If you work in the world of exporting and international trade, and you are looking to safeguard goods shipped overseas to your buyers, you may be wondering if you should use a letter of credit, or export credit insurance.
Both of these methods can help minimize payment risks, and ensure that you are paid on time, based on the terms and conditions that you have signed with your foreign trade partner. So, what are the differences – and which one is right for you?
Find out by reading this article. We’ll discuss what you need to know, and how to choose between these two financial products, and ensure that your accounts receivable are safe from bad debt and default. Let’s get into it now.
What Is Export Credit Insurance? How Does It Work?
This is a specialised form of insurance that is typically used in international trade to protect accounts receivable when you extend trade credit to another party.
That is, trade credit insurance is intended to ensure that any invoice you send out to a customer will be paid, even if the customer defaults on the payment, or enters bankruptcy. Depending on your policy, you may be able to insure a single invoice or a single customer, or take out a policy that covers your entire accounts receivable.
The way that export insurance works is simple. If you deliver a shipment, goods, or services to a customer, and they do not pay due to bankruptcy, stop responding to you, or they default on their payment for any other reason, your insurance company will compensate you, up to the limits set by your policy.
You will usually receive between 85-100% of the value of the transaction from your export insurance policy. This ensures that, even if a sale does fall through and you are not paid by the buyer, your cash flow will not be affected, and your business can simply continue operation.
One thing to note is that most export credit insurance policies do have discretionary limits in place, which limit the size of your transactions. Transactions over a certain value must be approved by your insurer, via credit checks, and other checks to verify the legitimacy of a buyer.
What Is An Export Letter Of Credit?
An export letter of credit is another very popular way to safeguard your cash flow and ensure that you are paid by a buyer when your goods or services are delivered. Unlike credit insurance, export letters of credit are issued by banks.
A letter of credit is, essentially, a commitment by a bank to pay your company (the exporter), on behalf of the foreign buyer (the importer). When properly drafted, it is an extremely secure document.
Essentially, the document states that, provided that all of the terms and conditions stated are met (on-time delivery, quality of goods, etc.) the bank guarantees payment by the importer.
These documents are often issued by foreign banks, and can be “confirmed” by an Australian bank. Confirmation means that the letter of credit is not just backed up by the original bank – but also by the Australian bank.
The most common form is called an “irrevocable” letter of credit. This means that, unless both parties agree to a change, the document cannot be changed in any way. Revocable letters of credit may be changed, unilaterally, by either party – so they are much less useful as a legally-binding document.
Once issued, the letter of credit will be “called” as soon as your credit terms are met. For example, if your goods are delivered on “Net 30” terms, and must be paid for 30 days after delivery, the issuing bank will draw and send the funds to you exactly 30 days after the delivery of goods. This ensures that you receive payment in a timely manner.
What’s Right For Me? Export Credit Insurance, Or A Letter Of Credit?
This depends on a number of factors. For a larger transaction with a new customer, a letter of credit can be a good way to develop a business relationship – and make sure you get paid on time by their bank. However, letters of credit can be complex and expensive, and in markets and countries where banking institutions are not always the most reliable, they may not be enough to guarantee payment.
Export credit insurance, however, will cover your costs for any default or bankruptcy on the part of your client. One benefit of this type of insurance is that, unlike a letter of credit, you don’t need the buyer to be involved in the process of developing and signing – meaning that you don’t need their consent. You can always insure your invoice, regardless of whether or not your customer is willing to sign a letter of credit.
To learn more, we recommend that you contact the team at Niche TC. We can clear up any other questions you may have, and ensure that you get the protection you need with our credit insurance solutions.
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