Trade Credit Insurance: Operational Value and Contract Choice

Abstract

Trade credit insurance (TCI) is a risk management tool commonly used by suppliers to guarantee against payment default by credit buyers. TCI contracts can be either cancelable (the insurer has the discretion to cancel this guarantee during the insured period) or non-cancelable (the terms cannot be renegotiated within the insured period). This paper identifies two roles of TCI: The (cash flow) smoothing role (smoothing the supplier's cash flows), and the monitoring role (tracking the buyer's continued creditworthiness after contracting, which enables the supplier to make efficient operational decisions regarding whether to ship goods to the credit buyer). We further explore which contracts better facilitate these two roles of TCI by modeling the strategic interaction between the insurer and the supplier. Non-cancelable contracts rely on the deductible to implement both roles, which may result in a conflict: A high deductible inhibits the smoothing role, while a low deductible weakens the monitoring role. Under cancelable contracts, the insurer's cancellation action ensures that the information acquired is reflected in the supplier's shipping decision. Thus, the insurer has adequate incentives to perform his monitoring function without resorting to a high deductible. Despite this advantage, we find that the insurer may exercise the cancellation option too aggressively; this thereby restores a preference for non-cancelable contracts, especially when the supplier's outside option is unattractive and the insurer's monitoring cost is low. Non-cancelable contracts are also relatively more attractive when the acquired information is verifiable than when it is unverifiable.

Keywords: credit insurance, cancelable insurance, trade credit, risk manaement, moral hazard, agency costs, operations-finance interface