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