This is the second article in a two-part series on general ledger accounting. Part one can be viewed online.
Only a few years ago, general ledger (GL) accounting was considered adequate by the industry consultants and regulators. To the more discerning insurance agency owners and stockholders the dissatisfaction with its inadequate performance has been most apparent in three important areas of the agency business: agency commission income reporting, return premium and commission accounting and trust account financial solvency. This is part two of this article. Part one was published in the May 7 issue of Insurance Journal.
This installment focuses on the GL accounting inadequate performance in reporting premium float, creating correct return premium accounting records, verifying the accuracy of the trust account cash balance and managing personal funds.
Policy Premium Float
In addition to tracking and controlling premium payments and bank deposits, premium management is also about controlling premium and commission disbursements. Tracking premium receipts and disbursements of each policy will help the “custodian” determine the policy premium float as a difference between the two. Because it does not control the earned commission process GL accounting cannot determine the policy premium float. As a result, GL accounting can neither report the trust account total premium float.
Premium float is used to determine the trust funds beneficiaries as well as the accuracy of the trust account cash balance.
Agencies maintain million of dollars in their trust bank accounts without knowing for sure who their beneficiaries are. Due to the lack of adequate accounting records, CPAs work hard to determine the beneficiaries of a trust account cash balance, especially in court cases. However, this should not be just a CPA’s job but a reporting function of the GL accounting system.
Return Premium Accounting
One of the most blatant demonstrations of GL accounting inadequate application to insurance transactions is revealed in the return premium accounting. Using the “returned merchandise” analogy, return premiums are recorded in the general ledger as “negative receivables.” Unlike a “merchandise return” which reduces receivables as well as income, return premiums are business transactions of a different nature. Return premium accounting should establish first the need to receive and deposit in the trust bank account (1) the net premium returned by the carrier and (2) the lost commission returned from the agency operating account. It should also set forth the “custodian’s” obligation (liability) to refund to the insured the return premium gross amount.
GL accounting misrepresents the business nature of the return premium transaction by unjustifiably converting a return premium liability into a “negative receivable.” Let’s look, for example, at a $1,000 return premium case. The “custodian” undertakes an obligation (liability) to refund $1,000 to the insured; at the same time it acquires the right to receive and deposit in the trust bank account $900 net premium returned by the carrier and $100 lost commission reimbursement from the operating account (10 percent policy commission is assumed). The “custodian” will refund the $1,000 only after $900 and $100 reimbursements are received and deposited in the trust bank account.
It must be also noted, a $1,000 return premium entered in the general ledger as a “negative receivable,” will unjustifiably reduce the agency balance sheet assets by $1,000 and, instead of having its liabilities increased by $1,000, will reduce the carrier liability by $900 and agency “retained earnings” by $100.
In current accounting practice, agencies verify the trust account cash balance by subtracting disbursements from bank deposits. This should be acceptable if the agency were sure all disbursements were legally made. To prevent incorrect or illegal disbursements many agencies require checks to be signed and cosigned by more than one person. However, commission checks used to transfer funds from the trust account to the operating account cannot be verified as correct or legitimate because no one in the agency can truly ascertain the check amount equals the amount of earned commission.
Similar doubts may exist about bank deposits. In current accounting practice payment checks received from insureds are treated as already deposited in the bank. The question is: have they all been deposited in the bank? To control bank deposits, most agencies use administrative procedures.
A sure way to verify the trust account cash balance is to determine the trust account premium float. The cash balance is correct when it equals the premium float, first determined for each policy, and then through aggregation, for each carrier and agency as a whole. GL accounting cannot accurately determine the premium float, mainly because GL accounting cannot control the commission transfer process. Most agencies today transfer commission based on needs rather than what they truly earn.
Some of the software applications currently in use generate reports of “Commission on Paid Items.” However, with no accounting controls in place, an agency may easily transfer more than once to the operating account the same commission amount.
Insurance code allows insurance brokers to maintain in the trust bank account personal (non-premium, non-fiduciary) funds to meet different contingencies. Many would like to maintain a commission reserve account to respond to cancellations and therefore commission losses. Such is the case especially with policies sold in the transportation or construction industries where large additional premium or cancellation endorsements are very common.
Similarly, the cash balance of a trust bank account earns interest. As non-premium funds, interest earnings should be maintained in a “non-premium” (personal funds) account. The agency is entitled to withdraw the interest at any time but not without proper documentation and audit trail.
GL accounting has no provisions for “personal fund” accounts in the trust bank account. Although a special journal entry could be created to post interest income transactions, setting up a commission reserve account appears difficult if not impossible.
Is GL accounting adequate for the insurance brokerage industry as it has been for every other industry for over 500 years? This paper was written to substantiate what dissatisfied owners and shareholders have known all along. The answer is unequivocally “no.” GL accounting is inadequate for P/C premium transactions simply because the P/C insurance product is fundamentally different from merchandise or service. Many insurance retailers today, even those using an advanced agency management system, are likely unaware their trust bank accounts may be financially insolvent. Some will be surprised to discover it when it is too late and possibly too costly.