Debtor Protection – what SMEs need to know

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Optimum Finance’s CEO Richard Pepler talks about why many businesses are turning to Debtor Protection and the benefits of insuring debtors, and provides his recommendations for avoiding the common pitfalls associated with such policies’ provisions

Debtor Protection is seldom a consideration for an established business with a healthy cash flow. However, I have recently noticed a new trend whereby established businesses that have not needed any form of finance before, let alone invoice finance, are suddenly opting to insure their debtors.

What’s the reason behind this? The answer lies in the growth-curve of a business. It’s not unusual for an established business to experience a significant growth spurt after winning a large contract or new customer, and this poses some important considerations for the survival and success of the business. The immediate concern is funding the stock requirements to satisfy the contract or project obligations, a cost that probably won’t have been budgeted for and as such poses a huge drain on the company’s cash flow.

The risk associated with this inflow of new business is another consideration that is often overlooked. Although a new contract or customer is a reason to celebrate, the more seasoned senior managers out there recognise that this jump in future profit brings its associated risks. What happens if the debtor fails? Could the business survive that kind of financial hit? How do we fund our raw materials if it takes 60-90 days to get paid?

One solution is Debtor Protection. In short, Debtor Protection is insurance of your debtor book. Should your customers not pay their invoices on time, or cease to trade, the insurer would pay the outstanding debt. But is it really just that simple?

It’s important for SME-owners to ask themselves when they last read through their Debtor Protection or Credit Insurance policy and if they understand terms and conditions. It must be emphasised that it really is not enough for SMEs to just take out such a policy without being aware of its provisions.

At some point we have all taken out a form of insurance without fully understanding the contract. For a business, however, this could come at a very high cost: what if your biggest debtor defaults on payment and the insurance claim is repudiated on a technicality? For that reason, here’s how to avoid some of the pitfalls associated with Debtor Protection.

The top 3 reasons for claims not being paid out:The wrong debtor

The Wrong debtor
You may think this impossible, but do you really know the incorporated names of all the businesses you trade with? It’s a simple mistake to make as you might be using a trading name on your contracts instead of the incorporated name at Companies House. To avoid confusion, always use a registered number when adding a principal to a contract.

Trading outside your limits
Insurers will always assess risk on the limits of how a company is trading, i.e. if debtor A has a £50,000 limit according to your credit policy, then the risk to the insurer is calculated on that amount. If you decide to trade outside your own credit policy because you like debtor A and he defaults, don’t expect any sympathy from your insurance company! Insurers will only honour debts up to the amount of your credit limit and amounts over and above this limit will be at your own cost. Always check with credit control to ensure the correct limits are in place.

Continuing to trade when an account is significantly overdue
It sounds like an obvious issue to avoid, but we all know it is incredibly difficult to say no to long-standing customers. Business owners often extend credit in these circumstances or have special “arrangements” with such customers to help them out. However, if you are trading in a way that would be considered as “reckless” by your insurer and extending credit that is clearly at risk of default, then you should expect non-payment in the event of a claim.

Insurers will only cover amounts that fall within the maximum extension period, i.e. 60 days after the due date of the original invoice. In other words, if you have 30-day payment terms you can trade for up to 90 days with the debtor. After this, you should cease extending credit as your policy will not cover this.

Another important consideration for businesses is how long it takes to pay out a claim. Generally, protracted default claims are paid out 30 days after receipt of all claim information, so SME-owners should be clued-up on what paperwork needs to be submitted.

If you believe a debtor is at risk of default, then it would be prudent to request a County Court Judgement (CCJ) against the debtor for the outstanding amount. In the event of an insolvency, however, you need to wait for an insolvency hearing before you can submit a claim. Should you believe a debtor is going to enter insolvency, it would still be prudent to register a CCJ as, even if your debtor doesn’t become insolvent, you have already started the process of submitting a standard claim to your insurer.

In conclusion, SME Debtor Protection or Credit Insurance policies are sophisticated tools that require a high level of skill to navigate in order to ensure that claims are successful. There are many hoops to jump through and policy wording must be carefully studied, with procedures being adjusted accordingly.

This process can often be simplified by taking out Debtor Protection insurance via a financier’s umbrella policy as the financier as they would have done all the necessary due diligence on the policy and on the debtors, and they would also be able to provide guidance and best practice.