Fiduciary (Trust) Accounting Genesis

To most industry professionals, insurance trust accounting is a black box. Although agency owners routinely deposit premium payments in trust bank accounts and write premium remittance checks to insurance companies, few understand the legal implications of being “custodians” of premium funds. Some may understand the agency has a fiduciary relationship with insurance companies, but few understand the danger of fiduciary violations.

Insurance trust accounting is premium accounting. Its primary objective is to monitor and control premium funds’ financial solvency. Penalties for utilizing trust funds for personal use are quite severe. This author has written and published several articles on insurance trust accounting, but few readers contributed feedback. This paper intends to provide a history of trust accounting and explain its fundamental difference from general business accounting.

Transacted Premiums

Insurance trust accounting is a system of premium financial management; its complexity exceeds that of other trust funds. Its process begins with policy transaction records, as policies are legal sale documents in P&C insurance. The premium invoice loses its accounting value in trust accounting. Premium payments and bank deposits bring the premium receivables accounting to an end. This is the system’s first module.

Although unessential, premium invoice is still used as a matter of industry tradition. To make it worthwhile in trust accounting, a follow-up on delinquent payments and the automation of policy endorsement invoices were added. Current lack of these two functions in the agency accounting practice has been the cause of premium receivables to be mismanaged and become a primary source of trust financial insolvency.  

Premiums Payable

There are two payable items in trust accounting: net premiums and agency sales commission. The critical element in payables accounting is the decision to treat the agency’s sales commission as “payable” to the agency, in the same way net premiums are payable to insurance companies. Commission income accounting is a major innovation in insurance trust accounting. It is fully automated. “Earned commissions” are collected in a dedicated ledger account and reported so that agencies can legally transfer them to the business operating account.

Without accounting tools, most agencies transfer commission funds to the operating account based on what they need rather than what they “earn”. Because of this practice, current commission management has become the second most important source of trust financial insolvency.

In trust accounting the net premiums payable process is fully automated. Its reconciliation with company statements is fully automated. Reliable remittance check vouchers eliminate the need for multiple signatures and fraud in the premium remittance process is no longer possible.

Return Premiums

In trust accounting return premiums generate receivables and payables in the same way transacted premiums do.  There are two receivable items to the trust account: return net premiums from insurance companies and return commission from the agency’s operating account. After both are received, return premiums are refunded (in gross amount) to insureds and/or finance companies. In current practice return premiums are grossly misinterpreted as “returned merchandise”. Entering them in the ledger as “negative receivables” is an accounting anomaly that distorts the agency’s financial statements.

Return net premiums may be received in cash or credit and so may be the returned commissions. Return premiums may be refunded either in cash or credit. Return premium accounting is further complicated by the fact that return premiums may be also offset to another client policy.

Trust Operation

The genesis of trust accounting started with a local agency asking our company to help manage its premium receivables. Being able to control receivables and do away with the receivables aging practice, the agency asked to see if net premium payables could be also automated. At the same time, the agency asked for help to figure out its commission income. The last operational process the agency was having problems with, was the return commission reimbursement from the agency operating account and premium refunds to policy holders.  After having these processes re-designed, the agency had the entire trust operational process fully automated.

Financial Solvency

There was one last question to answer: was the agency trust account financially solvent? Trust financial solvency was undefined at that time. There were no textbooks available. Colleges were not teaching it. An attempt was made first to define it. CA Insurance Code requires in Section 1734 the agency to maintain in the trust account a cash balance equal to the net premiums owed to the trust legal owners. This requirement was difficult to process due to the lack of complete trust accounting records.

In addressing this question, trust funds were separated from the agency’s business operating funds into a different ledger of accounts. Building a trust ledger to mirror premium and return premium transactions was a real challenge. A total of 82 trust ledger accounts were found necessary.

To report the trust financial solvency, developers used the business financial solvency reporting as a model. As business owners monitor and control business financial solvency using Balance Sheets and Income Statements, similar financial instruments may be possible to develop for trust custodians.

A Trust Balance Sheet could be possibly generated although trust accounting has many additional requirements. Since the business Income Statement had no meaning in trust accounting, it was replaced with a Statement of Trust Receipts and Disbursements (aka Float Statement). The Trust Balance Sheet information was further processed to generate Financial Solvency Analysis reports. The Float Statement information was used to calculate the trust “premium float” and further processed to generate Statements of Trust Funds Beneficiaries.  

Trust Accounting

A workable solution for insurance trust accounting was developed but was extremely difficult. Premium trust transactions are unusually complex. A new accounting logic was necessary to generate Balance Sheets and Float Statements. Journal entries of premium and return premium transactions were posted to the ledger via programming.

The Trust Accounting logic and software received a US Patent in 2017. 

For additional information on the trust accounting technology and US patent, send email to chris@paulmargroup.com 

Author: Chris Marinescu, Inventor and President at Paulmar Group LLC

September 23, 2019

IS INSURANCE TRUST ACCOUNTING AN AGENCY CORE BUSINESS?

Insurance trust accounting is premium accounting. It creates accurate accounting records of premium trust transactions and generates trust financial solvency statements. Agency owners can monitor and control trust financial solvency without help from accountants or CPAs. Conscious of the punitive consequences of fiduciary violations, agency owners will feel now safe to run fiduciary-compliant sales and service insurance businesses.

