A document issued by a financial institution bank guaranteeing that a buyer will pay to a seller on time with the correct amount. In case those buyers dont pay, then the bank will be required to cover the full or the remaining amount of the purchase. The LCs is often used in international transactions to ensure that payment will be received. LCs has been used for centuries to facilitate payment in international trade and their use will continue to increase as the global economy evolves.
Trade credit insurance, business credit insurance, export credit insurance or credit insurance is an insurance policy and a risk management product offered by private insurance companies and governmental export credit agencies to business entities wishing to protect their accounts receivables from loss due to credit risks such as protracted default, insolvency or bankruptcy. This insurance product is a type of property & causality insurance and should not be confused with such products as credit life or credit disability insurance, which individuals obtain to protect against the risk of loss of income needed to pay debts. Trade Credit Insurance can include a component of political unrest, expropriation etc.
These points to the major role trade credit insurance plays in facilitating international trade. Trade credit is offered by vendors to their customers as an alternative to prepayment or cash on delivery terms, providing time for the customer to generate income from sales to pay for the product or service. This requires the vendor to assume non-payment risk. In a local or domestic situation as well as in an export transaction, the risk increases when laws, customs, communications and customer's reputation are not fully understood. In addition to increased risk of non-payment, international trade presents the problem of the time between product shipment and its availability for sale. The account receivable is like a loan and represents capital invested, and often borrowed, by the vendor. But this is not a secure asset until it is paid. If the customer's debt is credit insured the large, risky asset becomes more secure, like an insured the large, risky asset becomes more secure, like an insured building. This asset may them be viewed as collateral by lending institutions and a loan based upon it used to defray the expenses of the transaction and to produce more product. Trade credit insurance is, therefore, a trade finance tool.
Trade credit insurance is purchased by business entities to insure their accounts receivable from loss due to the insolvency of the debtors. The product is not available to individuals. The cost for this is usually charged monthly, and is calculated as a percentage of sales for that month or as a percentage of all outstanding receivables.
Trade credit insurance usually covers a portfolio of buyers and pays an agreed percentage of an invoice or receivable that remains unpaid as a result of protracted default, insolvency or bankruptcy. Policy holders must apply a credit limit on each of their buyers for the sales to that buyer to be insured. The premium rate reflects the average credit risk of the insured portfolio of buyers. In addition, credit insurance can also cover single transactions or trade with only one buyer.
Letter of Credits (LCs) types:
1. Commercially letter of credit: Primary payment mechanism for a transaction.
2. Standby letter of credit: Secondary payment mechanism.
Beneficiary: Means the party in whose favour a credit is issue.
Issuing bank: The bank issues a credit to the request of an applicant or on its own behalf.
Advising bank: The bank advises the credit at the request of the issuing bank.
Confirming bank: The bank adds its confirmation to a credit upon the issuing bank's authorization or request.
Letter or credit characteristic:
A. Negotiability: The issuing bank is obligated to pay not only the beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are passed freely from one party to another almost in the same way as money. To be negotiable, the letter of credit must include an unconditional promise to pay, on demand or at a definite time.
B. Revocability: Letters of credit may be either revocable or irrevocable. A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is engaged in a transaction that involves a revocable letter of credit, it serves as the advising bank.
Credit Insurance:
Credit insurance provides a business with protection against the failure of a customer to pay their trade credit debts. This can arise as a result of a customer becoming insolvent or because your customer fails to pay within the agreed credit period. These risks are referred to as 'commercial risks'. The protection covers many other risks such as work in progress and binding contracts.
Benefits of Trade Credit Insurance:
There are many benefits including:
Better credit control and protection against catastrophic bad-debt losses.
Better risk management through an early warning system bolstered by the Euler.
Hermes database.
Better business planning through the elimination of unknown risks.
Improved working capital from your lender because you have enhanced the quality of your accounts receivable with trade credit insurance
Better sales targeting, thanks to Euler Hermes' proprietary information that can be used to target new customers and markets and monitor existing customers.
