In current practice, insurance premium accounting is based on general ledger (GL) accounting. It is used by all agency management software applications including AMS and Applied Systems just to name a few. Developed more than 500 years ago, GL accounting has been successfully used by both profit and non-profit organizations and it was only natural to become standard accounting practice in all software applications offered to P/C insurance retailers.
Only a few years ago, 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.
An insurance policy may be subject to multiple endorsements with the potential to cause the policy commission to either increase or decrease several times during its term. Some insurance brokers have expressed the need to maintain some of their earned commission in the trust bank account as a cushion against cancellation endorsements and related loss of commission income. GL accounting seems to have severe limitations in all these important areas of the agency business.
Many CPAs or accounting service providers argue they can make GL accounting work for both the agency’s sales and service operation and premium and return premium management. Some contend that determining an agency’s “trust position” or “trust ratio” is sufficient to prove its trust account financial solvency. Despite such assurances, one in three insurance retailers in California is presumed to be out of trust and operate a financially insolvent trust account. Many insurance brokers have lost their licenses and some have even faced legal prosecution for the mismanagement, in most cases unintentional, of premium fiduciary funds.
This article is delving into this controversial debate and attempts to prove that GL accounting is not only inadequate for P/C premium transactions but also a prime contributor to current mismanagement of insurance premium funds. It is published in two parts. This is part one.
Unlike other sales transactions, a P/C insurance transaction places stringent obligations on the seller. Insurance code mandates insurance brokers to receive premiums in a “fiduciary” capacity and assume full responsibility for their financial solvency. Acting as a “custodian” of premium funds is a responsibility an insurance broker must undertake in addition to his/her primary duty of maximizing the agency output and improving its profit performance.
The insurance broker’s dual capacity underscores the nature of insurance premium accounting and financial management objectives. On one hand, an insurance broker, acting as “business owner,” acquires the authority to invoice, receive and maintain insurance premiums in the agency’s trust bank account. On the other hand, the insurance broker, acting as “custodian” of premium funds, assumes the obligation to disburse the premium funds to their legal beneficiaries. The processes of receiving and disbursing premium fiduciary funds set up the premium invoice format in which the insurance broker must appear in his/her dual capacity of “business owner” and “custodian.” It is this dual responsibility of insurance broker that defines the insurance transaction’s dual character and uniqueness.
GL accounting is inconsistent with the insurance transaction’s dual character and therefore unable to adequately respond to its financial management requirements.
General Ledger of Accounts
By its very nature GL accounting places insurance premium funds in the same general ledger of accounts with the agency business operating funds. One would find this illogical because premium funds must be managed to a different standard. Business operating funds are managed to show business owners and shareholders if the agency is both profitable and financially solvent. They are also managed to enable agency compliance with the Tax Code.
Insurance premium funds are managed to a completely different standard. Since they are “fiduciary” funds, insurance brokers, acting as a “custodians,” manage premium funds to secure and report their financial solvency. There is no profit in the insurance trust account, only premium assets and liabilities. The insurance broker’s “custodian” position is an expression of his/her fiduciary duty.
It seems obvious that, having a different management standard, insurance premium funds should be placed into a different ledger of accounts, separate from business operating funds. Special journal entries, able to capture the true and unique nature of insurance premium transactions, would enable “custodians” to reliably report the trust account financial solvency.
An insurance transaction is more than a one-time event; it is a process that continues from the policy inception to the end of its term. Moreover, an insurance policy does not have a guaranteed fixed price determined at its inception but one that may change up or down as a client’s coverage needs may change. The insurance product is like no other product. In terms of accounting and financial management needs, the insurance product seems fundamentally different from a merchandise or service.
Premium Invoice Accounting
In GL accounting the accounting process starts with an invoice which is known to generate income in the agency P&L and receivables in its Balance Sheet. GL accounting compels the premium accounting process to also start with an invoice rather than the policy transaction itself. The problem is, in its current GL format, premium invoice accounting misrepresents the business nature of the premium invoice transaction.
A premium invoice should never generate “income” in the agency P&L as a merchandise invoice does; it should only generate premium assets and liabilities. A $1,000 premium invoice sets forth the trust account custodian’s right to receive from the insured $1,000 and, at the same time, his obligation to disburse $1,000, $900 net premium to the carrier and $100 commission to the agency operating account (10 percent policy commission is assumed). The agency commission “liability” compels the “custodian” to monitor the invoice payment and its bank deposit, so that, at the end of a tedious process, commission liability can become “income” through the process of transferring the commission funds from the trust bank account to the agency operating account.
Invoice payments are not income; they are just “premium receipts.” Once deposited in the trust bank account, premium receipts become “fiduciary funds” subject to Insurance Code processing mandates. Earned commission must be first calculated and then transferred to the agency operating account. An audit trail must be created for each policy not only for department of insurance auditors but also for the agency owners or managers.
Earned commission must be transferred in an exact amount; some of it may be maintained in a “commission reserve account” set up in the trust account. Without proper calculation, an agency is at risk of transferring either more or less commission than it earns. If it transfers more, the agency violates the custodian’s fiduciary duty; if it transfers less, the agency will understate its taxable income and therefore violate the Tax Code.
In its current GL format premium invoice accounting is a main source of agency commission and financial solvency mismanagement.
Policy Financial Status
The current GL accounting process is at odds with the very nature of the premium transaction process. After transacting a $10,000 policy, an insurance broker would certainly need to know at any given time during the policy term how much of the transacted premium was invoiced, how much was paid, and how much is still outstanding. Additionally, information on any policy endorsement, its invoice status and payment is critical to the policy financial management. Monitoring the policy financial status and reporting it is an integral part of the premium solvency management.
GL accounting cannot report a policy financial status because in GL accounting there are no accounting records of the policy transacted premium. To the insurance “custodian,” it is the policy financial status that matters rather than the number of invoices sent to insureds. To generate a report of how much of the policy transacted premium was invoiced or paid and how much is outstanding, insurance brokers generally maintain a spreadsheet outside the GL accounting system. This practice is not only costly but also unreliable. It is clear GL accounting cannot meet the management requirements of premium financial status.
The second installment can be viewed online.
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