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A Fantastic Risk-Reward Investment Avenue
I am a CFA and FRM Charterholder. I used to work as a Portfolio Implementation Manager for Aviva Investors managing £3bn+in Assets Under Management in the UK. I am very passionate about educating people on how they can make more money with their existing investments sustainably.
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In this series, we cover all instruments, schemes and products in the alternative investment space available for Indian retail investors.
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Trade Credit Insurance (TCI) protects businesses against non-payment risks by covering trade debts when a covered event occurs, with specific exclusions like political and fraudulent events.
TCI-backed invoice discounting involves the seller obtaining insurance based on the buyer's creditworthiness, allowing investors to purchase invoices with varying levels of principal coverage.
Risks associated with TCI include fraud, operational errors, sub-standard insurers, policy exclusions, and potential lower settlement amounts.
Companies use TCI to reduce financing costs and facilitate larger business transactions, benefiting both buyers and sellers.
While TCI offers a safety net, it remains an unregulated instrument, requiring careful due diligence and risk assessment by investors.
In the last article, we discussed how Bank Guaranteed invoice discounting products work, the risks involved, and why companies obtain a guarantee from the bank.
In this article, we will follow a similar approach and explain how Trade Credit Insurance-backed invoices work, the associated risks, and why companies use them.
To write this article, we had a quick call with a senior executive at altGraaf to understand the products and their details in depth.
This article assumes you are familiar with invoice discounting as an asset class. If not, it would be better to start by reading the tagged article first.
Trade Credit Insurance (TCI), also known as accounts receivable insurance, is a type of policy that protects businesses against the risk of non-payment by their customers or debtors. It provides protection and reduces losses due to non-repayment of trade debts when a covered event occurs.
I want to emphasize the term covered event because, like all insurance policies, it is very specific about what is covered and what is not. altGraaf kindly shared the policy document from The New India Assurance Co. Ltd (the largest non-life insurance company in India), which covers one of the sellers onboarded with altGraaf.
From my understanding, the policy promises to cover any payment due to the seller if the buyer becomes insolvent. But you might wonder, since insolvency proceedings in India can take years, do you have to wait that long to get your repayment? No, the policy includes a defined maximum waiting period. If this period passes, the insurance company will make the payment to the seller.
Unfortunately, altGraaf did not share the exact waiting period in the policy I reviewed due to commercial reasons. However, I assume it would be around 3-6 months.
The policy also clearly states which events are not covered, including political, nuclear, and fraudulent events.
There are some more terms and conditions, but sharing those will be too much for this blog, but you get the general idea of what's covered and not covered.
When you compare TCI structure to the BG structure, here the seller is the one who actually applies to take the insurance against the buyer. The insurance company performs comprehensive credit assessments on buyer to determine its creditworthiness and the insurance coverage limit.
The seller delivers the goods/services to the buyer and raises the invoice ("receivables") after obtaining trade credit insurance based on the buyer's creditworthiness.
The insurance company assesses the buyer's ability to repay and approves a limit.
Investors on the ID platform purchase these invoices. The buyer makes the payment according to the agreed schedule to the escrow account (controlled by the platform), and the payment is distributed to investors as per the agreed terms.
In case of default, the seller files a claim with the insurance company, which, upon approval, credits the escrow account.
Here is a simple workflow by altGraaf to show how the transaction works.
Some TCI deals on altGraaf have 100% principal coverage, while others have 90% coverage. After speaking with senior management at altGraaf, I learned they plan to offer different percentages of coverage based on borrower preferences and investor demand. So, in the future, you might see deals with just 50% principal coverage in a TCI-backed ID deal. Some form of protection will minimize your overall risk, but other risks still remain, such as:
Fraud Risk: The buyer might have provided forged documents to the insurance company to help the seller get the insurance.
Operational Risk: Genuine errors in documentation, communication, or processes may lead to claim rejection.
Insurance Provider Risk: If the insurance is provided by a sub-standard insurer with a history of bad claim settlements and delays, it can be problematic. Instead, choose deals backed by reputable insurers when you invest.
Exclusions Risk: If the loss occurs due to an exclusion mentioned in the policy and the buyer also refuses to pay, the insurance will not cover it.
Lower Settlement Risk: The insurer may offer low settlement amounts, which may not fully compensate for the loss. This product will not cover any default penalty interest, as an insurance claim can take up to 6 months.
The platform's due diligence should address all these risks and bring vetted buyers and sellers onto their platform with valid insurance coverage.
Naturally, this product is riskier than the Bank Guarantee structure because there are certain exclusions in the policy and the time to claim is longer. Currently, on altGraaf, this product offers returns between 11% - 13%, depending on the amount of principal coverage.
When the seller applies for trade credit insurance against the buyer, they pay a premium to the insurance company for extra protection and request paperwork from the buyer to submit to the insurer. What motivates both the buyer and seller to go through this process?
Let's understand this with a simple example:
Suppose the buyer and seller have had a good business relationship so far. Now, the buyer wants to do bigger business with the seller, but the seller isn't comfortable taking on a large risk. So, the seller gets Trade Credit Insurance (TCI) and asks the buyer to support this by sharing all necessary documents with the insurance company. The buyer agrees because they want to keep working with the seller. The seller benefits because their cost of financing (through invoice discounting or other means) will be reduced. This reduction might even be more than the cost of the insurance itself. Plus, both the buyer and seller can negotiate better terms or do bigger business together, making it a win-win for everyone.
To conclude, Trade Credit Insurance offers a valuable safety net for sellers by reducing the risk of non-payment from buyers. Although the process involves thorough credit assessments and specific coverage terms, the benefits of lower financing costs and stronger business relationships make it appealing. However, it is important to be aware of the risks and choose reputable insurers to ensure reliable coverage.
That being said, it's important to note that this secured structure is still an unregulated instrument from the SEBI/RBI perspective, so invest according to your own due diligence and risk tolerance.
I hope this article, along with the previous one on Bank Guaranteed ID structures, helps you make informed decisions about your investments in this asset class.
That's it for this one. If you found this article helpful, please like it and share it on social media to help promote our blogs on Google searches. If you would like to join our exclusive spam-free WhatsApp community, you can apply here.
Please note that this is an opinion blog and not official research advice. I am not a registered RIA in India. This blog aims to promote informed decision-making and does not discourage you from investing in any deals.
We plan to come up with more blogs discussing different types of instruments available in the world of startup investing, write on due diligence for some platforms, and also existing and upcoming alt investment deals in the Indian market. If you want to stay updated on the latest blogs, please subscribe to our newsletter so you get notified automatically.
