The Benefits of Forming Your Own Premium Finance Company

By | July 7, 2003

This is the first in a three-part series on captive premium financing. Part Two will run in the July 21 issue of Insurance Journal.

Agents and managing general agents continue to reap the benefits of a growing excess and surplus lines market while standard line carriers pull back from business that they were either not prepared to handle and/or not priced to profit from. This trend (a.k.a. “the hard market”) has, for the most part, resulted in increased commissions from higher premiums.

If you speak to agents about these good times, however, you will find that every rosy situation has it’s not so rosy side…in this case it’s client retention.

Agents may be earning more commission, but they’re also working harder than ever to retain their client base. Let’s face it; clients facing a double or triple digit percentage increase in premium from one year to the next not only need constant attention but new products and services that will make their life easier. Agents can provide some relief by capitalizing on an often-overlooked area of their business: controlling the billing terms offered to their insureds through an in-house premium finance company. Most agents and managing general agents that arrange financing for their insureds do so by choosing an outside finance company. By doing so agents are investing their sales and marketing dollars to close the deal and then allowing others to take a piece of the action.

Agents already offer a myriad of insurance products and services to their clients, so captive financing fits nicely within the business model.

Furthermore, no one knows the needs and financial wherewithal of a policyholder better then the agent placing the risk. By creating an in-house finance company, an agent can create competitive payment terms based on individual needs that can make the difference between winning and losing the deal.

The income derived by the insurance financing transaction averages two to three equivalent commission points to the bottom line of an agency. Instead of making 10 percent or $1,000 commission on a $10,000 premium, agents can earn $1,200-$1,300 or more. Now consider the number of financed policies an agency has the chance to place each week, month and year and we’re talking about a considerable income spike. This new venture becomes an additional profit center for the agency and helps build the overall value of the agency for years to come.

How does premium financing work?
Premium financing is used in place of inflexible carrier installment plans or if the only option is payment of the annual premium in full. The latter is typically the case with the E & S market. By signing a finance agreement, the insured is agreeing to have the premium finance company advance the annual premium to the insurance company on their behalf. The insured is then given a payment plan from the finance company that includes premium and interest payments. If the insured fails to pay one more installments when due, the premium finance company has the right to request cancellation of the policy from the insurance company.

How does your finance company generate income?
A finance company generates income by borrowing money at a certain interest rate from one source (i.e. a bank, private investors, etc…) and lending that money at a higher rate to policyholders that request financing. Profits from premium financing also include late fees and other incidental charges. The costs of forming and running a premium finance company include interest expense (i.e. cost to borrow the money), day-to-day administration and overhead, licensing and accounting expenses. With proper financial modeling and the commitment to promote the financing transaction, the income generated by a portfolio of premium financing loans can yield a considerable return on investment. Past experience shows that at a minimum, a captive commercial premium finance operation with average size premiums of $3,000 could realize anywhere from $20,000-$30,000 in income per year for each million dollars of financing. This number will vary depending on a variety of factors including the difference between the rate charged for funds and the rate paid for funds (i.e. the “spread”), the late fee income and how one chooses to administer the book of business.

Why captive financing?
The most obvious reason for captive financing is this: You (the agent) paid 100 percent of the cost to bring a deal in the door but failed to retain 100 percent of the potential income from that deal. In other words, you’ve left money on the table. Secondly, as covered above, the recent growth in premiums comes with the downside realization that insureds are strapped for cash to pay for their insurance and if they can’t pay for it, they may choose not to purchase it or purchase less of it… not a good outcome for the insured or the agent. Empowered with the ability to make decisions about your own finance company (as opposed to have terms dictated to you), your agency can solve a very important developing problem in a hard market.

How do you get started?
Every business has its minimums and premium financing is no different. The total amount of premiums that could be financed needs to be at a certain level to meet the start up and minimum ongoing costs of owning a premium finance company. What that minimum is also depends on the total number of loans that would be financed in a given year and the interest rates that will be charged for each premium range are very important.

These factors can help make the financial forecast much clearer in terms of understanding the return one can expect. Companies can run a financial pro-forma for you for free to help you in this process.

Once a decision has been made to proceed, the first task to consider should be the acquisition of capital. Agents might be able to work with their local bank or lending institution or even have a servicing/software vendor introduce them to lending relationships that specialize in this niche market. Those interested in borrowing capital can take comfort in the fact that interest rates are at an all time low since 1958; with more indication from the Fed that rates may be reduced again.

While you are securing your financing you will want to start the licensing process. You will need to secure licenses within each state you plan to write business…and while there are basic licensing requirements shared by many states there are also states that have more complex requirements. It is advisable to contact a consultant or your legal counsel to assist in the preparation of some or all of the licenses you may require. Doing so will allow you to continue to concentrate on your business while your finance company is being formed. Third party premium finance administrators and software development firms typically offer licensing services with their suite of products.

The benefits of forming a captive finance company are summarized in the table to the left.

The next step is to determine the direction in which you choose to run this new company. Part two of this three part series will concentrate on the pros and cons of outsourcing your new premium finance company to a third party servicer vs. licensing the software from a vendor and running the finance company in-house.

Benefits of Forming a Captive Finance Company
Area of Interest Captive Premium Finance
Commissions Earned up front as soon as the down payment is collected from the insured instead of over the life of the policy as the insured makes payments (common with direct bill).
Increased Profits Agency revenue equating to a 2-3% increase in commission per loan can be obtained via a captive premium finance operation.
Cash Flow for your Insured You determine the billing terms on a case by case basis depending on the risk. You have 100% control in offering more flexible payment terms for your insureds.
Control Costly cancellations and rewrites can be avoided by monitoring your accounts and offering flexible payment dates, terms or holds when needed.

Chris C. Farfaras is a vice president of Sales and Marketing for Input 1, LLC, based in Woodland Hills, Calif. Input 1 manages over $450 million in annual P/C premiums and provides online account access to over 700,000 policyholders for independent and captive premium finance companies throughout North America. Farfaras can be reached by e-mail at cfarfaras@input1.com or by phone at (888) 882-2554, ext. 2135.

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