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"YOU CAN'T PAY US THIS MONTH?
WHAT DO YOU MEAN 'NEW DEVELOPMENTS?"

Managing risk to your receivables

Receivables are more vulnerable than they have been. Should you assume this risk internally, or transfer it to an insurer? The derivatives market offers a clue: this year is shaping up as a record year for credit derivatives, by which large financial institutions hedge risk of default by their clients. The analog for those not playing in the derivatives market is credit insurance.

When a company gets into trouble it stretches out its payables; it may suspend payments ("temporarily"), and then it may descend into the ultimate insult to creditors, bankruptcy. This has been the way of the business world. What's new is the speed at which it can happen.

RISKS TO RECEIVABLES

Your customers are subject to more volatility than before. Thus, your receivables are facing greater risk. Note the following developments:

1. An economy based on Intellectual Property

Companies based on IP operate in a different environment than companies based on industrial products, or services. Bill Gates described the model:

"With intellectual property, the upfront costs are what it's all about. Say a piece of software costs $10 million to create and the marginal costs, because it's going to be distributed electronically, are basically zero. Once the costs of development have been recouped, every single additional unit is pure profit. But if someone comes along with a better product your demand can literally almost drop to zero."

This can happen because your competitor can get to market almost instantly, its distribution costs insignificant. You either win big, or lose big, quickly.

Hardware follows software. Witness the overnight fall of Lucent into junk bond status.

2. New litigation risk

No longer think of litigation risk in terms of the single BIG CASE (the shark attack). Think of it now in terms of a swarming effect, more like the way pirhana act.

The worst litigation today involves massive numbers of injured parties suing multiple defendants. This is litigation based on "environmental" factors, products or substances that are out in the society legally and are later found to be harmful. These substances are distributed widely because they are (or are in) products in general use. There is something insidious about these lawsuits in the sense that they are imputing hindsight to the defendants.

When W. R. Grace filed for bankruptcy earlier this year, it was the target of 330,000 asbestos injury claims. Each plaintiff has sued as many as 50 to 100 different companies, and the 500,000 individuals who have filed claims may represent less than half of the ultimate number of asbestos claimants. Asbestos litigation alone has driven 41 companies into bankruptcy to date. Tobacco litigation is just beginning. The net worth of Philip Morris is just $15 billion, down from $17 billion a year ago. This can disappear in a blink once the plaintiffs achieve some momentum.

Another development is the involvement of government entities in the litigation. An admittedly biased commentator (an attorney defending the Lead Industries Association against a suit by the state of Rhode Island) put it this way:

"When Blackbeard roamed the seas, governments defended citizens from predatory marauders. Now, however, governments are increasingly tempted to take on the role of marauders themselves. Armed with contingency-fee lawyers rather than swords, cities, counties and states are in danger of shifting their focus from responsible governance to unending quest for bounty."

With the punitive damage weapon, mass torts litigation and class actions, plaintiff attorneys can do significant damage to companies with little advance warning. Creditors of the defendants usually don't pay attention to pending litigation until a judgement is announced.

3. Unprecedented debt load

Corporate balance sheets are bloated. According to the Federal Reserve, corporations borrowed $437 billion in 2000, almost twice the amount raised in 1995. The New York Times lamented this last month that "Corporate debt recently stood at 85% of gross domestic product, a record high. This will only get worse now that the equities market, an alternative to debt, has dried up."

Debt has to be serviced, and companies will go to lengths not to default. Trade creditors will have to take a number and wait when cash gets tight.

The above three forces will be operating in the future regardless of the state of the economy. Combine them with a recession, and creditors need to be diligent.

4. Political risk

Political risk used to mean risk to assets deployed in or credit offered to foreign countries or companies. Since September 11, political risk has been brought home in the form of terrorism. This adds an extra element of volatility. Consider United Airlines. One day a solid payer, the next a bankruptcy candidate. Problems would filter down, of course, to all the airline's supplers as well if it should go under. Though it may not actually happen, many other World Trade Center businesses have in fact disappeared from the business scene.

If you have receivables outside the U.S., country risk is added to the customer's own risk profile. This has always been volatile, but will be much more so now. In April for example, Dun & Bradstreet applied the same risk rating to The United Arab Emirates as to Belgium and Portugal. Don't bet money that they are the same today. Saudi Arabia had a D&B rating just below Japan and not that much worse than Canada. Credit managers with large exposures in the area would be sweating profusely now.

THE CREDIT INSURANCE TOOL

Insurance is for risk transfer. Large but unpredictable losses are insured for a small premium. To the extent your receivables can be fully managed, losses are not unpredictable and risk transfer is not required. This has been the mindset among CFOs and credit managers.

The thesis is that times have changed. Just the way mortgage originators no longer take the risk of any single default, perhaps the risk of any single debtor default should not be retained, but should be pooled with other such risks via the insurance mechanism. Taking receivable risk is not your core business. There are firms whose core business it is, in fact, though. European businesses have long had a more positive view of risk transfer, with around 80% of them buying the coverage.

The insurance pays in the event of non-payment by the customer. The premium should range from one tenth to one quarter of one percent of sales per year for domestic sales, higher for foreign sales. The cost can be offset by a better rate from lenders, and an increase in the advance rate (the percentage of total receivables which lenders will advance). Coverage can be bought for all sales or for only key customers or certain groups of customers. The insurer also provides a form of business intelligence by advising you when when the risk profile has changed for a region of the world or a specific segment or an individual company. You can then adjust your sales activities accordingly.

Given the inevitability of losses, you'll be judged not by whether you were the victim of an event, but by how well you planned for it.

(C) 2001 Licata Kelleher Risk and Insurance Advisers, Inc. Permission granted for distribution as is (with full attribution).

Contact us for risk management strategy and implementation.

Licata Kelleher is a risk management and insurance advisory firm. The firm does not sell insurance, but does counsel clients on the effectiveness of insurance, on reducing the cost of insurance and on the risk management process.

The above is intended to be general information, and should not be construed as specific recommendations.

For more information, contact Debora Wu, at DWU@LicataRisk.com

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