow. A loss representing 1% of equity may be manageable, but one approaching 20% of equity could be disastrous. If, for example, a company with $500,000 in equity sustains a credit loss of $100,000, it has suffered severe damage. Furthermore, a company with a high markup on its products can weather much higher losses than a company operating with a low margin. Advertising businesses, for example, operate on a low markup, and any credit loss will affect their operations much more quickly than those of a company manufacturing a specialty item on which it normally grosses 50% to 60%.
Bad-debt policies are tailored to a company based on its vulnerability. Degree of vulnerability depends on type of industry, years in business, equity position, existing assets and liabilities, payment records, and revenue growth. There are no hard-and-fast rules for getting insurance. Retailers and consumer-lending institutions are not eligible because policies insure only business receivables, not those created by individual consumers. But beyond that, bad-debt insurers will attempt to write a policy for any company, which means that many more variables must be accounted for than in insurance -- such as fire and theft coverage -- involving standard qualifications.
Some types of businesses simply do not need insurance for bad debts. These include companies that sell on a COD basis, lease their products, or sell to government buyers. It also includes those that employ conditional sales contracts or other liens that tend to make transactions safer. But for manufacturers, wholesalers, and service companies that are vulnerable to losses, bad-debt coverage can be a welcome cost of doing -- and even expanding -- business.