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