California Insurance Code requires P/C insurance agencies to receive premium funds in a fiduciary capacity. Producer agencies are allowed to transfer earned commissions upon receipt of premium payments. Due to the fiduciary nature of premium funds the transfer of earned commissions to the agency operating account should be a controlled process. The lack of financial controls in current premium invoice accounting may explain why many insurance agencies operate out of trust. This article looks into the current premium invoice accounting practice, analyzes its shortcomings, and offers a solution for improvement.
Questionable journal entry
In current accounting practice the invoice journal entry shapes the premium accounting records and financial reporting of premium funds. The premium invoice drives the agency’s entire accounting process. For example, accounting records of premium payments cannot be created without reference to an invoice. Or, the premium remittance to carriers cannot be processed if the premium was not previously invoiced.
Premium invoice accounting currently follows the “sales” invoice model used in the sale of goods and services. A sales invoice generates income in the seller’s P&L statement and cash or receivable assets in the balance sheet.
The premium invoice generates commission income in the agency’s P&L statement and cash or receivable premiums in the balance sheet as the sales invoice does. Unlike the sales invoice however, a premium invoice also generates liabilities, such as the net premium payable to insurance carrier. The net premium liability account is used by financial managers to monitor and control the premium remittance process.
For example, the journal entry (JE) for a $1,000 premium invoice with 10 percent sales commission currently creates three accounting records:
|Net premium payable||$900|
This journal entry shapes up the balance sheet (BL) as shown below:
|BL 1 Before Closing||BL 2 After Closing|
|Cash in trust bank account||$0||$0|
|Cash in operating account||$0||$0|
|Net Premium Payable||$900||$900|
|Total Liabilities & Equity||$900||$1,000|
In BL 1 premium funds are out of balance prior to closing: $1,000 assets vs. $900 liabilities. After closing BL 2 shows the premium funds in balance as a result of including $100 retained earnings. The $100 retained earnings (owner’s equity) presume no expenses were posted against the $100 income. The agency producer commission (sales personnel commission) is an operating expense, therefore is not included in the analysis of premium invoice accounting.
GL accounting is known to require closing of the income and expense accounts so that the profit account can then be closed with retained earnings (owner’s equity).
There is an unsettling question about current premium invoice accounting. Since insurance premiums received by an agency are fiduciary funds the journal entry of premium invoice should generate strictly fiduciary assets and liabilities (no “retained earnings.”) A different journal entry represents the actual premium invoice process. This journal entry would create slightly different accounting records:
|Net premium payable||$900|
Current invoice accounting ignores the Insurance Code mandate for commission liability account and, as a result, insurance premium trustees are currently unable to monitor and control the transfer of earned commissions. The commission payable account used in JE 2 is similar to the net premium payable account used to monitor and control the premium remittance to insurance carriers.
Insurance Code requires premium trustees to manage especially the disbursement of premium funds as illegal disbursements are the primary source of trust account financial insolvency. Without adequate accounting and financial reporting trustees cannot fulfill their mandated obligations.
Tracking commission income
In their desire to track commission income insurance agencies currently manage premium fiduciary funds as they were business operating funds. In so doing, they alter accounting transactions and adequate reporting of premium funds. Insurance Code allows agencies to include in the agency balance sheet transacted premium funds, provided premium assets and liabilities are clearly and fully identified in the balance sheet. In our example (BL 1 and BL 2), the agency balance sheet should include $1,000 liabilities in two separate accounts: $900 payable to carrier and $100 commission payable to the operating account (refer to JE 2).
It is apparent the mandate to separate fiduciary funds from business operating funds is not carried out to its final conclusion. Agencies do maintain separate trust bank accounts but in the accounting process they treat premium funds as business operating funds.
Right from the start of the accounting process agencies ignore the fact that premiums are funds “in transit,” therefore not subject to a closing process. There is no profit in the trust bank account. The cash balance of a trust bank account is premium float continuously changing as premiums are received or disbursed. It should be obvious the trust account operation is fundamentally different from normal business operation and for this reason its financial management should require different accounting procedures.