The benefit of Euler Hermes' debt collection capabilities and network
Improved cash flow, because you receive payment for unpaid invoices that are insured.
1.2 RESEARCH AIM
Our analysis aim to investigation replacement the letter of credit by using the credit insurance, In from service business prospection Financial Institution of Bahrain and view the reason behind introducing this analysis and will show the effectiveness of the credit insurance activity and performance. More over we will conduct a questionnaire survey and interview in order to analyze the financial institutions and customers view on the proportional of replacement the letter of credit by using the credit insurance undertake by financial institution.
1.3 RESEARCH OBJECTIVE
To investigate the impact of letter of credits on the cost of sales with proposals of replacing letter f credit with a much lower costly system this is the credit insurance.
1.4 RESEARCH QUESTIONS
The paper will try to look into the replacement the letter of credit by using the credit insurance in model of financial institution, and will try to answer following questions through qualitative case study research:
What other mechanism would be able to "replace" the Letter of Credit"?
Does the Documentary Collection provide enough guarantee to both parties?
What other practices are common in International Advance Payment methods?
What are the Benefits of Trade Credit Insurance?
How Does a Trade Credit Insurance Policy Work?
Is trade credit insurance for everyone?
What kind of risk does a credit insurance policy not cover?
How can trade credit insurance ensure my company's liquidity?
When does insolvency occur?
Does credit insurance cover the effects of armed conflict?
Are there policies designed specifically for SMEs?
1.5 SIGNIFICANT OF THE STUDY
We are trying to conduct the research which explores the advantage of understand concept of the replacement the letter of credit by using the credit insurance in Kingdom of Bahrain in domain service business. We developed our interest in financial institution, their use importance and therefore to study the further through this research work. Bahrain is very successful place for financial institution and business advice in service sector like other big international countries.
Credit insurance provides not only the peace of mind to you, but also the following key benefits: Catastrophic loss protection, safe sales expansion, increasing borrowing, credit decision support and information on customers, allows companies to lower their bad debt reserve and helps avoid an unexpected significant impact on company/financial institutions.
1.6 DATA COLLECTION METHOD
In this project will use qualitative research which is use different appropriate collecting date or it's typically following method of gathering information. Moreover Date will be obtained from two sources. Primary data is collection information by electronic storage information, documents, prior studies, archival records, Literature review and Audit company website. Secondary data will be from survey' Auditor experts, consultant in auditing and Manager", direct observation, interviews and experiment treatment. Finally the aim of research is to gain culture's practices, motivations and be able to understand the culture of research experience.
1.7 SURVEY METHODOLOGY
The survey target local and international finance institution/bank in Kingdom of Bahrain. The questionnaire designed to collect large amount of information from large number of people in short period of time.
Questionnaire is analyzed scientifically and objectively than other method in research. Data discover from questionnaire used to compare and measure changes with similar research, and also it can help to create new theories or test existing hypotheses.
Moreover Questionnaire is initially designed to target companies, employees and customers in financial institutions/bank to measure the opinion and performance of credit insurance. Questionnaire will be distributed in hard copies to sample of financial institutions/bank or will be sending through emails.
1.8 LIMITATION OF THE STUDY
The purpose of this study is examines the replacement the letter of credit by using the credit insurance, information regards this study is available in internet by documents, prior studies and commerce and industry ministry websites. But the problems that finance companies not show all client name or the process of fees because it is secure information.
In other hand not all employees respond to my question because they might think that they will not benefit from responding perhaps even be penalized by giving their real opinion also there is difficulties to show their client financial report. The output of our research would be based on the big and small financial institutions and I will try my best to depict the whole picture of credit insurance in Kingdom of Bahrain.
Mostly in terms of cost and time, samples were nominated from Bahrain. The facts interview organization, data analysis and conversation, and conclusions were all complete based on accessible theories examined in the theoretical review of this study. The result of this study suggests that:
Certain accounts will have specific coverage limits assigned and the limits may be far less than the amount requested by the creditor.