Unlike business accounting, insurance trust accounting offers agency owners for the first time a commission income accounting. Agencies will no longer transfer sales commissions to the operating account based on what they need but rather on what they earn; return premiums will no longer show up in the ledger as “return merchandise” and distort the agency’s financial statements.

Fiduciary Accounting

Trust accounting is fiduciary accounting. Anyone involved in the management of trust funds becomes a “fiduciary” or legal “custodian” of the property entrusted to him/her for financial management. P&C insurance agencies are authorized by insurance companies to receive and maintain transacted premiums in agency-owned trust bank accounts until they are remitted. Happy to have the sale commission available upon the receipt of premiums, agencies agreed to submit themselves to fiduciary regulations, such as: separation of premiums from business operating funds, maintain accurate records and report financial solvency to auditors, whenever necessary. Agencies signed Company-Agency Agreements to officially accept fiduciary positions.

Unlike an attorney’s trust account, insurance trust account is much more dynamic and transaction-intensive. Premium receivable and payable transactions are complex and occur daily. Return premiums must be processed and refunded relatively quickly, either in cash or by credit. They may be also offset from one policy to another. Financial solvency must be reported for each policy, each insurance company and the entire trust account. The beneficiaries of the trust account cash balance must be also reported.

  

Fiduciary Mandates

Trust accounting has been available to users only during the past several years but due to limited advertising, few agencies are using it. Without trust accounting and training, agencies cannot meet Insurance Code fiduciary mandates. One third of P&C agencies in California operates out of trust exposing agency owners to a loss of business license and/or legal prosecution for theft. Violations of fiduciary duty are not consistently audited by the Dept of Insurance and/or insurance companies, which would rather see agencies sell more policies rather than check on agency fiduciary performance. Insurance consultants pay little or no attention to fiduciary compliance as they may not fully understand the difference between business accounting and trust accounting. Very few CPAs have publicly commented on agency fiduciary compliance requirements.

Core Business

Insurance agencies’ core business is to sell and service insurance products. The agency’s back office supports its core business by servicing policies and performing general business accounting. Many agencies use the “direct bill” business model. All transacted premiums are received by insurance companies which process sales commissions and pay them after generally 60 days. Most P&C agencies, however, use the “agency bill” business model, whereby the agency receives transacted premiums and agree to submit itself to fiduciary regulations. Agency-Bill agencies set up trust bank accounts and agree to manage premium funds in accordance with fiduciary mandates.

Financial Management

Managing tens or hundreds of million dollars every year in and out of the trust account, and reporting trust financial solvency is, by any standard, not an easy task. It requires knowledge and financial tools. Automation of trust account transactions is critical. Most small and medium size agencies have no one in their staff with knowledge and training to practice trust accounting. Agency bookkeepers receive premium payment checks, make bank deposits, and write premium remittance checks to insurance companies. Premium invoices are generally CSR’s (Account Manager’s) job. No one in the agency oversees the trust account management.

The receivables accounting routine is not trust-specific. Although payments are deposited in the trust bank account, invoice accounting model is imported from general business accounting. The invoice commission is recorded in the ledger as agency income rather than trust liability. Return premiums are wrongly recorded as negative receivables. Net premium vouchers are manually processed. The agency sales commission is not collected in a separate ledger account. As practiced today, trust accounting is nothing but an extension of agency general business accounting.  This explains why trust balance sheets or statements of trust cash balance beneficiaries are unavailable to agency managers. As an extension of the agency business accounting, the trust accounting practice is indeed a non-core business.

New Technology

With the advent of new technology, trust account premium and return premium transactions are now fully automated.  A new accounting logic is employed to generate trust financial solvency reports. Balance Sheets and Statements of Trust Funds Beneficiaries are standard in trust accounting. Agency owners can monitor and control by themselves the trust account operation as mandated by law. Trust accounting has nothing to do with the agency’s sales or service functions. Its integration in the agency business is the result of agency’s conscious decision to assume fiduciary responsibilities. Trust accounting represents about 85% of the agency accounting effort. Only 15% covers general accounting transactions.

Conclusion

In current modern financial management environment trust accounting becomes an agency’s stand-alone operation organized to manage transacted premiums and supply the agency commission income. Is the trust account operation an agency’s core business? We emphatically say it must be because agencies have opted to become fiduciary-based enterprises functioning alongside the sale and service core business. We suggest that, by accepting fiduciary responsibilities, insurance agencies committed to perform financial duties like any other financial institution, although much more involved. Insurance companies should consider providing agencies financial compensation for this very specialized work.

For additional information on the new trust accounting technology and the US patent obtained in 2017 to protect it, send email to chris@paulmargroup.com  

Chris Marinescu, Inventor and President at Paulmar Group LLC

Hybrid Trust Accounting: What Is It?

Trust accounting is an open-ended accounting concept currently used to support financial management of trust funds by not-for-profit organizations. Because it does not explicitly report trust financial solvency, it is hereby referred to as a hybrid product. Its procedures are limited to generating journal and/or ledger formatted information.

A new generation of trust accounting technology has been recently developed (and patented) to make trust financial solvency its primary objective while automating daily trust transactions. The solvency concept as well as the double-entry accounting practice employed by for-profit organizations has been adapted and introduced in the trust accounting practice regardless of the organization’s type of business (whether for profit or not). Balance Sheets and Trust Float Statements will be available for each trust funds beneficiary, especially critical when there are multiple trust beneficiaries in a single trust account.

