Trade Credit Insurance: Reducing High Concentration Risk & The 80/20 Rule
Today, many companies trade with a few large customers exposing themselves to significant financial risks. A business is considered to be highly concentrated, for example, when approximately 80% of a company’s sales is generated by 20% of the total customer base. In other highly concentrated situations, one buyer might make up 30 to 40 percent of total sales. In any of these or similar situations, if a key customer were to unexpectedly file for bankruptcy or slow their payments, the impact to cash flow could be significant and hard to ignore.
Despite these risks, some companies unknowingly avoid the issue altogether assuming that they’ll deal with the aftermath once such an event occurs. Other companies plan ahead and choose to absorb the risk themselves by self-insuring and setting bad-debt reserves at extraordinary high levels in the event the 800 lb monster comes crashing down on them unexpectedly Truth be told, in high concentration situations, it doesn’t make accounting sense to set reserves at a level in line with accounts receivable. Also, it isn’t necessary to absorb these losses especially when capital allocated for bad-debt reserves could be reinvested into other areas of the business. Many financial executives are beginning to see the benefits of trade credit insurance as a cost effective solution to reduce high concentrations of risk, free up bad-debt reserve capital, and protect the bottom line from catastrophic losses. Companies with a trade credit insurance policy also have the unique advantage of higher underwriting limits for qualified accounts making it easier to sell more aggressively to existing customers and expand into markets that might have been too risky in the past.
In recent years, premiums for trade credit insurance have come down considerably and are typically priced at a fraction of one percent of annual sales, depending on the risk grades of companies insured, credit lines requested, sales volume, risk sharing coinsurance, and policy deductibles.
Have a question or comment about trade credit insurance? Feel free to post your inquiry on this blog or contact Jack Trama directly by clicking here.
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