When Credit Insurers Say No: Credit Put Options Say Yes
Your company was a supplier for Blockbuster and you were about to fulfill a large purchase order on behalf of the retail giant. You called your broker to buy credit insurance and you were informed that none of the credit insurance companies were willing to cover Blockbuster due to the high risk involved. Upon hearing the news, you decided to take a chance and ship their order without any form of advance payment or payment guarantee. It’s Blockbuster after all, you wanted their business! On September 23, 2010, Blockbuster files bankruptcy, and to your surprise, you were left with a huge sum of money (receivables) that remained unpaid and open for months, maybe even years to come.
This scenario happens all too often. Commercial trade can be risky business.
Credit Insurance is a fantastic business tool when it’s available. Credit insurance pays a supplier when a covered company cannot honor their obligations, including when bankruptcy is filed. The problem in recent years has been that credit insurers have become selective with the companies they underwrite, particularly steering clear of underwriting coverage on financially distressed companies – like Blockbuster, and others. Until recently, a supplier had no option other than to assume the risk themselves once credit insurers denied coverage. But with this risk comes the uncertainty of not knowing if their uninsured customers will fail to pay what they owe. Not a great way to do business – particularly at a time with a country in recession and retail industry in decline. For some suppliers, a big loss could have a catastrophic effect. In the case of Blockbuster, there were many suppliers who took the chance and shipped large volumes of goods to Blockbuster on ‘open credit’ just before bankruptcy was filed. The cash flow of these companies were put at serious risk. The fact is, it could have been avoided with proper planning.
A highly specialized product called Credit Put Options give suppliers an alternative to credit insurance, particularly for risky accounts. Credit Put Options are simple contracts between the seller (supplier) and the credit put purchaser (major financial institution). The supplier pays a fee for specified receivables during the contract period. If the supplier’s customer files bankruptcy during the contract period, the put option is exercised and the supplier is automatically paid 100% face value of the covered receivables.
Credit Put Options have the following considerations:
Benefits: Credit Put Options are available on distressed companies (unlike credit insurance) and provide 100% coverage with no deductible or co-insurance. Coverage term is flexible, usually between 6 to 12 months, at the seller’s option. Credit Put Options are non-cancelable and do not restrict shipments made to customers with pending bankruptcies. Coverage is available on both private and publicly held companies and contracts can be executed immediately.
Drawbacks: Cost. A Credit Put Option, for example, may carry a fee of 1.25% per month, depending on the risk, at a cost of $75,000 for 12 month term for every $500,000 covered. Rates can be higher or lower depending on when the put option is executed. Credit Put fees are moving targets, fluctuate daily, and are based primarily on the financials of the subject company and the investor’s appetite for risk. Credit Put Options pay claims only upon a straight bankruptcy event. It does not pay claims for any other reason.
The Bottom Line: Credit Put Options are a good alternative when credit insurance is not available. Despite the higher expense, protection provided by a Credit Put Option can help a supplier justify continued sales to a troubled client without taking on risk or shortening credit terms. The supplier can ship confidently to the distressed client company without taking on the risk themselves. A Credit Put Option can also help increase sales as competitors selling without it are forced to lower their credit terms with the client, providing a considerable advantage to the supplier using Credit Put Options over its competition.
Have a question about credit put options? Feel free to call us at 1-844-315-4985 or contact us directly by using the form to the right.