Credit Insurance refers to any contract under which an insurer will compensate the policyholder if a financial loss is incurred due to the credit risk. The key features of Credit Insurance are that it provides protection against rare events, i.e. defaults or bankruptcies where the premium paid relates to expected losses and not actual losses, and that premiums rise when losses do occur.
Benefits of Credit Insurance:
- Protecting against rare events
The main benefits of Credit Insurance are that it protects against rare events, i.e. defaults or bankruptcies. By protecting the policyholder from such events, their income and assets should not be strongly affected. In other words, as long as the financial loss due to default is lower than the claim under Credit Insurance, their financial position should remain the same.
- Takes the hassle out of repaying a loan
Credit Insurance provides peace of mind that the bank loan will be repaid in case of default. This enables the borrower to focus on other investments and income-generating activities without worrying about their ability to repay banks.
- Transferring risk to the insurance company
It is in banks’ best interest to limit their losses when the borrower defaults. The cost of credit insurance shifts some of this risk to an insurer, who assumes part of the loan payment obligation in exchange for a premium. This allows bank lending to be more efficient because they do not need to monitor or control individual borrowers as closely.
- More financing options for small businesses
Another advantage is that it provides small businesses with more finance options. Credit insurance increases the pool of potential lenders by allowing banks to provide loans even if the borrower has a poor credit history, provided they are covered by insurance. This may lead to greater competition among banks for loan customers.
- Reducing the cost of credit
As the cost of insuring loans increases with loan size, insurance provides an incentive for small businesses to take out larger amounts of bank finance. This will increase overall lending and benefit the economy. Smaller firms would also be more willing to raise funds by issuing bonds if they can borrow more on bank loans, at lower rates.
- Protecting the consumer
Another benefit for consumers is that it protects against credit risk, allowing them to purchase high-cost items such as a car or home without having to save money first to prepare for repayment risks. This increases competition between sellers and allows consumers to have more choices open due to greater flexibility in funding purchases. However, it is acknowledged that insurance does not solve all the risks of borrowing and may even worsen them in some cases.
- Reducing bank exposure
If banks do not charge high premiums for Credit Insurance then their exposure to credit risk will decrease when borrowers obtain insurance cover. This reduces the bank’s incentive to manipulate policyholders’ actions and allows consumers to have greater freedom when deciding how much insurance they want to limit their exposure. (https://atradius.no/produkter-og-tjenester/kredittforsikring.html)
Credit Insurance is an effective way of transferring some credit risk to the insurer so that banks are more willing to provide loans at lower interest rates. This allows small firms to have more finance options available and consumers to have more choices on how they spend their money. However, insurance may also introduce new risks which must be handled with care.