Trust accounting is commonly used in the real estate (RE) industry (escrow accounts) and legal profession (attorney’s trust accounts); other industries also use it. Guidelines to RE brokers for trust accounting procedures have been issued by different states to help bookkeepers create reliable accounting records and for trustees to avoid fiduciary violations. Several software vendors offer trust accounting products to attorneys (listing on Capterra website) to help them separate trust funds from business operating funds and establish trust account beneficiaries.

P&C Insurance

An industry where trust accounting is not fully recognized by professionals is the property/casualty (P&C) insurance brokerage industry. P&C insurance trust accounts are much more dynamic and more demanding than the escrow and/or attorney’s trust accounts; they are subject to heavy daily financial traffic and have requirements nonexistent in other industries. The existence of P&C trust accounts is not acknowledged by major national institutions entrusted with regulating or standardizing accounting practice, such as American
Institute of CPAs (AICPA) and Financial Accounting Standard Board (FASB). The AICPA Tax Division published in 2007 a Practice Guide for Accountants who perform fiduciary accounting services. Alerted to the problem of P&C insurance retailers’ inadequate income accounting practice, the FASB is yet to provide a solution. 

Trust Funds

Trust funds are money, or any other property, received by a broker in a fiduciary capacity to manage it for the benefit of others (legal owners). The law requires brokers to maintain trust funds in trust bank accounts separate from the broker’s business operating funds. Fiduciary capacity is understood as an obligation to manage trust funds not as owners but custodians of funds until they are disbursed to the persons legally entitled to. Diverting trust funds or appropriating them for personal use is a fiduciary violation.

AICPA defines the fiduciary relationship as undivided loyalty to trust funds beneficiaries. It requires an above-reproach conduct and a high standard of care for negligence. AICPA also defines the trustee’s fiduciary duty as: 1) duty of management to preserve and protect the trust property, 2) duty of loyalty to keep the interests of trust beneficiaries ahead of those of third parties, 3) duty to account, to keep accurate records of trust funds, and 4) duty to disclose trust information to trust beneficiaries as such information belongs to beneficiaries as much as to the trustee.

Trust Accounting

It is significant to note that, although the custodian’s ultimate fiduciary duty is to keep the trust account financially solvent, the state-issued trust account guidelines for RE brokers do not specifically identify solvency as a management target. They seem to imply that merely keeping accurate trust records would inherently guarantee the trust financial solvency. The notion of “trust assets and liabilities” as well as “trust balance sheet” does not exist. It is apparent the guidelines consider the keeping of receipts and disbursements journals and ledgers of trust beneficiaries is sufficient; an accountant will determine if the escrow account is financially solvent.

P&C Trust Accounting

Compared to those in the real estate and/or legal profession, trust funds accounting procedures in the P&C retailing industry are quite different. While trust fund transactions in either RE or legal professional practice generate no “income”, in the P&C retailing industry, due to a 45-year old unfortunate practice, premium invoice does create “income” records. The invoice accounting was erroneously set up so that while invoice payments are deposited in the agency’s trust account, the income accounting records are maintained in the agency’s general ledger. The ensuing result is an accounting mess that causes agency’s owners to have no control over premium trust funds while exposing them to potential fiduciary duty violations.

The State of California, for example (and similarly other states), requires agency owners, acting as “trustees”, to provide proof of solvency i.e., proof that there are sufficient premium assets in the trust account to meet the trust liabilities (obligations to P&C trust beneficiaries). Such proof requires elaborate accounting since there can be multiple beneficiaries in a P&C insurance trust account: insurance companies, insureds and premium finance companies, and agency itself (owner of earned commissions).

The erroneous set up of the P&C premium invoice accounting made it impossible for agency owners to have “trust account balance sheets” and/or “premium float statements”. The latter would have the information necessary to determine trust funds beneficiaries; the former would enable accountants to establish the trust cash financial solvency (liquidity solvency in general business accounting) based on accounting records (no formulas).

The most egregious downside of P&C agency’s current trust accounting practice is its inability to support agency income accounting necessary to determine the agency’s “earned” commission income. Most agencies transfer commission funds to their operating accounts based on what they “need” rather than what they “earn”. The uncontrolled transfer of commission funds out of the agency’s trust account is a major source of trust financial insolvency.

Hybrid Trust Accounting

With the advent of a new accounting logic for trust funds, it became necessary to distinguish the current hybrid trust accounting practice (used in RE and legal profession) from the new trust accounting technology. The new trust accounting logic is founded on trust financial management requirements: 

1. Complete separation of trust funds from the brokers’ business operating funds using a separate trust ledger of accounts. This requirement is currently met in the RE industry where commingling of non-fiduciary funds in the escrow account is not permitted. This is not the case in the legal profession and/or P&C insurance brokerage industry;
2. The trust ledger must have a chart of accounts with sufficient detail to support trust balance sheets and statements of trust float;
3. Trust Balance Sheets can be easily processed to generate trust financial solvency reports, especially trust cash financial solvency (liquidity statement in general business accounting); trust accounting is “cash accounting”, no funds can be disbursed out of the trust account before related cash or credit funds are deposited;
4. The Trust Float Statement can be easily processed to generate Trust Funds Beneficiaries Statements, especially when multiple beneficiaries are present in the broker’s trust account;
5. No manual journal entries should be permitted in trust accounting; all trust accounting transactions should be fully automated, i.e., programmed and executed by computer;
6. Financial solvency reporting should replace current journal and/or ledger reporting system so brokers and auditors can easily and instantly verify trust account financial solvency;
7. Financial solvency reporting will demonstrate:

• Trust assets equal trust liabilities;
• Trust cash balance equals the trust account float;
• Trust cash assets equal trust “due and payable” liabilities (cash solvency);
• Trust cash balance calculated for all beneficiaries equals the trust account float;
• Financial solvency is reported for each trust account beneficiary.

