Credit Insurance

Updated on March 18, 2024
Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What is Credit Insurance?

Credit insurance is an insurance policy that covers paying the existing debts of the policyholder in case of death, disability, insolvency, or loss of employment of the insured or due to any other reasons covered in an insurance policy. It might be a great option for credit card holders as well during economic turbulence.

However, most credit insurance companies make it difficult to process a claim through terms in fine print. Moreover, they are costlier than other forms of insurance as the benefits against the prices paid are not considered viable. Nevertheless, during financial turmoil, they come in handy and can potentially save a business from shutting down permanently.

How Does Credit Insurance Work?

Credit insurance covers the risk of credit, i.e., debt repayment of the policyholder in case of death, disability, loss of employment, or any other reason. There are various types of policies that cover different types of risks, like life insurance, disability insurance, property insurance, trade insurance, etc. The company charges a premium based on the amount covered and the type of risk covered.

As the debt changes, the premium amount also changes; this is applicable in loans or trade creditors. When a company or business entity obtains insurance, it is called trade credit insurance, which protects against customer insolvency. The insurance company will pay the amount to the creditors or lenders in case of an event occurred.

It covers the risk of repayment of debt. As any transaction requires the security of money, and so the policy of credit insurance increases the business growth and credibility in the market. Creditors want to sell goods to those who give a guarantee of payment, and similarly, lenders or banks provide easy loans to those whose security is vital, and the risk of non-repayment is low.

To cover all types of risks, the policy provides risk coverage by securing the debt. Policyholders have to decide which kind of trouble it wants to cover like life insurance, disability insurance, property insurance or trade insurance, etc. Insurance companies choose premiums according to the amount insured and risk covered. Policyholders then have to pay the premium and agree to the terms of the insurance company.

In case of an uncertain event for which policy is taken, the policyholder or his representative or legal heir has to approach the insurance company by submitting the proof of debt. After this Insurance Company has to verify the obligations and pay the amount to the creditor on behalf of the policyholder, and the amount cannot be more than the amount covered in the policy.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Types

The three major types of this insurance are unemployment, disability, and life credit insurance. However, there are other such insurances as well. Let us understand them in detail through the explanation below.

Credit Insurance

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Credit Insurance (wallstreetmojo.com)

  1. Credit Life Insurance: In this case, the company will pay the debt, i.e., outstanding balance to the creditor on the death of policyholders. The loved ones of policyholders don’t have to worry.
  2. Credit Disability Insurance: If a policyholder has any disability for a certain period covered by policy terms, then the insurance company will pay the amount due or covered. Whichever is lower to the creditor or lender after verification of claim and disability.
  3. Credit Unemployment Insurance: If the policyholder remains unemployed for the period as per terms of the policy, then the insurance company will pay the debt on behalf of the policyholder by verifying the unemployment status and proof of claim.
  4. Credit Property Insurance: It protects the personal property from being destroyed, theft, etc. it also covers the debt repayment to the lender in case of loan taken.
  5. Trade Credit Insurance: It is a type of insurance that protects the business against the risk of customers or clients who don’t pay because of insolvency or other events.

Examples

Let us understand the concept of life trade insurance and other types of such insurances with the help of a couple of examples.

Example #1

A policyholder took the policy of securing the debt of the creditor amounting to $25,000 by taking a trade credit insurance policy. The situation arose when the policyholder was unable to pay the debts of $5,000 due to one of the conditions covered by policy terms. The policyholder approached the company for the claim by submitting proof of debt. Now, the insurance company will verify the debt by demanding original bills and confirmation from the creditor. On satisfaction, it will pay $5,000 to the creditor on behalf of the policyholder.

Example #2

Hong Kong’s government formed the Export Credit Insurance Corporation (ECIC) to ensure the exporters in the city got better coverage for situations like payment defaults from mainland Chinese clients.

A team of five of the largest banks in Hong Kong Including HSBC, DBS, Hang Seng Bank, Bank of China, and Bank of East Asia came together to form ECIC.

They set clear terms and agreements and since there was government intervention, the deal was not lopsided in the favor of the banks but a fair deal was structured for both parties involved. However, the maximum coverage ceiling was set at HK$100 million or USD $12.88 million per buyer group.

Cost of Policy

The cost of getting coverage for trade credit insurance and other such forms of insurance depends of a variety of factors such as sales, revenue, and others. Let us deep dive into the critical points that determine the cost of coverage through the explanation below.

This policy premium will be decided on the type of insurance and the amount of coverage. If credit changes, the tip also changes. And it pays the claim based on the amount covered or the amount due, whichever is lower after verification of the validity of a claim.

Various types of risks are covered life insurance, disability insurance, property insurance, etc. The limitation is not all types of threats and situations are protected.

The premium depends upon the type of risk and amount covered as well. The event insurance company will verify the claim and pay it to the third party on behalf of the policyholder. It is more or less similar to a letter of credit, but the difference is a letter of credit covers a higher amount and risk as compared to credit insurance.

Majorly, it is dependent on the percentage of the sale. Conservatively, it is priced at 0.25 cents a dollar. As in, if the company has sales of $2 million in the previous year, their premium would be lesser than $5,000.

Importance

Let us understand the importance of credit insurance companies providing these services through the discussion below. This will help us understand the intricacies of the concept and its related factors as well.

Importance of Credit Insurance

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Credit Insurance (wallstreetmojo.com)

  1. Protection from Risk: It will protect against the risk of an uncertain event that may or may not occur and gives financial support to the policyholder.
  2. Assurance to Creditor: This policy will give security to the creditors of their amount due.
  3. Increase Creditability: It will increase the credibility of policyholders as it gives assurance of debts to the third party.

Advantages

Let us understand the advantages of trade credit insurance and other such type of insurance in the domain despite the relatively high premium charges.

  • Increases Creditability.
  • More reliance by suppliers.
  • Assurance of repayment to creditor or lender.
  • Tool for securing future in case of uncertainty.
  • Ease in granting loans by banks.
  • Strengthen Business relationships.

Disadvantages

Despite the various advantages mentioned above and throughout the article, there are a few factors that prove to be pain points for businesses. Let us understand the disadvantages of life credit insurance and other such insurance in the same domain.

  • There are limitations on coverage, which creates a problem.
  • Lots of procedural requirements and formalities.
  • It is not available for high-risk accounts.
  • It doesn’t cover every type of situation.
  • Not a cost-effective measure.

Credit Insurance vs. Letter of Credit

Credit insurance and letter of credit have been widely used by businesses to hedge their risk of non-payment and to clear off their debts for decades. However, there are differences in their fundamentals and implications. Let us understand them through the comparison below.

  • Credit insurance covers the risk of debt due to the third party in case of an uncertain event. In contrast, a letter of credit substitutes the threat of payment to the third party if the issuer cannot pay the amount due.
  • In the case of credit insurance the amount of debts varies, whereas a letter of credit guarantee amount is fixed.
  • Credit insurance might not cover 100% debt, but the letter of credit covers 100% debt.
  • Credit insurance is suitable for smaller amounts and transactions, whereas the letter of credit is ideal for more massive payments and transactions.
  • In credit insurance, the insurance company guarantees repayment, whereas in the letter of credit the issuer bank will give a guarantee of repayment.

Recommended Articles

This has been a guide to What is Credit Insurance. Here we explain its benefits, types, examples, importance, costs, and compared it with a letter of credit. You can learn more about from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *