In our January/February 2025 issue 151 of the KPMG Corporate Treasury Newsletter, we already delved into the depths of traditional counterparty risk and looked at current developments. Building on this, in this issue we take a closer look at traditional operational credit management with the inclusion of credit insurance solutions.

"Put the bad ones in the crop, the good ones in the pot" was the saying used over 200 years ago in the adaptation of the fairy tale Cinderella by the Brothers Grimm. And the saying has lost none of its relevance to Risk management and credit insurance to this day.

In the context of the insurance industry, this is often referred to as "cherry picking". In the context of so-called receivables pools (usually entire bundles of receivables are insured), policyholders tend to remove lower-risk receivables from the pool and limit the scope of insurance to selected high-risk receivables, which in turn is to the detriment of the insurer.

To prevent this form of cherry picking, the contract between the policyholder and the insurer usually follows a two-stage process. Firstly, the insurer examines a representative part of the receivables portfolio in the form of a preliminary review before a framework agreement is subsequently drawn up. On the one hand, this preliminary review serves as the basis for the subsequent insurance benefit; on the other hand, the insurer uses the portfolio insight to provide the insurance premium with an adequate risk component. Depending on the sector and portfolio, this can lead to reductions or increases in the insurance premium. In addition, it becomes apparent whether the debtor portfolio offered is limited to high-risk tickets, i.e. whether the potential policyholder is trying to move the "bad" risks into the insurer's "pot" while the "good" ones remain in their own "pot" in order to save on insurance premiums

During ongoing insurance operations, the policyholder fulfils the obligations agreed in the insurance policy in order to continue to enjoy insurance cover. For example, debtors above a certain volume of receivables must be reported to the insurer for review (this is referred to as the "designated area"). The insurer then has the option of responding to the insurance cover for individual debtors individually, for example in the form of full underwriting, partial approval or rejection. To illustrate this, please refer to Figure 1 below, which visualises the trio of insurer, your company (i.e. policyholder) and customer (i.e. debtor). While the contractual risk exchange of insurance cover for premium takes place between the insurer and the policyholder, the insurer continuously monitors and controls the receivables from the customers.

Fig. 1 Insurance triangle

Early intervention by the insurer in the form of limit reductions or even cancellations leads to a reduction or even avoidance of defaults in operations. Insurers have a broad network of information and assessment procedures at their disposal for the early detection of such emerging risks. What policyholders particularly appreciate about their insurers is that they can identify payment delays among other policyholders almost in real time and immediately include them in the risk assessment.

In general, credit insurance can be defined as an exchange of secure payments (definitely present premium payment) for uncertain payments (compensation payment conditional on the occurrence of an insured event and therefore not secure). In other words, by paying a premium, the policyholder transfers part of his income uncertainty to the insurer. Credit insurance can generally be divided into two variants: Classic credit insurance, which follows the portfolio approach, and individual cover, which can be based on debtor, project or even individual receivables (and is therefore particularly tempting for cherry picking). There are also other variants and mixed concepts such as excess-of-loss insurance, individual receivables insurance or factoring solutions, which are not discussed in detail in this article.

In the classic form of accounts receivable insurance, the insurer generally insures the entire receivables portfolio of its policyholder at a contractually agreed indemnity rate (common practice: cover for 90% of the net receivable). The policyholder is obliged to actively monitor the limits of its insurable items in order to avoid entering into uninsured transactions, for example following the rejection of a debtor due to creditworthiness or the expansion of the business relationship. The insurer, in turn, benefits from the premium payment and the diversification of its own risk portfolio. Typical for this type of receivables insurance are so-called master agreements, so that a stable structure of the credit portfolio can be guaranteed. The master agreement defines the parameters for recurring hedging transactions between the two contracting parties. The parameters may include, for example, maximum agreed payment terms, insurance ratio, minimum premium or other operational regulations such as reporting periods, waiting periods or collection regulations.

In contrast to insuring an entire credit portfolio, individual risk positions can also be selectively insured. Reasons for this can be, for example, orders from new customers, selected major customers or one-off projects. Such transactions are often not based on a framework agreement, as the business relationship is generally not designed for the long term. The prerequisite for this form of single receivables insurance is a sufficient minimum size of the receivable.

To understand the importance of credit insurance as a complementary credit management tool for treasury organisations, just take a look at the financial losses caused by corporate insolvencies in recent years. While financial losses of €23.5 billion were incurred in 2019, the estimate for 2024 was already €56 billion. This was reported by Creditreform in the publication "Insolvencies in Germany 2024" in December 2024. This corresponds to an increase of almost 240%. There is no direct correlation between the financial losses and the absolute number of insolvencies (see 2019 vs. 2024)¹.

Fig. 2 Corporate insolvencies

It can be deduced from this that the insolvencies correspond to a mixed portfolio of small and large companies. Based on this assumption, it is clear that insuring one's own pool of receivables can serve as an attractive risk transfer instrument for a large number of companies. According to Versicherungsmagazin, around 600,000 companies were using trade credit insurance in 2023, which at that time corresponded to coverage of around 18.4% of German companies².

