Letter of Credit vs Trade Credit Insurance

Letter of Credit vs Trade Credit Insurance

Today’s volatile economic environment has increased the risks for businesses manifold. The issue of unpaid invoices is one of the biggest challenges facing many businesses today.

Fortunately, there are financial instruments which can be used to mitigate the risks of non-payment of invoices and this article will explain a couple of them: Letter of Credit and a Trade Credit Insurance Policy.

What is a Letter of Credit?

A Letter of Credit is a financial instrument issued by a bank on behalf of the buyer to the seller as a guarantee of payment for the goods or services. The bank acts as an intermediary to guarantee payment to the seller of goods or services. Buyers pay a fee to the bank for issuing the Letter of Credit and they also need to provide margin amount as collateral.

The seller submits the required documents to the bank and the bank upon verification of documents releases payment to the buyer.

A Letter of Credit thus acts as a financial backstop guaranteeing payment for the seller even if the buyer defaults on payments.

What is a Trade Credit Insurance Policy?

A Trade Credit Insurance Policy is a type of insurance policy that protects the Insured Business from Non—Payment of Invoices by insuring the Accounts Receivables.

If the buyer does not make payments owed to the seller, either due to bankruptcy or delays payment beyond a specified period, the Trade Credit Insurance Policy will pay out a percentage of the Invoice Value to the seller.

What is the difference between Letter of Credit and Trade Credit Insurance Policy?

Following table summarises the difference between Letter of Credit and Trade Credit Insurance Policy:

Letter of CreditTrade Credit Insurance Policy
Letter of Credit is a Financial Instrument that guarantees paymentCredit Insurance Policy is an insurance policy which compensates the seller for the loss
Letter of Credit is a contract between the buyer and seller with the bank as an intermediaryTrade Credit Insurance Policy is a contract between the seller and the Trade Credit Insurance Company
Letter of Credit is used for Pre-Shipment FinancingTrade Credit Insurance is used for Post-Shipment Financing
Covers a single buyer and a single transactionCan cover multiple buyers and multiple transactions

What are the advantages of Letter of Credit?

A Letter of Credit offers the following advantages:

  1. LC offers security for both, the buyer and the seller
  2. The credit standing of the buyer is replaced by the LC issuing bank
  3. A Letter of Credit enables the seller to borrow against the receivables

What are the disadvantages of Letter of Credit?

A Letter of Credit, though very useful, has some disadvantages:

  1. A LC covers only a single transaction for a single buyer and is thus time consuming
  2. A Letter of Credit is comparatively more expensive than a Trade Credit Insurance Policy. Buyers also need to provide margin as collateral to get a Letter of Credit which ties  up working capital for the buyer. This can be disadvantageous for the seller as the competitors can offer open credit terms to the buyer. On the other hand, the seller just needs to pay a premium to purchase a Trade Credit Insurance Policy and avail protection from risk of non-payment
  3. The claims process for Letter of Credit is more tedious as compared to a Trade Credit Insurance Policy

Final Take

Letter of Credit and Export Credit Insurance are both useful tools to mitigate the risk of non-payment for the buyer. A letter of Credit or LC is a guarantee of payment while a Trade Credit Insurance compensates the seller for the loss.

A Trade Credit Insurance Policy enables the seller to grow sales without any concerns about unpaid invoices as the Credit Insurance Policy provides protection against delayed payments or non-payment by the buyers. Additionally, since the receivables are secured with a Credit Insurance Policy, the seller can extend competitive credit terms to the buyers thus enabling them to increase sales.

It is advisable to take the assistance of a Trade Credit Insurance Broker when purchasing a Trade Credit Insurance Policy. Qian is an experienced Trade Credit Insurance Broker with tie-ups with top Trade Credit Insurance Companies in India. We can assist you with comprehensive Trade Credit Insurance Coverage at competitive premiums.

If you wish to purchase a Trade Credit Insurance Policy, you can email us at insurance@qian.co.in or call us on 022-22044989. We would be glad to assist you.

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