What is Credit Insurance?
Credit insurance is an insurance policy that covers to pay 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.
- This policy 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 the different types of risks, like life insurance, disability insurance, property insurance, trade insurance, etc. The company charge 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 insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.. The insurance company will pay the amount to the creditors or lenders in case of event occurred.
How does it Work?
- It covers the risk of repayment of debt. As any transaction require the security of money, and so the policy of credit insurance increases the business growth and creditability 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 company to choose premium 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.
For example, the policyholder took the policy of securing the debt of creditor amounting to $25,000 by taking a trade creditTrade CreditThe term "trade credit" refers to credit provided by a supplier to a buyer of goods or services. This makes it is possible to buy goods or services from a supplier on credit rather than paying cash up front. 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 the 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.
Types of Credit Insurance
- 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.
- 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.
- 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.
- 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.
- Trade Credit Insurance: It is a type of insurance that protects the business against the risk of customers or clients who doesn’t pay because of insolvency or other events.
Cost of Credit Insurance Policy
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 amount due, whichever is lower after verification of the validity of a claim.
- 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.
- Assurance to Creditor: This policy will give security to the creditors of their amount due.
- Increase Creditability: It will increase the creditability of policyholders as it gives assurance of debts to the third party.
Credit Insurance vs. Letter of Credit
- Credit insurance covers the risk of debt due to the third party in case of happening 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 amount of debts varies, whereas a letter of creditLetter Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk. 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 ideal for more massive payments and transactions.
- In credit insurance, the insurance company guarantee of repayment, whereas in the letter of credit issuer bank will give a guarantee of repayment.
- Increase 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
- 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 is the type of insurance which guarantees the repayment of debt or amount due to creditors or third party. 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. 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 the higher amount and risk as compared to credit insurance.
This has been a guide to What is Credit Insurance & its Definition. Here we discuss the types of credit insurance, examples, and how it works along with importance, cost, advantages, and disadvantages. You can learn more about from the following articles –