Find out more about the latest developments in credit risk management for your industry.

Logo Created with Sketch. SCHUMANN - EN

Hedging Credit Risks in Difficult Times

Credit protection is an instrument for reducing the risk of payment defaults. What options do companies have to protect themselves against credit risks?
Schumann Insights, Blog Post, Videos
12.12.2022, Prof. Dr. Matthias Schumann

How Can Credit Risks Be Hedged in Difficult Times?

Especially in economically turbulent times like these, credit protection plays a significant role. It is an instrument for reducing the risks of payment defaults. How can companies protect themselves against credit risks? And how do factoring and trade credit insurance support them in this?

Forecast for 2023

For 2023, we can expect a further deterioration in the economic situation in various sectors. The chemical industry is already seeing a significant drop in sales, and private building construction is also feeling the effects of subdued demand. Other sectors are suffering from various negative economic influences.

Banks will or have increased their interest rates for current account or short- and long-term loans due to the higher key interest rates. Also contributing to this is the deterioration in corporate risk due to the economic outlook in the affected industries. The risk premium is also reflected in the higher interest rates.

Consequences of the Economic Situation

Comparatively speaking, this means that the supplier credit as a financing instrument is becoming more of a focus for supplying companies. Apart from the fact that the company's own risk of bad debt losses is increasing and therefore requires close scrutiny of the customers affected, it will not be possible to reduce the credit limit across the board or shorten the payment period. These would be measures to limit risk. And retention of title is not helpful in most cases.

The tendency is for longer payment terms to lead to a higher level of receivables, combined with a higher level of capital commitment. In case of doubt, this must be financed at high interest rates via bank loans.

What Are the Possibilities for Companies?

Factoring offers a possibility to avoid capital commitment on the one hand and to ensure a rapid inflow of liquidity on the other. The receivable is sold, the liquidity is available at short notice for further activities and/or further credit lines do not have to be drawn on for financing. On the other hand, factoring offers the possibility, in the case of risk assumption, to hedge against the risk of bad debt loss at appropriate discounts. Flexible and individually adapted solutions are possible here. Incidentally, this also applies overall to the procurement side, with purchase factoring.

Other Risk Protection Options

If the focus is only on risk hedging, trade credit insurance can be helpful. Different forms can be used. Individual receivables can be insured at a fairly high price, but in a targeted manner. Classically, trade credit insurance with a blanket insurance range up to a tender limit with the obligation to apply for insurance cover above. It is also possible to exclude certain industries or countries from the contract. Of course, in crisis situations or crisis industries, the insurance will draw more cautiously. Nevertheless, this protects the policyholder. If the underwritten limits are not sufficient, there is the possibility that possibly a second top-up insurance provides additional coverage. Finally, if you want to insure yourself against the risk of large defaults and bear the risks yourself up to a certain amount, excess of loss insurance may be an option. In this case, however, you have to prove to the insurance company that you have your own, very good IT-supported customer verification processes.

All in all, there is a whole spectrum of instruments that can also be used for hedging in times of higher risk. The aim must be to compare the relevant variants and to consider different forms of arrangement in order to obtain the best possible risk protection. The aim must be to avoid jeopardizing potential sales in particular. In case of doubt, even payment plan agreements with the customer can improve the security of a transaction.

With this in mind, I wish you a good choice in your risk hedging strategy.

About the Author
Prof. Dr. Matthias Schumann

Since 1991, Prof. Dr. Matthias Schumann has held a professorship in Business Administration and Information Systems (Chair of Application Systems and E-Business) at the University of Göttingen. He also heads the joint computing center of the Faculty of Economics and the Faculty of Social Sciences. He is a shareholder of Prof. Schumann GmbH.

Prof. Schumann's research interests include information systems at financial service providers and systems for credit management, as well as issues related to knowledge and education management. Prof. Schumann has a wide range of experience in consulting companies, extensive lecturing activities and more than 350 publications.

University of Göttingen

Matthias Schumann q