Letter of credit insurance is a type of insurance coverage that helps to ensure that an exporter’s banks are protected from the possibility of sustaining losses when extending services to sellers who accept letters of credit as the terms of payment for orders placed and received. Essentially, this type of insurance protects the banks from any issues that may lead to the cancellation or default of those letters of credit, and situations in which the exporter is unable to settle the debt from obtaining a discount on a letter of credit. There are several different ways an issuing bank can structure letter of credit insurance and protect the institution from carrying a great deal of risk.
One example of letter of credit insurance is a one-time plan that addresses a single letter of credit. In this scenario, the coverage is obtained for a short period of time, and relates to the eventual presentation of payment by a buyer within the terms and conditions determined in the sales contract. This approach is often ideal for businesses that primarily sell goods and services within the country of origin and only occasionally export goods to clients in other countries. Like all forms of letter of credit insurance, this allows the seller to obtain a loan on the letter of credit in the expectation that the buyer will pay according to terms. In the event that does not happen and the seller is unable to pay off the loan to the bank, then a claim on the insurance can be submitted, allowing the bank to avoid incurring a loss.
For businesses that routinely export goods and work with clients on the basis of letters of credit, banks will often offer what is known as a blanket letter of credit insurance plan. Here, the bank may accept multiple letters of credit issued to the same exporter and provide advance financing to help with manufacturing and delivery costs, with the provision that those loans are retired according to the terms agreed upon by the two parties. This type of blanket coverage normally includes a clause known as irrevocable payment undertaking, allowing the bank to receive payments on those letters of credit from the buyers, deduct the amount due, and pass the remainder on to the seller once the loans are retired in full. Should one or more defaults occur with those letters of credit, the insurance provider covers the balance due on those loans if the exporter is unable to do so.
Many letter of credit insurance plans will cover a wide range of events, including disasters at sea in which the goods are lost and never delivered to the buyer, theft during transit, and many other issues that can arise during the shipment of ordered goods. Even issues in which the bank that issued the original letter of credit should close and there is no way to collect on that financial instrument, letter of credit insurance will protect the exporter’s bank from incurring the loss. For this reason, many banks that offer financial services to exporters will use letter of credit insurance to protect its interests, even when there is no apparent reason to believe that the terms of that original letter of credit will not be honored.