Commission income accounting
There is another way to monitor the agency commission income without altering the trust funds accounting. While a commission payable account is used in the trust account (see JE 2), a commission income account could be used in a parallel journal entry to help agencies monitor the commission income embedded in invoiced premium (JE 3 below):
Another journal entry will be made when the earned commission is transferred to the operating account:
|Operating bank account||$100|
The commission income accounting we propose (JE 2 and JE 3) has the advantage of giving an agency the financial tools to monitor its commission income while the commission liability account in the trust account enables trustees to monitor and control the transfer of earned commission.
Monitoring commission income transfer
An audit trail of the commission liability account would provide the trustee with valuable accounting information to verify if funds, other than earned commissions, were transferred to the agency operating account. The balance of the commission liability account will show whether an agency transferred the right amount to its operating account (Scenarios 1 and 2):
|Scenario 1||Scenario 2|
Scenario 1 illustrates the case of an agency transferring to its operating account $10 more than it earned. In Scenario 2 the agency has $10 outstanding earned commission that can be transferred to the operating account.
In current accounting practice agencies transfer commission funds with no control. If an agency needed $15,000 to make a payroll the agency would transfer to the operating account $15,000, whether or not it had $15,000 earned commissions in the trust account. It may be for this reason so many agencies currently operate out of trust, possibly without even knowing it. Published statistics suggest many independent insurance agencies dip into trust account funds jeopardizing their business licenses or potentially facing legal prosecution.
Two accounting ledgers
Having a commission liability account in the ledger is an Insurance Code mandate and, on this basis, the current journal entry for premium invoice (JE 1) needs to be re-evaluated and changed. We suggest using the JE 2 format that secures regulatory compliance and helps agencies avoid insolvency caused by uncontrolled commission transfer.
JE 2 will be used in conjunction with JE 3 to give agencies a financial tool to monitor their commission income and retained earnings. This procedure requires two separate ledgers of accounts, one for premium funds and another one for business operating funds. Without accounting separation JE 3 will distort the agency balance sheet.
|BL 1||BL 2||BL 3|
|1. Cash in trust bank account||$0||$0||–|
|2. Cash in operating account||$0||–||–|
|3. Premiums receivable||$1,000||$1,000||–|
|4. Commission receivable||$100||–||$100|
|5. Net premium liability||$900||$900||–|
|6. Commission liability||$100||$100||–|
|7. Owner’s equity||$100||–||$100|
|Total Liabilities & Equity||$1,100||$1,000||$100|
As shown below, the Accounts receivable and Owner’s equity accounts distort the balance sheet assets and liabilities (refer to BL 1). If premium funds were separated into a different trust ledger of accounts agencies would be able to generate two separate balance sheets, BL 2 and BL 3, one capturing premium fiduciary funds, the other one reporting business operating funds. Both BL 2 and BL 3 have the advantage of being accurate and conforming to Insurance Code requirements.
Since “Commission receivable” is already included in the $1,000 invoiced premium the balance sheet Total Assets is unjustifiably increased by $100, to $1,100. To generate separate balance sheets (BL 2 and BL 3) the seven accounts listed in BL 1 need to be segregated and placed in two different ledgers, one ledger for premium funds (accounts 1, 3, 5, and 6) and the other one for business operating funds (accounts 2, 4, and 7).
Financial controls in the premium accounting are mandated by Insurance Code to prevent the mismanagement of premium fiduciary funds. Currently insurance agencies can monitor and control the disbursement of net premiums to insurance carriers. They are unable to do the same with commission funds transfer. Three changes are proposed in the current invoice accounting:
Current invoice accounting is standard in all accounting software products distributed with current agency management systems. Agencies with manual accounting follow the lead of automated agencies. The trust account process is not only different but significantly more complex than the agency’s core business process. New accounting procedures are needed to support the intricate reporting and financial solvency requirements.
Insurance Code places on insurance producers important fiduciary obligations many may not be fully aware of. In the process of transacting insurance they become legal trustees of premium funds. Without adequate financial tools however trustees cannot fulfill their fiduciary obligations. This article is published to foster a public debate on the subject topic and possibly lead to changes in current premium invoice accounting. Premium trustees, producers, managers and auditors will largely benefit from such changes.
Chris Marinescu is president and CEO of Paulmar Software Inc., a Southern California firm specializing in insurance premium accounting and solvency management. He can be reached at firstname.lastname@example.org. Emma Hart is an insurance professional with over 15 years experience in the management of insurance trust account.
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