Alex Yang

 

Professor Alex Yang  [London Business School] 
Title Cancelability in Trade Credit Insurance
Date & Time Friday, November 18, 2016
Place UCLA Anderson School of Management 
Room D310

 

Abstract
Trade credit insurance (TCI) is a risk management tool commonly used by suppliers to guarantee against buyers defaulting when purchasing on credit. Most TCI policies differ from those issued within other insurance sectors in that the insurer can cancel this "guarantee" during the insured period. A guarantee that can be canceled is both paradoxical and controversial. This paper explores the role of cancelability in TCI and its operational implications. Using a game-theoretic model to capture the strategic interaction between insurer and supplier, we find that the utility of cancelability in TCI is linked to the two roles that the insurer plays in this setting: the insurance role (smoothing the supplier's cash flows), and the monitoring role (tracking the buyer's continued creditworthiness during the insured period, which enables the supplier to make more efficient shipping decisions). Non-cancelable contracts rely on the deductible to implement these two roles, which results in a conflict: A high deductible inhibits the insurance role while a low deductible weakens the insurer's incentive to fulfill the monitoring role. Yet, under cancelable contracts, the insurer's right to cancel coverage ensures that information acquired through monitoring is reflected in the supplier's shipping decision. Thus, the insurer has adequate incentives to perform his monitoring function without resorting to a high deductible. The downside of cancelable contracts is that the insurer may exercise the cancelation option too aggressively. As such, when both his monitoring cost is low (e.g., due to advances in information technology) and the supplier's outside option is unattractive (e.g., during an economic slowdown), the supplier may favor contracts with non-cancelable coverage for the value of commitment. Our findings help explain the historical dominance of cancelable contracts in TCI, and they also offer insight into the recent industry trend of offering non-cancelable TCI coverage.

Alex Yang