Conclusions

Trust accounting products offered to attorneys (see Capterra website) or escrow companies are functional in as much as they provide on journals and/or ledgers information regarding trust receipts and disbursements, trust funds beneficiaries, etc. They do not explicitly report financial solvency.

Brokers and auditors do not find direct answers to the trust account financial solvency question. Escrow final statements are generally cumbersome, difficult to read even by people with knowledge of trust transactions. A CPA confidentially admitted the trust accounts of his client-attorneys were messy.

Because of limited accounting procedures and lack of trust financial solvency reporting current trust accounting products are hereby referred to as “hybrid” products. The new trust accounting product is branded T-Trust Accounting (T for True) or NOBL Trust Accounting. It is fully automated and performs as detailed in the above 7-item list of solvency management requirements.

The new trust accounting technology stands to change current trust accounting practice with great benefits to accountants, trustees and trust beneficiaries. It is currently available only to P&C insurance brokers; it will be also ready for distribution in other industries during the months to come.

Article written by Chris Marinescu, Founder and President at Paulmar Group LLC and Emma Hart, Industry Consultant. For more information on T-Trust Accounting contact the author or Emma Hart by email: chris@paulmargroup.com or Emma@emmahart.com A link to our US Patent is also provided:
https://www.paulmargroup.com/technology/PressReleaseJun2018.html

US Patent Submitted – Patent Pending for Missing Link in Insurance Industry

After the considerable amount of work undertaken by our patent attorneys, a patent application was filed on October 11, 2016 with the U.S. Patent & Trademark Office for P&C Insurance Trust Automation and Financial Solvency Management technology. Two inventors take credit for the development of this unique product: Chris Marinescu and Emma Hart.

Chris Marinescu, President of Paulmar Software, Inc. stated: this product represents the “missing link” of P&C insurance agency automation. While not competing with current agency management systems, such as: AMS or Applied Systems, this product will easily integrate with them for complete automation of P&C agencies.  By fostering the outsourcing of agency’s trust account management, this product paves the way to rapid organic growth, higher productivity and increased profit performance. A significant advantage for both P&C producing agencies and insurance companies will follow as agencies will be able to focus solely on sales and service.

This product brings to the market a new fiduciary accounting concept for P&C insurance premium and return premium trust funds, fundamentally different from business accounting. A new trust financial solvency reporting system has been developed and included.

The introduction of this product into the marketplace will change the management paradigm of the P&C insurance brokerage industry and help it become leaner and significantly more efficient.    

To learn more about this product, go to www.paulmargroup.com/missinglinkpatent Or contact Emma Hart at emmahart@paulmargroup.com or 949/233-2545.

P&C INSURANCE AGENCY AUTOMATION

PREMIUM TRANSACTIONS ARE STILL MANAGED MANUALLY!

 

Much is being said about insurance agency automation. Not enough has been said or done to help the agency owners automate premium and return premium transactions. The general perception is P&C agencies are just sales and service operations. Mostly ignored is the fact that the undertaking of trust financial duties makes P&C agencies operate much like financial institutions.

Financial Institution?

Small agencies receive and disburse on the average $3 to $5 million annual premiums. Medium size agencies’ annual premium is close to $15 million or more while large agencies’ financial traffic through their trust bank accounts may exceed $50 million a year. We know mega insurance brokerage houses transact hundreds of million dollars every year. None, regardless of their size, is equipped with financial management tools necessary to handle such an intense financial traffic.

This article is not however about agency financial management. Few recognize insurance agencies as financial institutions. It is the automation question we would like to address in this paper. Known as sale and service operations, insurance agencies are well equipped to manage customers and marketing, rating and claims. The problems they have struggled for more than 40 years remained to this day without solutions.

Automation Shortcomings

The shortcomings of insurance agency’s operation are not in the front office but in its back office. They hinder agency’s organic growth and its profit performance. Here is a sample of them:

1.    The follow-up on delinquent invoices is still manual; this affects primarily the agency’s CSRs (account managers);

2.    Endorsement AP invoices and follow up are still manual; many invoices are easily neglected by CSRs who have much more important things to care for;

3.    Agency “earned” commission is a problem affecting all P&C insurance agencies. Being unable to determine it, agencies incorrectly transfer commission funds to the business operating account based on what they “need” rather than what they “earn”;

4.    Company Statement reconciliation is still manual, although not entirely;

5.    Cancellation endorsement reconciliation is still manual; return premium refunds are simply reduced to “paying negative invoices”;

6.    Direct Bill Commission statement reconciliation is still manual. Many agencies prefer not to do it and therefore lose control over their DB commission income;

7.    The NSF check process is manual; most agencies delay or fail to request policy cancellations for non-payment of premium when payment checks are return for insufficient funds. Losses due to NSF checks can be significant;

All these processes are or should be performed in the agency’s back office. The front office is critical because it develops the agency business but a weak back office will hinder growth and diminish profits. Since trust account operation is highly regulated, the danger of fiduciary violations is not only real but always present. Some details follow.

