Export Credit Insurance vs Letter of Credit: Trade Finance Decoded

Export credit insurance vs letter of credit – for exporters, knowing when to use one or the other is a key aspect of doing business the right way. While both options provide a measure of financial security during export sales, they differ greatly in application and execution. Knowing what factors to take into account when selling to overseas customers makes it much easier to choose between the two.

As per the Export-Import Bank of the U.S. (EXIM), a letter of credit (LC) ensures payment to the seller upon meeting agreed-upon terms. Export credit insurance (ECI) shields exporters against buyer non-payment. Both cater to different exporter needs, but ultimately serve to mitigate risks when selling to foreign buyers.

In this article, we’ll compare and contrast these two valuable tools of the export trade. 

Export Credit Insurance vs Letter of Credit: What is the Difference?

To put it simply, the key difference between a letter of credit and export credit insurance can be summarized as follows.

While a letter of credit is used to secure payment from the customer to the exporter, export credit insurance lets an exporter recuperate funds if the customer fails to pay. 

Where an LC requires agreements between buyers and sellers, ECI is strictly handled by the seller.

With that being said, the real question should be when to use one or the other. To do that, we’ll first need to review some more detailed information about ECI and LCs, including the different types available, advantages, and disadvantages.

What is a Letter of Credit?

A letter of credit, often referred to as an LC, is a commitment issued by a bank on behalf of a buyer. It guarantees that the seller will receive full payment for a given invoice or series of invoices, so long as they fulfill their end of the contract. 

There are a few different types of LCs, but for the purposes of international trade, the type most commonly used is a commercial letter of credit (CLC).

In the event that a buyer does not pay for their order, the bank that issued the letter of credit may have to pay the exporter. This varies based on the type of LC issued by the bank. Considering the many uncertainties that surround international trade, the use of letters of credit provides peace of mind to wary exporters.

Letter of Credit Examples

Let’s take a look at how a letter of credit might be used in a typical business scenario. Consider the example of a US-based company doing business with a buyer in Germany. 

• Initial Business: The exporter, Sunshine Solar Panels, is a U.S.-based firm selling solar panels. They’ve received a large order from Evergreen Energy, a buyer in Germany. This is the first time the exporter has dealt with this buyer.
• Request for LC: Due to the significant value of the deal and the unknown creditworthiness of Evergreen Energy, Sunshine Solar Panels requests an LC from the buyer to secure the transaction.
• Issuance of LC: The buyer agrees and approaches its bank in Germany, which issues an LC in favor of Sunshine Solar Panels. The LC assures payment to the exporter, provided it meets the specified obligations. 
• Shipping the Order: Upon receipt and confirmation of the LC, Sunshine Solar Panels ships the order to Germany and submits the shipping documents to its bank in the U.S.
• Payment: After verifying the documents against the LC conditions, the U.S. confirming bank sends them to the German bank, which checks the documents and pays the beneficiary.

This example showcases how a letter of credit provides Sunshine Solar Panels with payment assurance from the foreign buyer, enabling a smooth transaction between two unfamiliar parties. While ‘cutting out the middle man’ is often a favorable business practice, involving the bank as a third party ultimately produced a favorable result and helped foster trust in the buyer.  

What is Export Credit Insurance?

On the other hand, export credit insurance is a policy taken out by the exporter. It covers the risk of non-payment by foreign buyers due to a range of reasons such as insolvency, protracted default, or political risks. 

In simple terms, ECI provides coverage for exporters if their foreign buyers fail to pay.

Export Credit Insurance Example

The following scenario lays out the process of purchasing and using ECI. In this case, the U.S. company is working with an overseas business located is a politically unstable market. 

