(This article appeared in Agency Equity on May 15, 2013)
P&C independent insurance agencies derive their income primarily from the sales and service of insurance products. Unlike the income of typical sale and service operations, the agency commission income is filtered through a highly regulated trust account that makes it quite difficult to manage. While agency proceeds from sales must be deposited into a “trust” bank account where they become “fiduciary” funds, regulatory mandates prohibit agencies from transferring sales commissions to the operating account without proper documentation and audit trails.
P&C independent insurance agencies derive their income primarily from the sales and service of insurance products. Unlike the income of typical sale and service operations, the agency commission income is filtered through a highly regulated trust account that makes it quite difficult to manage. While agency proceeds from sales must be deposited into a “trust” bank account where they become “fiduciary” funds, regulatory mandates prohibit agencies from transferring sales commissions to the operating account without proper documentation and audit trails.
Reliable Commission Management
Agency sales commission has a long metamorphic line that must reach its end before it can become “income”. “Transacted” policy commission (commission on a “legal” sale document) becomes available only after it is “earned”; this requires transacted premiums to be invoiced, received and deposited in the bank “trust” account. One must be aware that agency commission “income” is not realized in the “trust” account. To become “income” and be reported on the agency’s Income & Expense (P&L) Statement, the sales commission must be first “transferred” to the agency’s operating account.
Since an agency’s very existence depends on the sales commission management, reliable information on its metamorphic stages will help owners/ managers to control operating expenses and plan ahead agency financial operations. Quick answers to questions such the ones listed below will empower owners/managers to manage the agency business with confidence:
- What is the agency “transacted” commission during any given period of time?
- How much of the transacted commission was invoiced, how much is uninvoiced?
- How much of the invoice commission was “earned”, how much is outstanding?
- How much of the “earned” commission was transferred to the operating account, how much is outstanding?
- How much of the “earned” commission is maintained in a “commission reserve” account (maintained in the trust account)?
- How much of the “commission reserve” was used for return commission reimbursements, what is its current balance?
- What is the agency “true” commission income? Did the agency transfer to the operating account more than it earned or less”; in other words, did the agency overstate or understate its taxable income?
- What is the “commission loss” due to cancellation endorsements, how much was reimbursed to the trust account?
- How much commission did the agency lose due to uncollectible NSF checks?
Current Practice
None of these questions have answers in current practice. Commission management has remained an open question for many years. Current agency management systems offer no solution to their users. Most agencies transfer commission funds out of the trust bank account based on ”needs” rather than on what they “earn”. Some agencies transfer more than they “earn” and, in so doing, they violate insurance broker’s fiduciary duty. Others transfer less, just to be conservative, and in so doing they will underestimate taxable income. An IRS audit may potentially find them in violation of the Tax Code.
The reason why commission income management has had no solution to the present day is the use of incorrect accounting procedures. General ledger accounting use for premium and return premium transactions is intrinsically inadequate.
New Accounting Procedures
A new accounting system has been developed to manage agency commission income from the time a policy is transacted until the policy commission is “earned” and “transferred” to either the agency operating account or a commission reserve account maintained in the trust account. This new accounting system is a collection of new accounting procedures designed to mirror the nature of premium and commission transactions.
Agency commission accounting logic is complex; it employs ledger accounts whose balance is dependent on other ledger accounts, such as: premium receivable, invoice payments and bank deposits, cash on hand and cash in bank account. Commission loss accounts are dependent on the return premium accounts. A fundamental feature of the new accounting system is the placement of premium funds in a different ledger of accounts, separate from the agency’s business operating funds.
The new premium and commission accounting works at the policy level and provides critical information on the policy premium float. How much of the policy premium float is owned by the carrier (net premium) and how much by the agency (earned commission) are questions that enable the much needed premium float analysis and the determination of the trust funds beneficiaries (owners). The new accounting procedures are known as Trust Ledger Accounting.
Commission Income Account
The only commission account agencies maintain in the general ledger is the invoice-based one. For any practical consideration this account is unreliable. Agency commission must be first “earned” and then “transferred” to either the operating account or commission reserve before it can be reported as “income”. Due to its basic use in merchandise accounting, general ledger accounting used by agencies has no controls over the invoice-based commission being “earned” and “transferred” to become “income”. General ledger accounting is unable to generate a trust account separate balance sheet and isolate the “earned” commission from the “transferred” one.
Major Source of Financial Insolvency
The uncontrolled transfer of commission funds out of the trust account is the second most important source of trust account financial insolvency. The lack of control over agency receivables is viewed as being first. One in three insurance agencies in California, and possibly more, operates “out of trust” risking a loss of business license and potentially legal prosecution for theft. Department of Insurance does not consistently enforce Insurance Code’s fiduciary mandates but no one can be sure this practice will continue in the future. Best business practices demand insurance agencies to reliably monitor and control their trust account operation and avoid the financial insolvency of premium trust funds.
Article by:
Chris Marinescu, CEO at Paulmar Group, LLC,
Email: chris@paulmargroup.com
Website: www.paulmargroup.com