Invoice Follow-up

Agency receivables are a primary source of trust financial insolvency. Delinquent payments disqualify an agency from timely “earning” its sale commission. In egregious cases, they can be the source of serious “earned premium liabilities”. By signing the Company-Broker agreement, agencies are obligated to remit premiums, net of commission, to insurance companies or MGAs, whether or not they receive such premiums from insureds.

Insurance customers must pay premiums on or before their due dates (as set forth by insurance companies). Despite a well-established standard, agencies continue to have “aged receivables” in excess of 30, 40 or even 60 days and risk earned premium liabilities.  For any $1,000 earned premium liability turned into a $1,000 loss, an agency must sell 8 to 10 times more premium.

Current agency management systems have not automated the invoice follow-up process.

Endorsements AP

Agencies do not maintain records of endorsements AP in the policy database. They just invoice them. Since the endorsement AP invoice is still a manual operation, CSRs may easily neglect it. It is not uncommon to see endorsement papers sitting in a box waiting to be invoiced. Delinquent endorsement payments may cause agencies to advance premiums to companies and risk losses due to non-payments.

Current agency management systems have not automated the endorsement AP invoice and follow-up.

Agency Commission

Agency commission on sales is the very reason insurance agencies are in business. The difficulty of having it easily available is a real nuisance; the sale commission is realized in the agency trust not in the sale and service operation area of business. To transfer it to the business operating account, agencies must determine it and then create an audit trail. Trust funds are regulated to prevent illegal disbursements. The problem is aggravated by the fact that sale commissions are embedded in every payment an agency receives and deposits in the agency trust. 

None of the agency management systems on the market today offers agencies the tools to determine the “earned” commission.  Many agencies use separate spreadsheets to track payments and related commissions. Since this is labor intensive and generally unreliable, most agencies transfer commission funds to the business operating account generally based on what they need to cover operating expenses.

Commission transfer out of the agency trust bank account is the second most important source of trust financial insolvency. If agencies transfer more than they earn, they violate insurance fiduciary duty and risk legal consequences.  If they transfer less, they may understate taxable income and risk IRS audits.

No current agency management system offers insurance agencies help in processing the agency sale commission and its transfer to the agency’s business operating account.

Co Statements

The processing of Co Statements or MGA invoices is only partially automated. Agencies use AMS, Applied Systems or similar agency management software, to manually reconcile the company statements by verifying statement line items against the agency’s invoice payments. Paid invoices are checked for company remittance and included on a computer-generated list (voucher) that is attached to the remittance check along with the Co Statement.

Company Statement premium items that are not paid (remitted) are manually identified on the Statement along with an explanation.

The Co Statement manual reconciliation is tedious and labor intensive.

Cancellation Endorsements

Most cancellation endorsements result in return premium to be refunded to either insureds or premium finance companies. In current practice, the cancellation endorsement process is misunderstood. Interpreted as “returned merchandise”, return premiums are processed as negative invoices neglecting that, before writing a refund check, the agency must receive from the insurance company the return net premium and from the agency’s business operating account the “unearned commission”.

While “unearned” net premium is generally reimbursed on Co Statements as credit, seldom or never agencies return to the agency trust account the “unearned commissions”. Agencies will refund from the trust account return “gross” premiums without returning/reimbursing first the “unearned commissions”. The difference will illegally come from premiums received under different policies.

No agency management software has offered insurance agencies automated procedures to manage cancellation endorsements and related premium refunds.

Direct Bill (DB) Commission

The reconciliation of DB Commission Statements is tedious and time consuming. The DB policy commission may be paid by insurance companies either in full after the down payment is received or gradually as installments are paid by insured. Keeping track of DB commission payments is a real challenge. Many agencies trust the insurance Company. Reconciliation is too expensive and is therefore not done. 

No agency management system today offers insurance agencies an automated reconciliation of DB Commission Statements. Some third party software companies have developed reconciliation software but their integration with AMS, Applied Systems or similar software applications continued to be a real challenge.

NSF Checks

NSF checks do occur and can be quite aggravating, especially if an agency advanced premiums, net of commissions, to insurance companies. To avoid “earned premium” liabilities, agencies should immediately request the policy cancellation for non-payment of premium. If they do not, the policy continues to “earn” premium until it is cancelled. According to the Company-Broker Agreement, all “earned premiums” must be paid by the agency.

Some agencies do request policy cancellations following NSF checks but many do not. No agency management system offers agencies an automated NSF process.

 

Final Thoughts

The latest research and development effort lead to the development of a massive premium database encompassing all elements of premium and return premium transactions: policy transaction, billing, payments and bank deposits, agency commission, company remittance, return premium credit and refunds, DB policy commission.

Intense programming of premium and return premium transactions has resulted in the achievement of some major automation goals. Here are the agency’s back office functions that are now fully automated: 

1. Premium invoice and follow-up;
2. Endorsement AP billing and follow-up;
3. Agency commission income process;
4. Company Statement process;
5. Cancellation endorsement reconciliation and premium refund process;
6. DB policy commission statement reconciliation;
7. NSF check processing.

For more information on these achievements, contact Chris at chris@paulmargroup.com or visit www.paulmargroup.com.

Article written by Chris Marinescu, President of Paulmar Group LLC.

INSURANCE TRUST (FIDUCIARY) ACCOUNTING:

WHY IS IT DIFFERENT FROM STANDARD TRUST ACCOUNTING?

