How Analytics Can Help You Quantify Your Trade Credit Risk

Following the financial crisis in 2008, the 2016-17 financial year yielded the first annual increase in insolvencies in six years.

In a recent Risk in Context blog, Tim Smith, Marsh’s Global Trade Credit practice leader, expressed his belief that this increase looks set to continue, and perhaps even accelerate, in 2017. Against this background, protecting a firm’s receivables is expected to become an increasing concern for many business leaders.

Understanding the potential trade credit losses a firm could be exposed to, their magnitude, and what solutions are available to finance them are important steps in deciding on an appropriate risk mitigation strategy.

How Significant Is Your Trade Credit Risk?

A firm’s trade credit risk profile is unique, and is dependent on its buyers and the business environment it operates in. Risk analytics can help a firm quantify this risk. From the output, the quantitative loss potential can be compared to the firm’s willingness to accept risk (that is, its risk appetite) to determine a tailored solution.

The key inputs to a trade credit risk analytics model include, but are not limited to, the following:

1. Buyer risk: The inherent credit risk posed by a buyer of goods or services.
2. Buyer limits: The credit limit associated with each buyer.
3. Country risk: The global risks faced when trading in differing economies.

The analytics can be used to calculate average losses and the magnitude of more severe events. The projected losses can then be compared against your firm’s overriding appetite for risk. For example, the analytics can be used to show that there is a one in 10 year chance that losses could exceed your firm’s previously defined risk appetite.

How Can You Finance Your Trade Credit Risk?

Once the loss potential of your trade credit exposure has been quantified, you can make an informed decision about the optimal blend of your own capital and insurance to finance losses, taking into consideration your risk appetite, your weighted average cost of capital (WACC), and the cost of insurance.

The analytic output will help you objectively evaluate how to finance your trade credit risk, whether by retaining the risk on balance sheet, transferring it to the insurance market, or a blend of these options. It also provides the foundation for a robust, auditable risk finance strategy for the future.