Invoice Financing & Credit Insurance: Is the problem with the product or the conduct?

The world of credit insurance was propelled into prominence last year, when an underwriter in Australia did not renew its insurance policy with Greensill, setting into motion a staggering sequence of events culminating in the collapse of the behemoth invoice financing company. The collapse of Greensill is a cautionary tale of many things but none the more important than ensuring the alignment between the product of credit insurance and the conduct surrounding its cover.  In today’s liquidity crunch with rising interest rates and inflated commodities prices, the role of credit insurance is back in the spotlight as companies desperately look to raise capital by selling their invoices. 

Trade credit insurance is a useful product designed to provide coverage over the non-payment by an obligor relating to a supply of goods. In a supply chain context, it provides cover of non-payment of an invoice owed by a buyer, typically a large company. Invoice receivables from such highly rated buyers, lumped into a portfolio and wrapped with credit insurance, would make a pretty compelling business proposition for any investor. But credit insurance is not a panacea for funders in the invoice financing business: what is required is a critical assessment of the transparency needed between the various actors and layers involved from the inception of the lending structure to a claim under the policy. 

The deployment of credit insurance has metamorphosed over the years as traders began to see it as means to an end of obtain financing, particularly in commodities trading.  The vanilla credit insurance policy, designed as a risk mitigant for sellers, increasingly found itself mischaracterised as a financial guarantee, unlocking access to staggering sums of cash looking for a low-risk return. With cover in place, transactions that might not have stood on their own, would suddenly appear attractive for financing by incorrectly employing a risk mitigant product to achieve the effect of a risk substitution. The expectation that an insurance policy means that all the risks related to non-payment has moved to the insurer and will continue to be renewed each year, needs to be tempered with better understanding of the product.  The standard credit insurance coverage operates as a risk mitigant and not a risk substitute: expecting it to perform like a letter of credit, is not too different from hoping an umbrella would keep you dry in a tsunami. If a transaction or indeed the entire business model will collapse without credit insurance, difficult questions particularly with over-leveraging and over-reliance risks must be asked. And therein lies the most fundamental problem with the current use of credit insurance: while the wording of the insurance policy might resemble that of a financial guarantee, the product operates on the foundation of a partnership between funder/lender and insurer with both parties taking cognisance that information sharing is vital for the effective use and responsiveness of the product of credit insurance.

With the glossy wrapping of insurance coverage, lenders, fund managers and investors of invoice receivables portfolios may be tempted to avoid detailed scrutiny of what’s under the hood, both psychologically and structurally. Worse still, funders might be reluctant to share full details of the transaction flow being funded to avoid complications in getting the much needed insurance in place. The underwriters however are focussed on the credit risk of the buyer (and its relationship with the seller) and without full visibility of the entire deal flow, need to work in partnership with the lender who is funding the flow. This is because the insurance contract, unlike a financial guarantee is built on a duty of good faith and information symmetry goes a long way in ensuring risks are presented fairly to insurers. With an insurance wrapper, more difficult questions surrounding the physical flow of the goods, the commercial rationale for transactions and the links between parties, may get pushed to the background. Sometimes, even the validity of the trade itself may not be apparent – when we investigate trade fraud, it is often remarkable how easy it is to sell an invoice of a trade without proving valid ownership of the underlying goods.

Without visibility of the physical goods, unscrupulous traders looking to benefit from easy financing, can manufacture their paperwork to fit the requirements of an invoice financing business. Without robust due-diligence, circular or fictitious trades designed to channel money between related parties might not be spotted. Without responsive credit management procedures by the insured, a small debt might quickly snowball into a large default. The lack of transparency of these and other issues, only gets compounded, when more layers of securitization are added, with each layer adding further distance between the invoice and the investor. This is all the more acute when it comes to the use of a “gatekeeper” model: an entity that would collate the debtors into an investment vehicle, insure and securitize the portfolio. If the gatekeeper is given the liberty to decide what goes into the portfolio within some broad guidelines, this may incentivize, the creation of a hodgepodge of invoices within the portfolio – obligors with different credit ratings, over-concentration of invoices of one particular obligor and in extreme cases, the creation of invoices for goods that have not been contracted for or delivered.

Like any business, invoice financing must be predicated on transparency to investors and insurers alike and this becomes self-evident in the claims process where insurers are required to assess compliance with the policy. It is easy to get blinded by the steroidal growth of portfolios supercharged with insurance cover as investors get swayed by the assurance of insurance cover. But it is really at the claims process, that the lack of transparency becomes evident, and this can be frustrating for funders who might not have direct rights under the policy and are hamstrung with a non-responsive insured borrower or one that itself has gone into liquidation. At that stage, funders are often forced to revisit their understanding of the commercial rationale of the deal flow and only then understand the true dynamic of the partnership between funder and insurer when it comes to information sharing. The experience can feel unsatisfactory to both funders and investors alike who relied on the product as a trampoline for growth and returns but without sufficient consideration of what is needed for the insurance product’s basic feature – as a safety net for when a default occurs.

There is little point in being a beneficiary of a credit insurance policy if there is no visibility over how the insured trades were structured, operated and monitored – essential elements to ensure that the conduct fits the product.

* This article was first published in The Singapore Business Times on 20 October 2022.

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