Policies include annual and per loss deductibles meaning that credit insurance is not first dollar loss coverage so the creditor self - insurers for a portion of the risk.
Insurance policies often contain exclusions and limitations on coverage.
Credit insurance policies will usually not pay the creditor company if the debtor asserts that the balance due is in dispute and customers in serious financial trouble often claim the balance due is disputed.
Credit insurance involves risk sharing, not risk transfer from the creditor to the insurance company and most insurers decline coverage on companies they consider high risk. The problem is that these
Chapter two
2.1 INTRODUCTION
Credit insurance provides a business with protection against the failure of a customer to pay their trade credit debts. This can arise as a result of a customer becoming insolvent or because your customer fails to pay within the agreed credit period. These risks are referred to as 'commercial risks'. The protection covers as standard goods or services sold and delivered, but can be tailored to cover many other risks such as work in progress and binding contracts.
Companies that export can protect themselves against a range of political risks which may prevent or delay payment.
Companies of all sizes use credit insurance. Euler Hermes has credit insurance solutions which suit the needs of an SME up to the largest multi national company.
Research suggests that 18% of companies that fail do so because they have experienced bad debt or poor working capital. Businesses protect their tangible assets such as property and plant, but often neglect to cover their receivables which can represent 40% of their current assets.
Credit insurance can reduce the unnecessary cost of bad debt and protect hard - earned success and provide the cornerstone of secure growth.
Are There Additional Benefits?
There are many additional benefits to using Euler Hermes. These include:
A reduction in bad debt provisions, thereby releasing tied up capital. Better risk prevention through the 'early warning' system provided by the credit limits service, and Euler Hermes extensive information database.
Greater access to finance. A credit insurance policy can be used to provide security to a lender for trade or export finance.
Better sales targeting - our information can be used to target new customers and markets as well as monitoring existing customers.
Representation at meetings of creditors and fee legal and practical advice on enforcing Retention of title rights
How much cover is available?
On average, the level of indemnity is 85% but this can vary, depending on the type of policy you choose or on your specific requirements.
How much does Credit Insurance Cost?
The cost of a credit insurance policy is directly linked to the risk to which your business is exposed and is related to the amount of turnover that you wish to insure. It varies in relation to where your customers are located, your business track record in credit management, the nature of your customers, the trade sector in which you trade, etc.
Payment Options
The exporter should consider whether it is necessary to use a letter of credit method of payment could be acceptable, desirable or more appropriate. You may wish to consider other forms of payment, such as:
Payment in advance
Documentary collection (Bills of Exchange)
Open account terms
2.2 LITERATURE REVIEW
2.2.1 Risk Management: Trade Credit Insurance
By Al Modugno
Since the global financial crisis of 2007 to 2008, demand for trade credit insurance has been rising steadily. The insurance, which can be structured to help protect businesses, traders and financial institutions against the financial consequences of defaults, insolvencies and bankruptcies of their trading partners, has been a valuable tool for facilitating international trade, particularly in emerging markets.
Many international banks use structured trade credit insurance to expand their business with a single obligor or within specific country. A bank may have a ceiling or cap on how much it can lend in a certain country or to a specific counterparty. The purchase of trade credit insurance fees the bank to extend its credit, at least incrementally, and go beyond the cap. The insurance can help banks grow their assets and conform to risk-weighted standards under Basel II and Basel III.
2.2.2 Demand for trade credit insurance rises amid economic uncertainty
By Daljit Dhesi
The demand for trade credit insurance among Malaysian exporters, including the small and medium enterprises (SMEs), to protect for non-payment by overseas buys have risen significantly amid the global bleak economic scenario sparked by the eurozone sovereign debt crisis and the weak US economy.
More exporters are now taking such policies to protect their trade receivables although there are still some SMEs who are not aware of such protection.