For more than 40 years P&C insurance premium accounting has remained an industry problem without solution. Insurance retailing agencies continue to struggle managing premium funds. The attempt to use financial accounting for premium accounting has failed. Finally, the long overdue solution has been found. Insurance Trust Accounting is however not the same as standard trust accounting. This paper explains why.  

1      Financial Accounting for Premium Funds

Financial accounting is used to keep track of a company’s financial transactions. Its concept and rules are well understood by those who practice it. It has been used by professionals in all sectors of the economy.

Many years ago financial accounting was adapted by the Property & Casualty (P&C) insurance industry to keep track of premium and return premium financial transactions.

Standard accounting methods have not been very useful in the P&C industry mainly because, upon deposit in the agency trust bank account, insurance premium and return premium funds become fiduciary funds. As fiduciary funds, insurance premiums are subject to a financial management different from that of business operating funds.   

The difference between the premium fiduciary funds’ economic nature and that of business operating funds has not been well recognized by insurance professionals and, as a result, no effort has been made to this day to develop a suitable accounting method for these funds. It has become apparent the management of P&C insurance premiums has different rules and requires different accounting procedures.

Accounting methods and financial management of fiduciary funds in other industries, such as real estate or legal profession, did not prove to be a good model. The one thing that emerged useful was the need for separation of fiduciary funds from business operating funds. Real estate brokers, for example, employ outside escrow companies to manage real estate trust funds.

2      Insurance Trust Accounting

Little or nothing is known about P&C Insurance Trust Accounting. In current practice trust accounting is generally associated with the escrow or lawyers’ trust accounting. The need for trust accounting in the P&C insurance industry has not been widely recognized likely because P&C insurance agencies are considered merely sales and service operations, not financial institutions. Insurance fiduciary duty is however on the books and is mandatory for all insurance agents and brokers who receive premium payments under insurance policies or premium finance agreements.

Aware of fiduciary duty mandates, P&C insurance agencies have been waiting for an accounting solution that could help them manage the agency’s trust account operation. Current agency management systems, such as AMS or Applied Systems, have not addressed to this day insurance agency’s need for insurance fiduciary accounting.

Insurance Trust Accounting is not taught in college; there are no text books on insurance premium accounting and trust financial management. Insurance agencies are currently required to manage financial traffic varying from a low $5 million in small agencies to $100 million or more in large agencies.  This financial operation would logically qualify them as financial institutions; no one in the industry recognizes them as such.

3      Insurance Fiduciary Duty

Most commercial insurance products are retailed through the independent agency system, a community of independent insurance agents and brokers appointed/approved by insurance companies and/or general managing agencies. Insurance companies grant insurance agencies the right to receive transacted premiums and maintain them in agency-owned trust bank accounts.

Independent P&C insurance agencies, whether retailing or wholesaling, agree on a voluntary basis to receive transacted premiums from insureds or finance companies and maintain them in trust bank accounts of the so called “pooled” type. The designation refers to the fact that premium funds received under more than one policy or from more than one insured are maintained in a single common trust bank account.

Since premium funds are owned by others, insurance brokers agree to receive them in a fiduciary capacity and become “trustees” or “custodians” of funds until they are disbursed to legal owners.

4      Insurance Trust Financial Management

Trust financial transactions are numerous and complex. In the beginning money flows from insureds to the agency’s trust account, to insurance carriers and to agency business operating account. During the policy term, a policy cancellation may reverse the flow from insurance carriers and agency operating account to the agency trust account and back to the insured.

Keeping track of such flow of money requires good financial management. That is why insurance trust account management may be referred to as “money management” or “trust financial management”.

The ultimate objective of trust financial management is to monitor, control and report trust financial solvency. As in business for profit, trust financial solvency management implies control over the trust assets to prevent disbursements of funds to entities other than those legally entitled to them. In California, misappropriation of premium trust funds for personal use or to cover agency operating expenses is punishable by a loss of business license and/or theft as provided by law. Similar provisions are included in the Insurance Codes adopted by other States.

The Company-Broker Agreement places on insurance brokers the responsibility to remit to the insurance company transacted premiums, net of commissions, whether or not they received such premiums from insureds. The brokers’ legal obligation is referred to as “transacted liability”. Unless the policy incoming premium flow is properly managed, the agency is liable for transacted premiums, net of commissions. For this reason, trust account management may be also understood as “fiduciary liability management”.

5      Daily Financial Transactions

Capturing premium daily transactions in accounting records is fundamental to Insurance Premium Accounting. Such transactions include: policy transaction/sale closing, invoices and payments of premium, bank deposits, agency earned commission and its transfer to the operating account, company premium remittance, net of commission. Everyone is a financial transaction taking place in the insurance trust and, for this reason, they all must be recorded in a trust ledger, separate from the agency general ledger. On the way back to insured, return premiums must be also recorded in the trust ledger: return premium reimbursements, net of commission, agency unearned commission reimbursements and return premium refunds to insureds of finance companies.

Accounting transactions become much more complicated when, after a down payment, the policy premium balance is financed. The financed amount remitted directly to an insurance company is a financial transaction that takes place outside the agency trust account; nevertheless, accounting records of this transaction are necessary because insurance brokers are legally responsible for all policy financial transactions, whether inside or outside the agency trust account. 

6      Financial Accounting Engine

Financial accounting keeps track of a company’s financial transactions, creates accounting records and summarizes them in two financial statements: Balance Sheet and Income Statement. The engine of financial accounting is the sale invoice which creates income and assets, cash or receivables, in the seller’s general ledger.

