A major current asset on many companies' balance sheets is trade receivables; that is, money owed for goods or services provided on credit terms.
But what good is a sale if you don't get paid? Significant cash flow implications arise when debtors don't pay, and failure to manage them can be fatal to a business.
For this reason, many companies rely on trade credit insurance to protect against losses on "uncollectable" receivables. Like other forms of insurance, this transfers, at a cost in the form of premiums, credit risk away from the company to the insurer.
As with the banking industry, insurance companies have come under the microscope recently. Recommendations around their trade credit insurance practices will likely have far reaching effects on how businesses should now operate. In this article, we consider the recommendations, the reaction to them from insurance companies, and the implications for business.
Reaction from credit insurers to the banking Royal Commission Report
On 1 February 2019, Commissioner Hayne produced his final report of the Royal Commission into Misconduct in the Banking Superannuation and Financial Services Industry (Report).
The Report heavily scrutinised Australia's insurance industry and put the spotlight on misconduct and failures to comply with the general insurance code of conduct.
Of the 76 recommendations contained in the Report, 15 related to the insurance industry. They included:
- Replacing the insured's duty of disclosure with a duty to take reasonable care not to make a misrepresentation to an insurer. This makes it the insurer's responsibility to obtain the information it requires in order to evaluate the risks involved with providing insurance.
- Applying the unfair contract terms provisions set out in the ASIC Act to insurance contracts.
- Applying all voluntary codes in the financial sector to insurance contracts, and for them to be enforceable by ASIC.
- Claims handling to be classed as a financial service under the Corporations Act 2001 (Cth), which will oblige insurers to provide services efficiently, honestly and fairly, as is already required from financial service providers.
Unsurprisingly, the Report has prompted a reaction from insurers. We are seeing a steady increase in matters arising out of tightened trade credit insurance generally, or the total withdrawal of credit provided in some circumstances. For instance, more businesses are asking us to pursue portfolios of trade debts so the size of their trade debtors can be reduced in line with insurers' requirements.
Increased requirements by trade credit insurers can create unwanted risks, especially when an insurer limits the credit allowable to an insured's customer, or requires that the insured stops providing credit to a customer altogether.
A recent matter we managed for a client demonstrates these issues clearly.
Case Study: Revoking credit at the eleventh hour
We were engaged by Business A who had been contracted to provide goods and services to a university. Our client engaged its supplier, Business B, with whom it had been doing business for almost a decade, to source the goods needed to complete the works.
In obtaining the goods, Business A relied on the provision of credit by Business B.
With the delivery and installation date only two days away, Business B informed Business A that its trade credit insurer would no longer insure the credit provided to Business A. Business B now needed to make a decision; terminate the agreement with Business A to provide the goods, or supply the goods with the risk that Business A may fail to pay.
Business B decided to terminate the agreement.
After discussions between the two businesses, Business B contacted the university and offered to supply the goods directly. The offer was accepted and the works completed.
The insurer's decision to cease providing credit exposed each party in this transaction to a number of potential causes of action, as shown here:
|Party||Potential Defendant||Potential Claims|
|University||Business A||Damages for breach of contract for failing to supply, together with consequential losses incurred as a result of the delayed installation, if any.|
|Business A||Business B||Damages for breach of contract for terminating the agreement and damages for tortious interference with contractual relationships as a result of Business B contacting the University and arranging to provide the goods and services.|
|Business B||Business A||Damages for breach of contract for failure to pay amounts owing to Business B which would otherwise have been paid (in due course) by the insurer.|
What does this mean for you?
Trade credit insurers' shift in appetite for risk means that you and your business should pay close attention when either providing credit to customers (with the support of a trade credit insurer) or obtaining credit from a supplier.
If you are providing goods or services on credit, you should:
- Undertake thorough reviews, and contact referees provided (on any application made by your clients) to properly consider and assess your customer's creditworthiness.
- Provide your credit insurer with all information regarding the creditworthiness of the customer, including a history of past dealings and an outline of any circumstances where difficulties arose in obtaining payment from the customer. Failure to do this may result in the insurer denying indemnity for failing to disclose a material fact.
- Implement a business system to swiftly and methodically pursue your debts (for example issuing standard notices on overdue accounts, letters of demands, should they be required, and other follow up). This will help you recover unpaid debts and reduce the times you need to call on your trade credit insurer. This in turn will reduce the number of excess payments you need to make and probably lower your premiums too.
- Undertake a costs benefit analysis on whether it is preferable to recover certain debts yourself (noting the excess and likely increase in premiums) or engage the insurer.
If you are obtaining goods or services on credit from your suppliers and know the provision of credit to you is being insured, you should:
- Endeavour to make payments to suppliers when they fall due.
- Stay in constant communication with your supplier so they are aware of your circumstances and will be more likely to resolve any payment issues with you.
- Maintain up to date management accounts, including profit and loss statements and balance sheets, which you can provide to your supplier should they be requested to obtain them by the insurer.
- Ensure any information provided by you that is likely to be sent to the insurer is protected through a confidentiality regime or non-disclosure agreement.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.