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.
