Trade Credit Insurance: Operational Value and Contract Choice

72 Pages Posted: 1 Mar 2016 Last revised: 29 Nov 2019

See all articles by S. Alex Yang

S. Alex Yang

London Business School

Nitin Bakshi

University of Utah

Christopher Chen

Indiana University - Kelley School of Business

Date Written: November 25, 2019

Abstract

Trade credit insurance (TCI) is a risk management tool commonly used by suppliers to guarantee against payment default by credit buyers. TCI contracts can be either cancelable (the insurer has the discretion to cancel this guarantee during the insured period) or non-cancelable (the terms cannot be renegotiated within the insured period). This paper identifies two roles of TCI: The (cash flow) smoothing role (smoothing the supplier's cash flows), and the monitoring role (tracking the buyer's continued creditworthiness after contracting, which enables the supplier to make efficient operational decisions regarding whether to ship goods to the credit buyer). We further explore which contracts better facilitate these two roles of TCI by modeling the strategic interaction between the insurer and the supplier. Non-cancelable contracts rely on the deductible to implement both roles, which may result in a conflict: A high deductible inhibits the smoothing role, while a low deductible weakens the monitoring role. Under cancelable contracts, the insurer's cancellation action ensures that the information acquired is reflected in the supplier's shipping decision. Thus, the insurer has adequate incentives to perform his monitoring function without resorting to a high deductible. Despite this advantage, we find that the insurer may exercise the cancellation option too aggressively; this thereby restores a preference for non-cancelable contracts, especially when the supplier's outside option is unattractive and the insurer's monitoring cost is low. Non-cancelable contracts are also relatively more attractive when the acquired information is verifiable than when it is unverifiable.

Keywords: credit insurance, cancelable insurance, trade credit, risk manaement, moral hazard, agency costs, operations-finance interface

Suggested Citation

Yang, S. Alex and Bakshi, Nitin and Chen, Christopher, Trade Credit Insurance: Operational Value and Contract Choice (November 25, 2019). Available at SSRN: https://ssrn.com/abstract=2735907 or http://dx.doi.org/10.2139/ssrn.2735907

S. Alex Yang (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

HOME PAGE: http://faculty.london.edu/sayang/

Nitin Bakshi

University of Utah ( email )

1655 Campus Center Drive
Salt Lake City, UT Utah 84112
United States

Christopher Chen

Indiana University - Kelley School of Business ( email )

1309 East Tenth Street
Indianapolis, IN 47405-1701
United States

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