Credit Insurance: The 80/20 Rule
A business is considered 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 as much as 30 to 40 percent of total sales. If either of these situations hold true for your business, you could be putting your cash flow at risk without credit insurance or credit put option.
Companies in highly concentrated situations like these don’t often think about the impact a loss could have to their businesses until it’s too late – and other companies avoid the issue altogether. Yet others plan ahead and absorb the risk themselves by self-insuring and setting bad-debt reserves at extraordinary high levels in the event of a large default. The problem with self-insuring to cover a large loss is that it really doesn’t make accounting sense to set reserves at a level in line with accounts receivable. It’s also doesn’t make sense to subject a company to the potential of such losses particularly when capital reserved for bad-debt reserves could be reinvested into other areas of the business.
Premiums for credit insurance more than justify the coverage. Companies can leverage their premium dollars in ways they are unable to do so when they self-insure. If a self-insured business requires $1,000,000 in coverage on customer X, the business would need to set aside $1,000,000 in reserve capital to offset a loss if customer X defaults. That’s a lot of capital to tie up! On the other hand, credit insurance would only cost the company $10,000 in tax-deductible premium for the same amount of coverage – that’s a big difference!
Many executives are realizing the benefits of credit insurance or AR puts 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 credit insurance or receivables put options are able to balance their portfolios without concern of a major account interrupting their cash flow, or in some cases, putting them out of business.
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