• Initial Business: Company A is a U.S.-based manufacturer looking to export heavy machinery to Company B, located in a politically unstable emerging market. Despite tensions in the region, the potential for profit is too lucrative to pass up.
• Purchase of Export Credit Insurance: Given the region’s instability, Company A is worried about the possible risk of non-payment due to political and social circumstances. This leads them to purchase an ECI policy. The company pays an insurance premium, which is a small percentage of the total shipment value.
• Coverage: The ECI policy specifies that it covers non-payment for reasons such as political upheaval or unrest that could cause Company B to default on its payment. It also insures against commercial risks such as default or bankruptcy. 
• Making a Claim: Unfortunately, political conditions in Company B’s country deteriorate, and Company B is unable to make their payment for reasons outside their control. Company A, protected by their ECI policy, files a claim with their insurer.
• Verification and Payment: After verifying the claim, the insurance company reimburses Company A for the covered percentage of the unpaid invoice. This is usually 85 to 95 percent of the invoice’s value, depending on the policy.

This scenario showcases how ECI can protect an exporter when the unexpected happens, turning a potentially disastrous situation into a manageable one. With ECI, the exporter can confidently venture into risky markets, assured that they have a safety net in place.

Letter of Credit vs Export Credit Insurance: Which Should You Choose?

Now that we have a solid grasp of how LC and ECI work, let’s answer the question of which you should purchase for a given situation.

When to Purchase Export Credit Insurance

• Protection From Unpredictable Risks: While ECI doesn’t offer full invoice value coverage as some forms of LC do, it’s applicable in situations that a letter of credit can’t cover. This includes non-payment due to circumstances the purchaser can’t control. Riots, political turmoil, inability to convert currency, and revolutions are just a few of these circumstances.
• To Offer Flexible Payment Terms: Insuring your export transaction means you can be more flexible in how and when your customer pays. International customers are more likely to purchase from sellers with flexible payment terms.

When to Request a Letter of Credit

• To Secure Full Payment of Invoice: When a bank issues a letter of credit for an international transaction, it’s usually a guarantee that they will pay the full price of an invoice if the buyer fails to provide adequate funds do so. ECI may cover a large percentage of invoice value, but the right type of LC covers 100 percent.
• Exporting to a Country With High Risk of Non-Payment: Smart exporters do their research. Some countries, regions, and markets have higher percentages of non-payment than others. It’s wise to secure transactions with these areas by requesting a letter of credit from purchasers.

The costs of ECI and LC should be factored into the decision-making process as well. Buisnesses need to ensure they have enough working capital to cover the needed costs. 

Export Credit Insurance vs Letter of Credit Cost Table

Rates from recreatecre.com and exim.gov

It’s worth noting that, depending on the issuing bank, there will be other flat fees associated with the purchase of a letter of credit. Two percent is an industry average for determining the cost of the premium itself. In practice, letters of credit will cost more than the premium’s price.

There are also scenarios where a case can be made for either ECI or LC. These include exporting on a large scale and selling to a country or buyer with whom you don’t have a strong business relationship

Advantages and Disadvantages of Letter of Credit

If you’re an exporter, you couldn’t be blamed for concluding that a letter of credit is almost always a better choice than export credit insurance. After all, a properly negotiated LC guarantees full payment rather than a percentage and puts most of the work on the buyer.

In practice, it’s not as simple as that. There are advantages and disadvantages to ECI and LC that extend beyond raw numbers.

Some advantages of getting a letter of credit include:

• Customization: LCs can be customized to suit different trade deals. They can accommodate various shipment terms, payment terms, and other specific requirements of an international transaction.
• Trustworthy: LCs are usually issued by reputable banks, which adds a level of credibility and trust for both parties involved in the transaction.
• Greater Security for Exporter: Assuming all terms are met, a letter of credit is the ultimate peace of mind for sellers shipping to foreign customers.

There are a few disadvantages that come with requesting a letter of credit, some of which are:

• Complex Processes: Obtaining and using LCs involve a lot of paperwork, strict compliance with terms, and banking procedures, which might be time-consuming.
• Costs: There are several charges associated with LCs, including opening charges, amendment fees, and courier charges. These costs can add up and impact the profitability of the deal. 
• Lack of Availability: Banks make decisions about whether to issue an LC based on a multitude of factors. Not every buyer is going to be approved for one, even if the exporter requests it.

It’s important to keep these pros and cons in mind when deciding how to protect your transaction.

Advantages and Disadvantages of Export Credit Insurance

ECI is a potent tool in any exporter’s arsenal. Even though LCs can potentially secure the full value of a transaction, there are times when export credit insurance is the better choice.