To better understand what a single bad debt loss means for companies, we use a maths experiment. Figure 3 below illustrates the impact of bad debt losses on turnover: if you offset the loss against the profit margin (reverse breakage), you can see how much additional turnover would be required to compensate for the loss. In concrete terms, this means that a comparatively "small" bad debt loss of € 100,000 with a profit margin of 10% would only be offset by additional sales of € 1,000,000. The smaller the profit margin, the more new sales have to be generated in order to compensate for the losses caused by bad debts.

Fig. 3 Losses vs. necessary additional sales

Depending on the risk profile, it is therefore worth exchanging the volatile risks for a fixed premium (usually in the per mille range based on insurable turnover).

To illustrate the abstract concept of "risk" and the risk profiles that depend on it, let's take a look at the following graphic, Figure 4. The graphic illustrates the four quadrants of possible risk profiles on a highly simplified basis. The X-axis represents low or high probabilities that risks will manifest themselves, visualised by the number and width of the potholes. The Y-axis, on the other hand, shows the extent of the risk volume, visualised by the depth of the potholes.

Fig. 4 Risk profiles in four quadrants

In the top right quadrant, we see a debtor portfolio with a high probability of default and a high loss volume, translated into credit risks. With this type of risk portfolio, insurance seems to be the obvious choice, as bad debt losses are practically pre-programmed. In practice, however, it has been shown that such profiles are recognised by the insurer and are actively managed and excluded through partial underwriting or rejection of individual debtors. Credit insurance is therefore not the best choice for this profile. Instead, the recommendation here is to take a strategic look at the target customer portfolio, expand lower-risk customers and gradually reduce the high-risk positions.

The quadrant at the bottom right represents a profile in which numerous and often regular, smaller structural losses are realised at the same time. In business areas that correspond to such a profile, every default is annoying, but does not jeopardise the existence of the company. The recommendation here is to recognise the easily predictable, minor losses themselves with an appropriate risk margin, provided this can be implemented in the market. In addition, active credit management can counteract the frequency of risk through evaluation with the help of external credit reports in combination with appropriate business consequences, e.g. by obtaining advance payment regulations.

The situation is similar in the quadrant at the bottom left. In this profile, only minor defaults are likely to be realised. Credit management efforts here can be limited to portfolio analysis by sector, country and other structural factors in order to recognise at an early stage if the risk profile changes.

The last quadrant, which combines low probability with high risk volumes, offers the most interesting potential for credit insurance. As the policyholder, you protect yourself against unlikely worst-case scenarios that could jeopardise your company's existence. For the insurer, on the other hand, the economic risks are manageable, as it can offset any insurance benefits that may arise through the diversification effects of its own insurance pool. In this case, the use of credit insurance is economically attractive for both parties and a clear recommendation.

Once we have recognised which of our business areas or services correspond most closely to which risk portfolio, we can optimally structure our portfolio as risk managers. For example, we can use value limits for receivables volumes to remove marginal risks with low volumes from the portfolio (i.e. the two lower quadrants). When separating the probability profiles, the subdivision of countries or customer sectors can help. In practice, this can usually be incorporated into a credit insurance policy as long as there is still adequate insurable turnover.

Our Corporate Treasury Advisory Team at KPMG will be happy to help you develop and implement the optimum credit management structure for your company. From analysing the current risk structure and developing standardised Risk management processes to (technical) implementation in daily business processes and decision-making, we support you and your company with our professional and technical expertise. We do not leave you alone in the change process during and after implementation and help you to establish your individual risk culture. If you are interested, please contact us right away.

The structure of the credit management mix and the benefits of credit insurance vary from company to company. Factors such as industry-specific risks, company size and structure or even cultural differences have a considerable influence on the modular composition of the service mix. With the right approach, this service mix can be individualised for your company and instruments such as credit insurance can be used in an optimised way. Given the current market conditions and rising insolvency ratios, it is worth reviewing and further developing your in-house credit management.

You can also look forward to a guest article from the experts at Professor Schumann GmbH in our next newsletter (issue 154 in May 2025). Here we will discuss system technology solutions in operational credit management and how you can use them to take your credit management organisation to the next level.

Source: KPMG Corporate Treasury News, issue 153, April 2025

Authors:

Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG
Lukas Kallup, Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG

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1 Creditreform (2024) Insolvenzen in Deutschland Jahr 2024. Verfügbar unter: https://www.creditreform.de/fileadmin/user_upload/central_files/News/News_Wirtschaftsforschung/2024/Insolvenzen_in_Deutschland/2024-12-16_AY_OE_analyse_UE-2024.pdf (Aufgerufen: 31.03.2025).
2 Schmidt-Kasparek, U. (2023) 'Jetzt in die Kreditversicherung einsteigen', Versicherungsmagazin. Verfügbar unter: https://www.versicherungsmagazin.de/rubriken/branche/jetzt-in-die-kreditversicherung-einsteigen-3430411.html (Aufgerufen: 31.03.2025).