Trust Accounting

Every once in a while, I write an article on trust accounting. Recently, I was searching my archives and came across one I'd written 20+ years ago. Nothing much has changed, so I feel I’m being redundant writing on this subject again and again. 

But many agencies and their CPAs do not know why or how independent insurance agency accounting is different. The problem is exacerbated by agency management systems that cannot handle insurance agency accounting. QuickBooks, for example, is not designed for the specific accounting needs of independent insurance agencies.

What is different about insurance agency accounting requirements? There are two kinds of billing: direct bill and agency bill. And agency bill is generally the issue. With agency bill business, the agency is responsible for collecting premiums on behalf of carriers. If the insured’s premium is $1,000, the agency must bill and collect $1,000. That money (less the commission) is owed to the carrier regardless of whether the insured pays, unless a cancellation is processed before the premium is earned.

In the most straightforward example, let’s say the agency collects $1,000 the day prior to the effective date. They deposit $1,000 and then write a $900 check to the carrier (the $100 is their commission).

What happens, though, if the agency pre-bills 30 days early and the insured pays 30 days early? The agency collects $1,000, which goes into cash. It does not go to income. The offset is a liability often named binder bill or pre-bill. This is because that $1,000 does not belong to the agency. That $1,000 still belongs to the insured. It remains the insured's until the effective date. The agency is holding that money in trust, or it is supposed to be.

No income is recorded, regardless of cash or accrual accounting, until the effective date. That prepayment should not be recognized on the income statement until the effective date.

What happens when the insured does not pay their $1,000 until after the effective date? The agency must pay $1,000 (maybe $900) to the carrier to effect coverage. At that point, does the agency have income? Not if it is on a cash basis. On an accrual basis, there will be a $1,000 premium receivable on the balance sheet offset by a $100 income addition and a $900 cash disbursement to the insurance company.

What happens when the invoice is due but not yet earned by the insurance company, but the insured hasn’t paid? There should be a premium payable offset by a premium receivable, in whole, not net of commission.

What happens when an insurance company refunds money? The carrier provides a credit to the insurance agency on agency bill business, and the agency typically has 30 days, under most state statutes, to return that premium. That credit is just another form of money held in trust on behalf of the insured or the carrier.

Agency bill is why insurance agencies cannot ever be 100% cash. Maybe on a tax basis they can be, although I’d argue against that. On an operating basis, though, if an agency has agency bill business, it must use accrual accounting, at least partially.

This unique situation is why agencies on a cash basis can incur bad debt, whereas under cash accounting, it is otherwise impossible to have bad debt. This situation occurs when the agency pays the carrier on behalf of the insured, but the insured never pays. Agencies write this off, even when using cash accounting, because the money they lost was largely not their own. They had to make up the loss to the carrier.

Why Does Agency Bill Exist? Many decades ago, the technology did not exist for insurance companies to collect money directly. Then, once the technology was available, many agencies refused to use it because they wanted to collect money early and invest this “float”. This was when interest rates were high.

Agency bill now exists in a much more limited fashion, typically because of accounts in surplus lines where billing is more complicated by the addition of a second middleman. It exists in other situations because some carriers cannot afford a direct bill system. Direct bill is cheaper for retail agencies, and these carriers want to push costs to their agencies.

Trust Laws Trust laws, which exist in all 50 states and at the federal level, are designed to prevent agencies from spending funds that are not theirs. These laws vary slightly from state to state, but the general rule of thumb is that agencies’ cash plus premiums receivable must exceed premiums payable and binder bills. In other words, the numerator divided by the denominator must be greater than 1.0.

This is the trust ratio. Violation of this is usually a statutory problem. It is also usually a carrier contractual problem where the title of the agency’s book of business is automatically, without notification, transferred to the carrier(s).

These laws get less sunlight these days because so much business is direct bill. Historically, some agency owners seemed to think the client/carrier monies were theirs, and they spent the money. At some point, their premium payables would be so large, they could not pay their carriers. At other times, someone would turn them into the federal government or state department of insurance. Often they’d go to prison.

What I normally see today is the result of agencies using accounting systems that cannot account correctly for agency bill business. Then, when they prepare to sell their agency or write a check to a carrier, they discover they don’t have enough cash. It is quite an unpleasant surprise. This is why understanding agency bill accounting and using systems that properly account for agency bill is critical.

Impact on Agency Value An agency out of trust does not likely own its expirations, so value is significantly impacted. Some buyers look the other way, deduct from the price, and then add enough cash to bring the trust ratio back to whole. Some walk away. Buyers should want to know exactly why the agency is out of trust before making a decision. If it is fraud, walking is the best strategy. If it is an accident caused by not knowing how to properly account for agency bill business, working out the situation likely makes the most sense.

Why Don’t CPAs Know All This? The majority of CPAs are jacks-of-all-trades. There is no way for them to know all the different accounting rules by industry. Furthermore, most agency owners only ask their CPAs to do their taxes, not offer operational accounting advice.

One reason I’m writing this is so agency owners can take this to their CPAs and request advice on doing their accounting correctly.

Agency bill accounting is a unique creature. Do not treat it the same for accounting purposes as you do direct bill. Furthermore, know your specific agency management system’s accounting function because the different systems handle agency bill quite differently. And if you’re using QuickBooks, know that it is not designed for agency bill. You will likely need to take some manual steps to account for agency bill business correctly. And remember, agency bill business is always on an accrual basis!

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NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.

None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.