The advantages of export credit insurance include:

• Availability: While LCs are contingent upon a bank’s approval, any exporter in the U.S. can get export credit insurance to protect their transactions. This requires no effort or cooperation from the buyer, making it a simpler process.
• Better Credit Options for Customers: Lessening the risk of non-payment allows exporters to provide more attractive credit terms to buyers. This allows sellers to compete more effectively in the international market.
• Enhanced Borrowing for Exporters: Banks and financial institutions often view insured receivables favorably. Having ECI allows exporters to use their insured receivables as collateral, enhancing their borrowing capacity.

Some disadvantages of ECI are:

• Insurance Premiums: Like any insurance policy, ECI comes with a cost. Exporters are required to pay premiums for their ECI policies. These premiums can be substantial, potentially cutting into the profitability of the export deal.
• Coverage Limitations: Typical ECI policies offer coverage from 85% to 95% of the receivables. This means that the exporter still carries some level of risk, which needs to be factored into their financial planning.
• Exclusions: ECI isn’t a catch-all solution. For instance, it doesn’t cover non-payment due to contract disputes. Additionally, it doesn’t apply to circumstances like damaged shipments resulting from bad weather or mishandling.

Choosing between ECI and an LC isn’t a simple matter of which option stands to recuperate the most money for the exporter. Premium costs, customer reputation, and market stability must also be considered in the decision-making process.

What are the Different Types of Letter of Credit?

There is one last wrinkle in the ECI vs LC comparison process: looking at what types of letters of credit are available to you.

Letters of credit aren’t one-size-fits-all. Different types exist to fulfill specific business needs and to addressspecific concerns. Some examples of different letter of credit types are:

• Commercial Letter of Credit: This is the type of LC we’ve referred to throughout the article. A CLC guarantees payment to the beneficiary (exporter) by a bank representing the customer. This payment is dependent upon terms and conditions in the contract.
• Irrevocable Letter of Credit (ILOC): This can be thought of as a sub-type LC. An irrevocable letter of credit can’t be altered by the issuing bank unless all involved parties agree to do so. Most CLCs are also ILOCs.
• Revocable Letter of Credit: The issuing bank can amend, change, or outright cancel this type of LC at any time. For this reason, they’re not commonly used in the business of exporting.
• Confirmed Letter of Credit: This is perhaps the most secure type of LC. It involves a second bank guaranteeing payment for received commodities. This second bank is usually in the exporter’s country. This stands in contrast to an unconfirmed letter of credit, which is backed solely by the buyer’s financial institution.
• Revolving Letter of Credit: An LC structured to pay out a portion of its value on a set schedule over a pre-determined period of time. For instance, a $100,000 dollar payment over a four-month period would be structured to pay out $50,000 a month.
• Standby Letter of Credit: While a typical letter of credit guarantees payment upon fulfillment of certain conditions, this type of LC kicks in if a client doesn’t fulfill certain obligations. It can almost be looked at as a form of insurance when compared to a standard CLC.

For the purposes of international trade, CLCs and ILOCs are the norm.

Types of Export Credit Insurance

There are three main types of ECI available to exporters in the U.S.

• Express Insurance: For small businesses with limited experience, express ECI makes the most sense. The application process is simple and premiums can be paid over time.
• Single Buyer Insurance: This is designed to cover transactions from a single customer over a set period of time. 
• Multi-Buyer Insurance: Exporters looking to insure transactions from multiple customers and different types of commodities use multi-buyer insurance. 

These policies are available in short term and medium term configurations. Short term ECI covers 90-95 percent of value for a period of up to a year. Medium term policies are good for up to five years and 85 percent coverage.

Why Partner with Cargo Export USA for Your Exporting Needs?

Like most aspects of the exporting business, choosing between ECI and LCs can be a complicated process. At Cargo Export USA, our years of experience can help you make the right choices in international trade. 

In addition to our expert consulting services, look to us for assistance with:

• AES Filing
• Schedule B lookups 
• Export compliance manuals
• And more

Don’t play guessing games with your export shipments. Call our team of export specialists at (866)-301-0635 today or connect with us online. We’re here to help you grow your export business.