Two Common Tools for Managing Payment Risk
When selling on open account — whether domestically or internationally — businesses face the risk that a customer will not pay. Two common tools for managing that risk are trade credit insurance (TCI) and letters of credit (LCs). Both can provide protection against non-payment, but they work very differently and are suited to different situations.
What Is a Letter of Credit?
A letter of credit is a financial instrument issued by a bank on behalf of a buyer, guaranteeing payment to the seller provided the seller meets specified documentary requirements. The bank's obligation to pay is independent of the underlying commercial transaction — if the documents are in order, the bank pays, regardless of whether the buyer has received or accepted the goods. LCs are widely used in international trade, particularly for large transactions or when the seller has limited knowledge of the buyer.
What Is Trade Credit Insurance?
Trade credit insurance is a policy that protects a seller's accounts receivable against the risk of non-payment due to a buyer's insolvency or protracted default. Unlike an LC, TCI does not require the buyer to arrange financing or involve a bank in each transaction. The seller applies for coverage, the insurer evaluates and approves credit limits for individual buyers, and the seller can then sell on open-account terms with the knowledge that covered losses will be reimbursed, subject to the policy's terms and conditions.
Key Differences
Letters of credit require the buyer to arrange bank financing for each transaction, which can be costly and administratively burdensome. They also require strict documentary compliance — a discrepancy in the documents can delay or prevent payment. Trade credit insurance, by contrast, allows the seller to offer open-account terms, which buyers generally prefer. TCI can cover an entire portfolio of buyers under a single policy, rather than requiring a separate instrument for each transaction. However, TCI does not guarantee payment in the way an LC does — it reimburses covered losses after a waiting period, subject to the policy's terms, conditions, and exclusions.
When a Letter of Credit May Be Appropriate
LCs may be appropriate for large, one-time transactions with unfamiliar buyers; for sales to buyers in high-risk countries where TCI coverage may be limited or unavailable; or when the buyer's bank is willing to issue an LC at a reasonable cost. LCs can also be useful when the seller needs immediate payment certainty rather than the reimbursement structure of an insurance policy.
When Trade Credit Insurance May Be Appropriate
TCI may be more appropriate when the seller has an ongoing relationship with multiple buyers and wants to protect a portfolio of receivables; when the seller wants to offer competitive open-account terms without requiring buyers to arrange bank financing; or when the seller wants to use insured receivables to support a larger borrowing base with its lender. TCI can also be more cost-effective than LCs for high-volume, repeat transactions.
This article is for general informational purposes only and does not constitute insurance, legal, financial, or tax advice. Coverage terms, conditions, exclusions, and availability vary by insurer and policy. Consult with a qualified insurance professional regarding your specific situation.