The business invoice is an instrument of sale, whereby a buyer acquires a merchandize or service in exchange for a sale price. Invoice accounting marks the beginning of financial accounting.

Insurance Trust Accounting is powered by a different engine: the policy. Its objective is similar to that of cost accounting. It does not compute insurance policy cost (this was already established) but in a similar way manages the incoming and outgoing flow of money related to a single insurance product: the policy.

That is why Insurance Trust Accounting may be also understood as Insurance Policy Accounting.

7      Invoice vs. Insurance Policy

Is the business invoice as relevant in the P&C insurance industry as it is in other industries? The answer is an emphatic NO. It cannot be because, in the P&C insurance industry, the invoice is not an instrument of sale; the insurance policy is.

The sale of insurance products is consummated upon the binding of insurance policies. In this industry, premium invoice is just a document that reminds insureds to pay a premium they already agreed to when the policy was signed.

One may want to compare the premium invoice with the loan coupon used in the lending industry to remind borrowers to send a payment.

The financial status of insurance policies is the core objective of premium accounting in the same way a bank depositor’s account is in banking accounting. Banks know and are able to report the account balance of each of its bank depositors.

8      Insurance Trust Accounting Equation

P&C Insurance Trust Accounting cannot be the same as business accounting. The business invoice process does not exist or is very different in policy transactions. There is no income in the P&C Insurance Trust Accounting, only assets and liabilities. The accounting equation is simply reduced to Trust Assets = Trust Liabilities. There is no agency owners’ equity in a P&C insurance trust.

9      Why Agency Owners Need Insurance Trust Accounting

80% or more of the agency accounting effort is related to insurance premium accounting. Absent premium funds, P&C agency financial accounting is relatively simple. P&C agencies have no inventories and few are involved in transactions other than insurance policy transactions.

A fully automated Insurance Premium Accounting will significantly reduce the agency workload while providing the means to fully control and report the agency’s trust financial solvency. Insurance Premium Accounting: 

1. Automates the premium billing and follow up process, currently considered the first most critical source of trust financial insolvency;
2. Eliminates receivables aging as inconsistent with required insurance premium payment on or before the coverage becomes effective. As a result, earned premium liabilities are eliminated;
3. Introduces the concept of “cash on hand” vs. “cash in the bank” to prevent theft in the handling of payment checks;
4. Automatically determines and reports agency “earned” commissions for full control over the commission funds transfer to the operating account. Mismanagement of agency commission income is considered the second most important source of trust financial insolvency;
5. Improves the Company Statement processing through automatic reconciliation and generation of remittance check vouchers;
6. Reconciles cancellation endorsements and automatically processes premium refunds to insureds or finance companies;
7. Reconciles Direct Bill Commission Statements, currently a labor intensive process;
8. Creates a commission reserve account in the agency trust to simplify the reimbursement of unearned commission to the trust account;
9. Reports agency production based on sales along with agency and producer transacted commission income;
10. Reports the agency trust financial solvency of each policy, each insurance company and entire agency trust. 

10   How Insurance Companies Benefit From Insurance Trust Accounting

Insurance companies’ business prospers when producing agencies sell more and are able to minimize the cost of managing premiums. Using Insurance Trust Accounting, producing agencies will offer insurance carriers real benefits:

1.         By controlling receivables and having the Company Statement process fully automated, delinquency of premium remittance can be entirely eliminated;
2.         Company bad debts/write offs will be also eliminated if remittance delinquency is eliminated;
3.         Carrier’s in-house workload will be reduced if producing agencies’ remittance process is automated;
4.         Workload reduction will reduce carriers’ operating costs;
5.         Carriers will be able to directly verify the solvency of premiums maintained by producing agencies.

P&C insurance industry will become more productive and more efficient if both carriers and producing agencies can improve the management of insurance premium funds. Insurance consumers will also benefit from a better service and possibly lower premium rates if the industry can operate more efficiently.

Insurance Trust Accounting is currently being offered to P&C insurance retailers. For more information, visit www.paulmargroup.com or contact chris@paulmargroup.com.  

Article written by Chris Marinescu, President of Paulmar Group. Copyright by Chris Marinescu, July 12, 2016

Groundbreaking Accounting System for the Insurance Industry

Why Creating/Inventing It Was Necessary

In my previously published papers, I repeatedly argued against the improper use of general ledger business accounting for insurance premium and return premium transactions. I reached this conclusion after years of studying the P&C agency trust accounting and its governing standard.

Insurance fiduciary duty and its profound implications upon the P&C insurance agency’s financial operation have apparently received little or no attention from the agency owners or vendors of agency management systems. I presumed this attitude was likely encouraged by a belief that the trust account operation is so complex that no one would have knowledge or skill to capture it in accounting records.

To those unfamiliar with Sections 1733 and 1734 of the CA Insurance Code, P&C insurance agencies must not only maintain premiums and return premiums in separate “trust” bank accounts but also manage them in compliance with fiduciary laws. Due to its inherent limitations to business operations, general ledger accounting has apparently obscured the meaning of “insurance fiduciary compliance” and, as a result, no one has attempted to break outside its conceptual boundaries.

Understanding the risk of failure but confident a solution will be found, I put together a development team and embarked in a long and tedious effort to create/invent a new trust accounting system for the P&C insurance industry.

The natural thought barriers raised by general business accounting were so high that we had to think completely out of the box in tackling the development of a new accounting system. These barriers are briefly reviewed in this paper because their removal became the foundation blocks of the new insurance trust accounting.