The trade credit insurance policy issued by the bank can be assigned to a financial institution to facilitate policy holders to obtain financing facilities, adding that in the event of non-payment, claim will be paid directly to financial institution, hence, servicing the loan by exporters.
2.2.3 Trade credit insurance faces overhaul
By Richard Tyler, 2010
Businesses will see trade credit insurance premiums increase as well as cover educe if their customers suffer weak trading in future, one leading insurer. But contrary to claims by the Business Department, the credit insurance industry will survive the recession. Coface, which has 1,500 business customers in the UK, has begun a two month transition to new contract terms with its customers as part of a shift in its business model.
The insurer has said premiums will remain higher than those seen before the recession because past premiums did not accurately reflect the risk that businesses would fail to pay their bills. It added that businesses would in future be expected to be more transparent about their current trading performance in return for trade credit insurance cover for their suppliers.
2.2.4 Trade credit insurance: Protecting your business against non-payment of accounts receivables
By Rahim Tejani, CFA
As competition intensifies and trade barriers disappear, businesses today are faced with the task of managing significantly more financial risk exposures in their day-to-day operations. Businesses are now forced to be educated in various risk mitigation strategies including:
Foreign country business practices and laws
Currency exposures
Political risk exposures
Collection risks
In reality, a number of insurance companies exist that provide protection against non-payment of both domestic and foreign receivables. Credit insurance is more flexible than in the past as it is designed to fit a corporations' business. In practice, corporations are purchasing the product for specific portfolios of receivables while still providing the insurer an acceptable spread of risk.
2.2.5 Application of UCP
The Uniform Customs and Practice for Documentary Credits, 2007 Revision, ICC Publication no. 600 "UCP" are rules that apply to any documentary credit, including to the extent to which they may be applicable, any standby letter of credit when the text of the credit expressly modified or excluded by the credit.
2.2.6 Credits v. Contracts
A credit by its nature is a separate transaction from the sale or other contract on which it may be based. Banks are in no way concerned with or bound by such contract, even if any reference whatsoever to it is included in the credit. Consequently, the undertaking of a bank to honour, to negotiate or to fulfill any other obligation under the credit is not subject to claims or defences by the applicant resulting from its relationships with the issuing bank or the beneficiary. A beneficiary can in no case avail itself of the contractual relationships existing between banks or between the applicant and the issuing bank.
An issuing bank should discourage any attempts by the applicants to include, as an integral part of the credit, copies of the underlying contract, proforma invoice and the like.
2.2.7 Commercial Invoice
A commercial invoice:
Must appear to have been issued by the beneficiary
Must be made out in the name of the applicant
Must be made out in the same currency as the credit
Need not be signed
A nominated bank acting on its nomination, a confirming bank, if any, or the issuing bank may accept a commercial invoice issued for an amount in excess of the amount permitted by the credit, and its decision will be binding upon all parties, provided the bank in question has not honored or negotiated for an amount in excess of that permitted by the credit.
The description of the goods, services or performance in a commercial invoice must correspond with that appearing in the credit.
2.2.8 Accept the Requirement and Safeguard the Letter of Credit
By Michael Evan Avidon
Although it is not recommended, one option for the beneficiary is obviously to accept the requirement that is must present the original letter of credit. Fortunately for most beneficiaries, mishaps are relatively rare, and even beneficiary to enable it to obtain the payment supported by the letter of credit; of course, if the applicant is then insolvent or not on good terms with the issuing bank, the applicant may be unable to cause the issuing bank to pay the letter of credit and may be unable to pay the beneficiary itself or procure a replacement letter of credit.
2.3 CONCLUSIONS
Letter of credit plays an important role in a variety of real estate and other commercial transactions. The documents associated with the letter of credit, and the letter of credit itself, need to be drafted in a way that recognizes the current volatility in the financial markets. While most documentation will work as the parties intended, increased vigilance is imperative until the banking industry stabilizes.
