Accounts Receivable Coverage

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The loss of accounts receivable records can devastate a small company. If a fire or other peril destroys its billing records, a firm may be unable to collect money it is owed by customers. Fortunately, businesses can mitigate such losses by purchasing accounts receivable coverage. This coverage protects a company against financial losses caused by damage to its accounts receivable records. The following example demonstrates why this coverage is important.

Example

Glen owns Glen's Glassworks, a company that sells glass products like windows and patio doors. Business has been good, and the company has attracted many new customers. The firm replaced its paper-based accounting system with a computerized one a few years ago. All customer accounting records are stored on a computer in Glen's office. Each customer is billed within a week of the date the work has been completed. The company sends invoices by email, unless a customer demands a paper invoice sent via the U.S. Postal Service. While some of Glen's customers pay promptly, others take weeks or months to pay. At any given time, the company may have up to $50,000 in outstanding invoices.

Late one night, vandals break into Glen's office and dump water on the company's computer. The water damages the computer and destroys all of Glen's accounting records. Glen's office manager has not backed up the company's computer files in months.

Consequently, it will be difficult, if not impossible, to reconstruct accounting files on current customers. Without those records, Glen's Glassworks may be unable to collect the money it is owed. The loss of cash flow could cripple the company, endangering its ability to survive.

Not the Same as Trade Credit Insurance

The coverage explained in this article is not the same as trade credit insurance.

The latter covers financial losses a business sustains because its customers have failed to make payments in accordance with credit terms. Trade credit insurance covers defaults by customers who fail to pay money they owe due to bankruptcy, cash flow problems, an ownership change or some other reason. Trade credit insurance is sometimes called accounts receivable coverage, but it is not the coverage outlined below.

Endorsement Required

Most commercial property policies don't cover financial losses that result from damage to accounts receivable records. This is because accounts don't qualify as "covered property". Accounts are typically listed under the section entitled Property Not Covered. However, losses stemming from damage to accounts receivable records can be covered by an endorsement.

Covered Losses

Accounts receivable coverage typically covers the following types of losses:

  • Sums due from customers that you can't collect: This is money you are unable to collect because your records of what customers owe you have been damaged or destroyed by a covered peril.
  • Interest charge on a loan you've obtained to offset the sums you can't collect: If you are unable to collect money your customers owe you, you may be forced to obtain a loan to make up for the lost funds. In that event, your insurance should cover the cost of the interest.
  • Collection costs in excess of your normal collection costs that are necessary due to the loss: Virtually every business incurs routine costs to collect money owed by customers. For instance, your accounting clerk may spend a few hours each month reminding customers that payments are due. Accounts receivable insurance covers expenses that are over and above your normal costs, and that are a direct result of a loss. An example is the cost of hiring a temporary worker to assist with the collection process after a loss has occurred.
  • Other reasonable expenses you incur to re-establish your accounts receivable records: This catch-all clause covers any other costs you sustain, other than those described above, to re-create your accounts receivable records. For example, you hire a consultant who is an expert in restoring lost accounting records.

    Covered Perils

    Accounts receivable coverage is usually subject to a handful of exclusions listed in the endorsement. These differ from those that apply to buildings and personal property. Here are some exclusions commonly found in accounts receivable endorsements.

    • War, Government Action, and Nuclear Hazard: These exclusions may include anti-concurrent causation wording.
    • Dishonesty: Excludes dishonest acts committed by you, your employees or company principals.
    • Falsification of Records: Excludes the alteration or falsification of records when the purpose is to hide the fact that someone took, withheld, or gave money to someone else in violation of the law.
    • Bookkeeping or Billing Errors: Excludes losses caused by accounting or billing errors.  
    • Electrical or Magnetic Injury: Excludes damage to electronic data caused by electrical disturbance or erasure. Some policies also exclude damage caused by programming errors, faulty data processing equipment, or power service interruption.
    • Loss Based on Records Audit: Excludes any loss that requires a records audit or inventory calculation to prove it exists.

    How Losses Are Calculated

    When its accounts receivable records have been damaged, a business may be unable to determine how much its customers owe. This was the case with Glen's Glassworks. Vandals destroyed the firm's accounting records, and no backup copies were available. Accounts receivable endorsements explain how losses will be calculated in this situation. The manner in which losses are assessed may vary a bit from one endorsement to another, but most insurers follow the same general steps.

    First, the insurer will calculate your total accounts receivable for the twelve-month period prior to the loss. It will then divide your annual receivables by twelve. The result is your average monthly receivables. For example, suppose your accounts receivable records are destroyed by a fire on January 1, 2017. Your insurer adds up your receivables for the period December 31, 2015 to December 31, 2016, and then divides that number by twelve. If your annual receivables are $1 million, your monthly average is $83,333.

    Next, your insurer will consider whether normal fluctuations in your business caused your receivables be to be higher or lower than the monthly average on the date of loss. Many companies generate higher sales at some times of the year and lower sales at other times. Your insurer will consider the timing of the loss, and increase or decrease the monthly average accordingly. 

    Deductions

    Once your insurer has calculated your adjusted monthly receivables, it will subtract any the following that are applicable:

    • Accounts Not Lost: Your insurer will not provide any payment for accounts receivable records that have not been lost.
    • Accounts Re-Established or Collected: Likewise, your insurer will not afford any payment for accounts you have been able to re-establish or collect.
    • Bad Debts: The insurer will make a deduction for your normal bad debts. These are debts you could not have collected even if the loss had not occurred.
    • Unearned Interest: Your insurer will deduct interest charges and service charges you can't collect from customers because your receivable records have been destroyed.

    Other Provisions

    The most your insurer will pay for losses under accounts receivable coverage is the limit shown in the endorsement. The limit applies to each occurrence.

    If you recover any part of a loss paid by your insurer, you must return that money to your insurer. For example, suppose your insurer has paid you $50,000 for accounts you are unable to collect because a fire has destroyed your billing records. A client subsequently pays you $5,000 for work you performed. If the amount the client owed you was included in the $50,000 insurance payment, you must return $5,000 to your insurer.

    Extended Coverage Endorsements

    Many insurers include accounts receivable insurance as part of an "extended coverage" endorsement attached to a property policy. This insurance may not be equivalent to the coverage provided by separate accounts receivable endorsement. For one thing, it may be subject to all of the exclusions that apply to buildings and personal property. Secondly, a sublimit will probably apply, and it is likely to be low. Moreover, the sublimit is part of (not in addition to) the business personal property limit.