Pitfalls to Avoid in Running a Captive Premium Finance Company
This is the third and final part in a series of articles discussing captive premium financing.
The decision has been made to form a captive premium finance company. The method in which you plan to run your operation has also been chosen whether it be outsouring to a third party vendor or using software to run the operation in house. Chances are your lending arrangement and state licensing is all in place as well. You’re now ready to get started and you want to book your first loan. Before you open your doors for business, take a moment to consider some important factors in this new frontier of insurance premium financing.
Price and terms
Building a sound game plan and understanding the components of your business are critical. The fundamental choice of the right interest rate, for example, is an important factor in determining your overall return. You obviously want to make sure you charge an appropriate APR that will not only cover your borrowing costs, administrative overhead and other expenses but one in which will allow you to make a healthy return on your investment.
The down payment and installment terms you offer will have an effect on your overall return. For example, playing it safe and offering terms of 25 percent down payment and nine installments on your business will keep you above water in most circumstances. In specific cases (i.e. certain coverage types or geographic regions) you may be able to offer a lower down payment but in other cases, you will want to require a higher down payment. The same is true for the number of installments…in some cases nine or even 10 installments is just fine. In others, seven or eight might be a more prudent decision.
Your outsource service provider and/or lender should be able to provide you with a pro forma income statement that helps you determine what you should be offering and the resulting return you can expect from your business.
Type of coverage and policy provisions
Believe it or not one of the most important factors in accurately determining the down payment and number of installments for a loan involves a clear understanding of the provisions that exist for a particular policy. It would be nice if every policy you plan to finance has a 10-day cancellation, no minimum earned premium, no auditable provisions and is earned on a pro rata basis. As you probably already know, this is seldom the case. What you may not know is how these provisions can affect the financing.
For example, for a policy exhibiting a short rate return instead of pro-rata return, in the event of a cancellation you are going to receive five percent less in unearned premium. If you financed a $10,000 policy, this means that your finance company may be as much as $500.00 short on the loan balance. This difference ends up coming out of your pocket unless your lucky enough to convince the insured that they need to pay this difference. In California, for example, the state mandates a pro-rata return when a policy is written by an admitted carrier and financed by a California-licensed finance company but this is not the case in all states.
Other policies such as Liquor Legal Liability and D&O may in fact have provisions that make the policy either fully-earned or have an accelerated earning provision thus making any expected return of premium less then what you expect. The effect of reduced unearned premium can eat into the profits of your company. There are other policy coverages that you will want to become more familiar with as well and as we’ve discussed before, you should consulate with your vendor, because if they’re worth their weight they should be able to help give you sound advice and feedback in this area.
Carrier insolvency
Although the risk of an insurance carrier becoming insolvent is very low, it is still a risk that must be considered when running your own premium finance company. It is advisable to finance premiums with carriers that have strong financial ratings and size. This can be checked against A.M. Best or Standard & Poors, the two most common carrier-rating bureaus.
Most commercial premium finance companies will only consider financing premiums if the insurance carrier has an A.M. Best rating of B+ (Very Good) or better and a financial size of at least V (capital, surplus and reserve funds between $10 and $25 million). The standards you choose to set for your own company will obviously depend upon your risk tolerance.
Know your state laws
So you’re running along smoothly and financing a lot of business when you get a phone call from the state governing body that oversees financing for the state(s) in which you operate. The regulatory body(ies) will want to conduct an onsite audit of your operation (if you have outsourced the servicing, the audit is typically handled by the service provider). Ensuring that you have charged the correct interest rates, charged the correct late fees and sent back all refunds exactly as required by the statutes will keep the regulators at bay.
Be sure to choose a vendor that has a solid understanding of the laws in those states that you choose to operate in. The software system being used, whether you outsource it or keep it in house, must comply with such items as maximum allowable interest rates, minimum and maximum late charges and when cancellation notices can be mailed to the borrower. However, it is really your responsibility and money on the line, so take a little extra time to become familiar with the laws.
Summary
Any endeavor that offers a considerable upside potential for profit requires a solid understanding of the risks and the operational requirements of the business. Captive premium financing is by no means risk free, but you can greatly mitigate the risk by doing your homework on the vendor with whom you chose to work, the states in which you plan to finance business and the type of business you plan to finance.
Captive premium finance companies have routinely provided their owners with a tremendous return on their initial investment. It is up to you to determine when you’re ready to start earning the additional profits from the business for which you already worked so hard and paid so much to bring in.
Chris C. Farfaras is a vice president of Sales and Marketing for Input 1, LLC, based in Woodland Hills, California. 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.