Barrier No. 1: Invoice Accounting

Insurance agencies have always used general ledger (business) accounting for premium transactions because they thought they were no different from merchandise or service sales. General business accounting begins with the seller billing the buyer for merchandise or service purchases. The invoice generates “assets” and “income” in the seller’s general ledger.

 The first barrier to overcome was the concept of current premium invoice accounting. In general ledger accounting the “invoice” is a “sale” document. In the P&C insurance the “sale” document is not the premium invoice but the insurance policy. The premium invoice is only a reminder to pay what insured had already agreed to when the policy coverage was bound.

Foundation Block No 1: Insurance premium accounting must begin with the policy transaction, not premium invoice.

Barrier No.2: Assets and Income Accounting

Upon receipt, fiduciary law requires premium payments to be deposited in a fiduciary “trust” bank account. They become fiduciary funds. If payments must be deposited in trust it is only logical that the premium invoice must also originate in trust. In an insurance trust, however, there is no “income”, only assets and liabilities. A premium invoice originated in an insurance trust will therefore generate premium assets, receivable from insured, and premium payables, premiums, net of commission due to insurance carriers, and sales commission due to the agency operating account.

Foundation Block No. 2:  In premium accounting an invoice generates trust assets and trust liabilities. The general ledger invoice model is incompatible with insurance premium accounting.

Barrier No. 3: Different Management Objectives

The main purpose of business accounting is to report profit/loss and help the agency determine its tax liability. An agency Balance Sheet includes business assets and liabilities necessary to establish the agency’s financial solvency.

Premium fiduciary accounting has completely different objectives, all related to the need to monitor and control the trust financial solvency:

• Generate a separate Trust Balance Sheet;
• Balance Sheet data will be utilized to established the Trust Financial Solvency;
• Generate a Premium Float Statement (aka Statement of Premium Receipts and Disbursements);
• Premium Float Statement data will be utilized to report Trust Funds Beneficiaries;
• Generate financial reports at all three levels of trust financial management: policy, carrier and agency.

Foundation Block No. 3: Insurance premium accounting must facilitate the reporting of trust financial solvency. Business accounting is incompatible with insurance premium accounting.

Barrier No. 4: Return Premium Accounting

In general business accounting, returns of merchandise are entered in the general ledger as negative invoices, i.e., creating negative assets and negative income.

Insurance return premiums are not merchandise returns; they are premium transactions in “reverse”, i.e., from insurance companies back to insureds. Return premium transactions generate “receivables” and “payables” in the same way premium transactions do. The only difference is receivables are due from insurance companies and agency, while payables are due to insureds and/or finance companies.

Return premium accounting is as complicated, if not more complicated than premium accounting. 

Foundation Block No. 4: Insurance return premiums generate receivables and payables in the insurance trust, in the same way premium transactions do. The returned merchandise concept is incompatible with insurance premium accounting.

Barrier No. 5: Funds Transacted Outside Agency Trust Account

Premium financing is routinely practiced in the P&C insurance industry. Agencies set up loans to finance an unpaid premium balance after the insured makes a down payment. The financed amount may be either paid to the agency or remitted directly to the insurance company/general managing agency. In the case of policy cancellations, often resulting in return premiums, the insurance company refunds the “unearned premium, net of commission” to the premium finance company, while the agency returns “unearned commission” to the same.

Direct remittance and direct refund transactions bypass the agency trust account. However, insurance fiduciary accounting must include the financial records of both direct remittance and direct refund because, by statue, the insurance agency is ultimately responsible for all policy financial transactions.

Foundation Block No. 5: Insurance premium accounting must include direct remittance and direct refunds.

Barrier No. 6: Financial Solvency Reporting

There is no concept of trust financial solvency in current practice. This is because general ledger accounting does not report it. Agency owners are unable to verify the trust financial solvency for which they are personally responsible. Because the general ledger accounting does not support trust financial solvency reporting, CPAs use formulas. No formula has been proposed for establishing the trust cash financial solvency.

Foundation Block No. 6: Insurance premium accounting must report the trust financial solvency at all three levels required by fiduciary laws: policy, carrier, and agency.

Final Thoughts

The development effort of more than 12 years has resulted in the creation/invention of a new and long overdue insurance premium accounting. Referred to as Insurance Fiduciary (Trust) Accounting or Trust Ledger (TL) Accounting, this unique accounting system will assist agencies in managing both daily trust operations and trust financial solvency.

The current lack of premium and return premium accounting has been a major cause of financial insolvency of agency P&C trust funds. In California, violations of insurance fiduciary duty expose agency owners to a loss of business license and/or potential prosecution for theft.  Similar provisions are included in the statutes of other states. 

Insurance agency owners will be now able to fulfill their fiduciary obligations as legal “custodians” of premium and return premium funds.

Article written by Chris Marinescu, President of Paulmar Group LLC

Chris Marinescu has Master Degrees in Civil/Structural Engineering and Engineering Economics. Chris has published 15 articles on P&C insurance agency fiduciary duty and trust financial solvency management and teaches two CE classes on insurance fiduciary duty. Chris also maintains a structural engineering consulting practice which is currently limited to the seismic performance assessment of existing buildings and structures.

 For more information on Insurance Fiduciary (Trust) Accounting, visit Paulmar  Group at www.paulmargroup.com or contact the author/inventor at chris@paulmargroup.com.