The global economic landscape poses numerous challenges. That's why letters of credit are essential tools for exporting businesses. However, they aren't the only option. In many cases, credit insurance can be a better choice. What are the differences between these two solutions, and what are the advantages and disadvantages you should be aware of?
How does a letter of credit work?
A letter of credit provides exporters with a guarantee from the importer’s bank that an issued invoice will be paid in full and on time. If not, the bank will cover the owed amount. Essentially, it’s an irrevocable promise of payment by the issuing bank.
For sellers, this ensures a secure and predictable cash flow in international transactions. The risk of non-payment is minimized by the bank's guarantee. Similarly, letters of credit also protect buyers, as payment only occurs once the agreed-upon contractual conditions are met, such as receiving the delivery note
How much does a letter of credit cost?
Banks charge a commission and processing fees for their payment guarantee. They often require a portion of the invoice amount as collateral, depending on the importer's creditworthiness. Beyond financial costs, letters of credit can be time-consuming since they guarantee only one transaction at a time. Therefore, they are typically economical only for large amounts.
The key advantages and disadvantages of a letter of credit
Advantages:
- Mutual security - Both buyer and seller mitigate their risks simultaneously
- Strong guarantee - The buyer's bank ensures payment settlement
- Free liquidity - The buyer only commits funds at the transaction's conclusion, allowing for capital use in the meantime
Disadvantages:
- Lack of Flexibility - A letter of credit is valid only for individual transactions
- High costs - Expensive due to the bank's payment guarantee
- Significant workload – Managing and overseeing letters of credit for individual transactions demands substantial time and personnel
The Alternative to a letter of credit: how does credit insurance work?
Trade credit insurance ensures that an exporting company’s receivables will be paid within the agreed coverage amount. If trading partners delay or default on payments, the insurance steps in, guaranteeing cash flow.
Unlike letters of credit, credit insurance is also suitable for domestic transactions, and can be easily extended to other business partners and deals.
For new buyers, a credit check is first conducted, based on which an individual credit limit is set for that client relationship. New transactions do not require individual verification, saving significant time and effort. Additionally, the insurance handles debt collection in the destination country.
What does credit insurance cost?
The costs for credit insurance are individual. The sum insured, the specific risk, the creditworthiness of the buyer and the country risk all have an influence on the amount of the insurance premium. The payment period can also influence the price: The longer the period, the higher the premium often is.
Advantages and disadvantages of credit insurance
Advantages:
- Strong security - effective protection against trading partners' payment delays or defaults.
- Reduced costs - lower fees compared to a letter of credit.
- High flexibility - credit insurance multiple transactions and can be extended to various commercial relationships.
- Improved credit rating - ensured cash flow coverage can enhance credit ratings, facilitating borrowing.
- Minimal effort - in case of non-payment, the insurer manages everything, including debt recovery.
Disadvantages:
- Limited coverage - receivables are only covered up to the credit limit, typically up to 90% of the total amount. Coverage may change if the insurer reassesses the risk.
- Variable costs - the price of credit insurance can fluctuate based on the insured turnover and the number of credit limits established.
TradeLiner - Your credit insurance
With Coface's TradeLiner, protect your business against customer non-payments and economic risks in the destination country. Benefit from our in-depth knowledge of local markets worldwide, along with our debt collection and Business information services.
Country risks
How great are the business or political risks in your target country? Find out with just one click. We have summarized the analyses of our experts around the globe on our Country Risk Map.
Securing payments: credit insurance or letter of credit?
A letter of credit can fully secure a single transaction with a payment guarantee from the importer's bank, providing maximum security in international trade. However, it comes with significant financial and bureaucratic burdens, and cannot be extended to other clients or transactions.
Credit insurance offers more cost-effective protection for foreign transactions, with significantly less effort and maximum flexibility. As long as the coverage amount is within your credit limit, multiple transactions can be easily protected. Coverage extensions for growing transactions or new buyers are straightforward.
Additionally, with global credit insurers like Coface, you gain detailed insights into local markets (with on-site experts), access to exclusive financial data, and information on business creditworthiness. In case of verified risks, efficient recovery services are managed directly within the country.
