Author: VU Faculty

We've recently received several questions about trust accounts. How does an agency with an internal premium finance program know if it is in or out of trust? Can a trust be held in an interest bearing account? In this article, we'll take a look at some of these issues. As other arise, we'll be updating the article.

"How does an agency determine if they are in or out of trust? I know a simple way is the add the cash accounts and receivables, and compare them to the current payables. How is this affected by an internal premium finance program where the entire premium is advanced to the company, but the receivables from the customer are spread over 8 months, and a large amount of the receivables have not yet been billed as they are not due?

[Note: The following description of operations was added after a follow-up question from the VU (as indicated in a couple of faculty responses below). In order to get a timely response and allow our faculty to operate as efficiently as possible, please make sure your "Ask an Expert" questions include all relevant details.]

"The premium finance is not a separate entity, but a profit center within the agency. After receiving 25% down, the money for the finance principally comes from a line of credit which is secured by the building. The premium to the company is run as a full, annual pay and it is paid to the company on their accounts current. Then a separate policy is set up with the finance company as the company and the premium is run off. At that time the down payment and the first installment is billed to the customer and subsequent billings set up for future billing.

"I know it would be cleaner to have them separate entities, but this is the way it was set up a number of years ago with the help of the automation vendor."

Below are some thoughts from our agency management faculty. As indicated above, a couple of them were based on not knowing the true internal relationships and structure of the financing operation.

An "internal" premium finance program is, in fact, using agency (and trust) funds to sponsor clients' premiums. The agency will almost necessarily be out of trust and can be severely affected if any large account renigs on their "internal" premium financing – this is always a bad idea.

This is a great question. To give a clear concise and appropriate answer, I need to ask two questions: (1) define the relationship between the agency and the internal premium finance company, and (2) explain how business is transacted between the two and between the finance company and the carriers. I assume it is a premium finance company owned by the agency.

If so, the key issue is legal structure. Is it a separate legal entity from the agency, which it should be, or is it a profit center within the legal structure of the agency? With an understanding of both the legal structure/relationship of the two entities and the operational relationship I can provide you with the appropriate response.

Great Question. The first item that comes to my mind is whether the premium finance operation is a separate legal entity. If it is, then the simple formula mentioned still applies to the agency. Now whether the premium finance company is adequately financed is another issue and if not, you have the issue of off-balance sheet liabilities like Enron. If it is not separate, it probably makes sense to make it separate.

If it is not separate and making it separate is not an option, then is seems the same formula still applies because the agency is ultimately on the hook for paying the companies and getting paid by the customers. If the customer has signed a premium finance agreement and all the money is due within eight months, then the question becomes whether only billed receivables should be included in the trust definition or all receivables. And I do not know the answer to that. I've never seen a definition of "Trust Ratio" that distinguished between the two.

The "absolute" correct answer on whether your agency is in trust is based on the definition and guidelines for an Agency Trust Ratio as set forth in the regulations issued by the Insurance Commissioner for the state(s) in which you operate your agency and you should verify this answer against these regulations.

I would also suggest you speak with your legal counsel about whether it would be wise to create a separate legal entity for your premium finance company.

In general, as you stated, an agency is in trust if its trust ratio is equal to or greater than 1.0 or 1:1. The trust ratio is calculated by taking the sum of Cash, Cash Equivalents, and Premium Receivables divided by Company Payables. When you have a premium finance company, set up as a business segment within the agency, this basic metric doesn't change but it does add a little wrinkle to the mix.

In your case, your agency has two distinct business segments, which, setting the legal structure issues aside, essentially is like having two companies. Therefore, you essentially have two sets of Trust Ratios to review, one for ABC Insurance Agency and one for "XYZ Premium Finance."

Let me walk through the flow of a XYZ premium finance transaction, as I understand it, from your explanation, as part of the answer to your question.

Acme, Inc. receives and accepts a quote from ABC for a $1,000 policy. Acme decides to utilize premium financing. ABC collects the down payment, $250, and the credit application from Acme. ABC sends the $250 and credit application to XYZ. XYZ approves the application and draws $750 from its loan facility and remits $1,000 to BIG Insurance Company. Simultaneously, XYZ sets up a receivable from Acme equal to $750 plus interest and fees and a payable to the bank for the draw on the credit line.

Let's assume this transaction is fully executed within a calendar month. ABC has executed its fiduciary responsibility and has no trust issue. XYZ has also executed it fiduciary responsibility, and it too has no trust issue.

Now let's assume the transaction overlaps two months. As of the 31st of month one, XYZ has received the $250 deposit and approved the application and it requests $750 from its line of credit. It remits the $1,000 premium to BIG on the 15th of month two. Is XYZ out of trust on the 31st? The answer is no, it has used the credit line, to obtain cash and offset the liability; therefore, it is at 1:1 and in trust on the 31st.

Provided XYZ has separate operating cash, the down payment from the customer and uses the credit line to offset carrier payables it is in trust. Likewise, if ABC has the cash and customer receivables to offset its carrier payables, it is in trust.

Now let's put the legal structure issue back into view. Legally, ABC and XYZ are one company not two separate companies; therefore, there is only one trust ratio, not two, in the eyes of the law. However, the legal entity is in trust if the business segments are both in trust.

The best way to be certain that you don't have a trust problem is to be certain at no time are you commingling any insureds funds or funds borrowed by the insured from a finance company that you are holding in trust for an insured, with operating funds.

If you can't have separate balance sheets for each segment, then your consolidated balance sheet should have the following cash, receivable and payable accounts:

Group A - this group of accounts are the accounts used to calculate the Trust Ratio.
Cash - Agency Operating Cash - Premium Finance Operating
Cash - Agency Fiduciary Cash - Premium Finance Fiduciary
A/R - Agency Insurance Premiums A/R - Premium Finance Insurance Premiums
A/P - Agency Carriers Payable A/P - Premium Finance Carriers Payable

Group B -
A/R - Premium Finance Financing Payments Due
A/R - Agency Other Receivable A/R - Premium Finance Other
A/P - Premium Finance Credit Line Payable
A/P - Other Payable A/P - Premium Finance Other Payable

Secondly, to be certain collection problems don't arise for the premium finance company, make sure your management system has appropriate triggers set up to send cancellation notification, etc., in a timely manner and to enable nonpayment situations to be resolved before the agency could be responsible for an earned premium.

I hope this information clarifies your question regarding your agency trust ratio.

"I know we must maintain a separate trust account for non-contract company premiums. Can we keep this money in an interest-bearing account or is there any regulation against earning interest on this trust money in an interest bearing/money market type account?"

The answer to your question depends on what your Department of Insurance regulations say. Most trust account states allow funds to be kept in an interest bearing account with carrier permission and this permission is routinely given.