Trade finance is the backbone of international trade, especially in a dynamic and fast-paced economy like India. Exporters, importers and businesses engaged in cross-border trade face the constant challenge of managing risks and ensuring payment security. This is where tools like Trade Credit Insurance (TCI) and Letters of Credit (LC) come into play.
But when it comes to choosing between Trade Credit Insurance and a Letter of Credit, which one suits your business needs better? In this blog, we will explore both options in-depth and provide you with a clear understanding of their differences, benefits and when to use each one in India.
Let’s dive in!
What is Trade Credit Insurance?
Trade Credit Insurance is a policy designed to protect businesses from the risk of non-payment or late payment by their customers. In simpler terms, it acts as a safety net, ensuring that businesses are compensated if their buyers fail to pay due to insolvency, bankruptcy or protracted default.
Trade Credit Insurance is commonly used in both domestic and international trade transactions. It’s an excellent tool for companies that deal with credit sales, as this credit insurance policy ensures a continuous flow of revenue even when customers fail to settle their dues.
How Trade Credit Insurance Works:
When a business enters into a trade agreement with a customer, the insurer evaluates the customer’s creditworthiness. Based on this, the insurer provides coverage for a specific percentage of the invoice value in case the buyer defaults. In many cases, the coverage under a TCI policy can be up to 90% of the invoice value, depending on the buyer’s credit profile and the insurer’s assessment.
Key Benefits of Trade Credit Insurance:
- Protection Against Buyer Default: TCI shields your business from the risk of customers not paying their bills, even if it’s due to circumstances like insolvency.
- Improved Cash Flow: When you know your invoices are covered, it boosts your confidence in offering credit terms. This, in turn, improves cash flow and helps expand your business.
- Access to Better Financing Options: Banks often look more favourably upon businesses with Trade Credit Insurance when they apply for working capital loans or trade finance facilities.
- Global Reach: TCI can be used for both domestic and international transactions, making it an ideal choice for businesses expanding their footprint overseas.
Scenarios Where TCI is Useful in India:
- Exporters dealing with overseas clients who might be prone to payment delays or insolvencies.
- Manufacturers selling goods on credit to domestic clients in industries with fluctuating payment habits.
- Businesses that want to ensure stable cash flow while maintaining healthy customer relationships.
What is a Letter of Credit?
A Letter of Credit (LC) is a payment guarantee issued by a bank on behalf of the buyer. In essence, it assures the seller that the bank will pay them once the stipulated terms and conditions of the contract are met.
There are several types of Letters of Credit, with the most common being:
- Irrevocable Letters of Credit: Cannot be amended or cancelled without the consent of both the buyer and seller.
- Confirmed Letters of Credit: A bank (usually the seller’s bank) confirms the LC, guaranteeing payment even if the buyer’s bank fails to pay.
- Sight Letters of Credit: The payment is made as soon as the documents are presented and verified.
- Deferred Payment Letters of Credit: Payment is made after a certain period, often used for larger deals.
How a Letter of Credit Works:
The buyer applies for a commercial letter of credit with their bank (the issuing bank), which outlines the transaction terms. The issuing bank then forwards the LC to the seller’s bank (the advising or confirming bank). The seller must present compliant documents such as a bill of lading, invoice, and packing list. Payment is made only if these documents strictly match the LC terms.
Key Benefits of Letters of Credit:
- Payment Security: A Letter of Credit guarantees that the seller will receive payment, provided they meet the terms.
- Reduced Risk for Both Parties: A Letter of Credit eliminates risks such as fraud, non-payment, or disputes over contract terms.
- Flexibility: The buyer and seller can negotiate the terms of the commercial letter of credit, providing a tailored solution for various types of transactions.
- Credibility: Using an LC can enhance the credibility of your business, especially when dealing with international partners.
Scenarios Where an LC is Useful:
- International trade where the buyer and seller are not familiar with each other.
- Exporters and importers dealing with high-value or high-risk shipments.
- Transactions where the seller requires an assurance of payment before shipping the goods.
Trade Credit Insurance vs Letter of Credit: Key Differences
While both Trade Credit Insurance and Letters of Credit help manage financial risk in trade, they operate in fundamentally different ways. Let’s break down the key differences.
1. Coverage and Protection
- TCI: Protects against the risk of non-payment by the buyer, regardless of the nature of the transaction (domestic or international). It ensures that if a buyer defaults, the seller receives compensation (usually up to 90% of the invoice value).
- LC: Provides a payment guarantee only if the seller complies with the terms outlined in the commercial letter of credit. While it doesn’t insure against insolvency like TCI, a confirmed LC protects the seller because the confirming bank commits to payment, even if the buyer becomes insolvent.
2. Function and Purpose
- TCI: Primarily designed to safeguard against the risk of default from buyers. This credit insurance policy is ideal for businesses that have regular credit sales and want comprehensive protection.
- LC: Ensures payment security for international transactions. The commercial letter of credit guarantees payment from the buyer’s bank, provided the terms of the contract are adhered to.
3. Risk Exposure
- TCI: Covers the risk of both buyer insolvency and protracted default. The buyer may default for various reasons and the insurer will cover the seller’s losses.
- LC: The risk is transferred to the buyer’s bank. The seller receives a guarantee, but must ensure compliance with strict documentation terms.
4. Cost Comparison
- TCI: The cost involves paying premiums to the insurer, based on the creditworthiness of the buyer and the policy limits. TCI premiums may be lower for businesses with regular credit sales.
- LC: Fees for a letter of credit include issuance and confirmation fees charged by the bank, which can be higher for one-off or high-value deals. The cost varies based on the size of the transaction and the issuing bank’s charges.
5. Impact on Cash Flow
- TCI: By securing the risk of non-payment, TCI allows businesses to offer more favourable credit terms to buyers, thereby increasing sales and improving cash flow.
- LC: While LCs guarantee payment, delays can occur if documents are not compliant or if there are discrepancies. Efficient documentation can mitigate these delays, but sellers must be meticulous to avoid hold-ups.
When to Choose Trade Credit Insurance vs Letter of Credit in India?
Choosing between TCI and LC depends largely on the nature of your business and the type of transactions you engage in.
Trade Credit Insurance is ideal for businesses that frequently offer credit terms and need protection from a wide range of buyer-related risks, whether domestically or internationally. It’s also suitable for companies looking to boost their credit sales without worrying about payment delays.
Letter of Credit, on the other hand, is more suitable for international trade or high-value transactions where payment security is a priority. It’s the go-to option when dealing with new clients or markets, as it provides a clear assurance of payment from the buyer’s bank.
Final Thoughts
Both Trade Credit Insurance and Letters of Credit are powerful tools for managing financial risks and ensuring secure payments. However, their applicability depends on the specific needs of your business. While TCI is more comprehensive in protecting against buyer defaults, an LC ensures payment security, especially for international deals.
For businesses operating in India, both options provide vital financial protection. Assessing the nature of your transactions, the level of risk and your need for liquidity will help determine the best solution for your business. Consider consulting with financial experts or banks to choose the most suitable trade finance option tailored to your needs.
By understanding the nuances of both tools, you can make an informed decision that secures your business’s financial health and supports growth.
