Understanding Cancelable vs. Non-Cancelable Limits under Trade Credit Insurance Policies [Business Credit]

There's been a lot of discussion lately within the U.S. trade credit insurance market about the difference between so-called "cancelable" and "non-cancelable" trade credit limits. Trade credit insurance, of course, is the protection provided by an insurance company against a loss that may be suffered by the policyholder when, having sold a product or service on credit terms, the policyholder's customer defaults in its repayment obligation. The trade credit limit is the amount of loss that the insurer will reimburse to the policyholder (prior to any coinsurance or deductible) for a specific customer.

Long viewed as separate yet ordinary features of the trade credit insurance landscape, the distinction between cancelable and non-cancelable forms of coverage hit center stage during the financial crisis several years ago. Throughout that period, some policyholders with cancelable limit-type policies experienced withdrawals of some of their trade credit limits. Although withdrawals had always been a possibility under the terms of these policies, and while some policyholders had previously seen isolated withdrawals, the relatively large number of withdrawals that took place during the crisis was unusual.

Among the reactions to this credit limit withdrawal exercise was a decision by some to investigate coverage options under a non-cancelable format. Reasonable enough. But a business decision of this sort merits careful consideration of the differences between the products and why some limits are withdrawn in the first place.

An important point to know is that a number of trade credit insurance companies offer both cancelable and non-cancelable limit-type products. So, the distinction is not necessarily one of insurance company but of product offering. Both products have been sold successfully in the United States for many years and, in a sense, each tends to serve a different constituency. Another fact is that while some insurers went through a credit limit withdrawal exercise for some of their cancelable limits during the financial crisis, not all insurers that offer cancelable limits took the same approach. Generally, the magnitude and frequency of the withdrawals, if any, were driven by each insurer's risk assessment (underwriting) models, business decisions and the characteristics of its policyholder base. It should be understood, too, that the credit limit withdrawal exercise that occurred among some insurers is long-concluded, reflecting an easing of the financial crisis.

So, what is the difference between cancelable and noncancelable limits? The terminology is obvious but it's only shorthand for the dynamics of what can or cannot happen.

Cancelable Limits

Under a cancelable limit, the insurance company may, at its discretion, amend or withdraw coverage attaching to future transactions between the policyholder and its specific customer. Even this description may be simplistic because each insurer typically has conditions about how much notice may be given prior to withdrawal and whether there are any exemptions or appeals that may apply to the withdrawal.

While policy language allows the insurer to amend coverage at their discretion, in fact, limit reductions or withdrawals will typically be the result of a serious deterioration in the risk being insured, such as the credit quality of the policyholder's customer. Such heightened risk may arise from factors specific to that customer (e.g., serious breach of loan covenants or material cash flow deficits) or by virtue of an industry-wide or country-wide problem that suggest a loss event is now likely within the policy period.

It is important to appreciate that policyholders who opt to purchase a program with cancelable limits often are companies that use a credit insurance policy more holistically than for just reimbursement of a loss. That is, some companies perceive value in having the insurer serve as an adjunct to their own internal credit management function and an early warning beacon about problems associated with their customers, in addition to helping manage and avoid potential losses.

Of course, there are many other reasons why companies buy a cancelable limit policy and it can often relate to the overall insurance program being offered.

Non-Cancelable Limits

Under a non-cancelable limit, the insurance company may not amend or withdraw a limit, once issued, for the duration of the validity period of that limit. Even this description may be simplistic because most policies typically have conditions that cause coverage to not attach to future transactions between the policyholder and its customer if a dangerous adverse circumstance occurs. Such situations include the customer is becoming bankrupt, is in grave financial difficulty, is more than a certain number of days overdue on existing undisputed obligations, or other known facts that reasonably may be expected to cause a loss under the policy. Dialogue between the policyholder and the insurer is important if these kinds of events come into play.

Purchasers of non-cancelable limits value the fixed certainty of the limit, but understand that these limits are not intended as carte blanche or free pass coverage, irrespective of circumstances. As managers of the risk, the policyholder accepts the responsibility, in the event of a claim, to have demonstrated proper effort, due diligence and expertise. Similar to policyholders with cancelable limits, the non-cancelable limit policyholder must be aware of their duty to behave prudently and to handle their customers as if they were uninsured.

Certainly, there are many reasons why companies buy a noncancelable limit policy and often it can relate to the overall insurance program being offered.

Obviously, a short article such as this can only provide an overview and, in so doing, may use words and phrases not necessarily found in any specific insurance policy. To properly understand each insurance company's coverage, it is important to read the actual policy. It is also important to tap into the advice and expertise of an insurance broker or agent that specializes in trade credit insurance. These experts offer a useful means of comparing and evaluating all the variables of trade credit insurance products, which-whether cancelable or non-cancelable-are becoming an increasingly important and powerful element of risk management for companies that trade in goods and services, and for the banks that finance them in these trade endeavors. 1

Long viewed as separate yet ordinary features of the trade credit insurance landscape, the distinction between cancelable and non-cancelable forms of coverage hit center stage during the financial crisis several years ago.

FCIB was pleased to have Atradius'Bob Wanuga, MBA, senior risk manager, as a panel expert for "Political Risks in Global Hot Spots" at its Annual Global Conference in September. Look for coverage of this event in the next issue.

Peter Aitken is vice president-special products at Atradius Trade Credit Insurance, Inc. He may be reached at 646-517-5356 (NY office), 516-721-0186 (mobile) or [email protected]. The Atradius group is a leading provider of trade credit and political risk insurance with a presence through 160 offices in 45 countries.

Reprinted with permission.