The Competitive Advantage: The Importance of Proper Accounting in Insurance Agencies

Independent insurance agencies’ accounting methods and contractual and legal requirements are unique, especially considering how lax enforcement is when all 50 states and the federal government have long-standing accounting rules that apply to 100 percent of all agencies. No exceptions exist. None. No such thing exists as a “non-trust” state (there are commingling and non-commingling states, but all states are trust states).

Therefore, it does not matter what advice your certified public accountant (CPA) gives if he or she does not know the statutes and necessary accounting conventions specific to insurance agencies.

The special characteristics of independent insurance agencies are also why the use of generic accounting software not specific to the insurance industry often creates large accounting problems. These systems do not work for agencies because they do not track what needs to be tracked. Some agency-specific software does a poor job, too. When you’re looking for a system, be sure to test the accounting portion before committing a large amount of dollars.

The uniqueness is due to multiple factors. One factor is the relationship to insurance company accounting, which follows statutory accounting rules rather than generally accepted accounting principles (GAAP) accounting rules. This affects agencies through the earned premium/earned commission angle. Agencies cannot really be cash or accrual in the normal sense, because their commissions are earned or not earned regardless of whether an agency is on a cash or accrual basis.

Another factor is contingency income. This is always cash because it is too unpredictable to accrue, although it is 100 percent accrued months prior to payment. Don’t try to accrue contingency income. Keep it separate on the agency’s financials because it is not the same, especially for valuation purposes, as commission income.

Bad debt is unique because even if an agency is on a cash basis, it can incur bad debt. Most other types of businesses using cash accounting cannot incur bad debt. Agencies can incur bad debt because they have to pay insurance companies/brokers even if the client does not pay them. If the client incurs earned premium but does not pay, the agency must pay (unless their contract permits them to turn the debt back to the company/broker and they do so in time, but not all contracts permit this).

If an agency is on a cash basis and the client does not pay, it would not incur bad debt if not for the fact that the debt is mostly premiums and those premiums are owned by the carrier. These premiums have been entrusted to the agency. When the agency fails to collect, the bad debt is really a third party’s money. The agency has de facto guaranteed that third party’s money, which is why an agency on cash accounting can still incur bad debt. Typical businesses are not entrusted with large sums of third party’s monies.

These third-party monies — company premiums — are by far the biggest issue making a difference in agency accounting. These monies are trust monies, and all states require all agencies to hold trust monies in trust all the time, every day, even if it means not being able to drain the cash balance at year-end. The states’ and federal government’s statutes are largely criminal. Choosing to ignore or pleading ignorance is not an excuse. If your CPA does not know these facts, educate him or her as soon as possible.

Furthermore, all company contracts automatically, or nearly so, take title to an agent’s book of business when an agency is out of trust. The trigger is when the agency is out of trust. The trigger is not when the agency misses a payment. Missing a payment is an alert but not usually the contractual trigger. This means an agency that is out of trust and wants to sell does not have clear title to its book of business, and therefore may not legally be able to sell.

Here are two excerpts from common carrier contracts that prove this fact:

Contract #1: “All premiums are our property and are held as trust funds by you. You have no interest in the premiums and, except for the amount of commissions authorized by us to be deducted by you, will make no deductions from or personal use of such funds nor retain any such premiums as an offset against any disputed claim you may have against us before paying the same to us. You will establish a premium trust account and maintain same. You may retain the interest income earned on such payments during the period between receipt of such payments from insureds and the time such payments are paid to us. You may disclose to your clients, our insureds, that you will retain such interest income. You may commingle these premiums with other premium trust funds in such account.”

Contract #2: “Premiums/Service Fees Are Our Property. All premiums/service fees are our property and are held in trust by you; however, unless we notify you otherwise in writing, you may earn interest on the premium/service fees while held by you as provided for in this agreement. Except as provided for here in, you have no interest in the premium/service fees and, except for the amount of commissions authorized by us to be deducted by you, will make no deductions from or personal use of such funds nor retain any such premium/service fees as an offset against any disputed claim you have against us before paying the same to us You will not be relieved of your liability to pay premium/service fees except as provided for in …”

If an agency is out of trust when it goes to sell, a solution is not to make up the cash shortage by holding onto clients’ credits. I have seen agency owners do this. Regulators tend to frown upon this practice, and knowledgeable buyers won’t fall for it. Ignorant buyers might, but not buyers who know what they’re doing.

Writing this in 2017 seems surreal given that so much business is direct bill (which has its own set of accounting issues mostly related to specific agency management systems’ limitations combined with inadequate knowledge by agency personnel of the accounting settings required). One reason we have this serious problem is many new and small agencies are not using insurance agency-specific accounting systems. Popular software packages are great, but not for insurance agency accounting. Some young agency owners are vocal in how poorly some agency management systems have been designed and how they are 20 years out of date. I do not disagree, but the alternatives lack the proper accounting modules. If I had to choose between a system that is 20 years out of date but has a quality accounting module specific to insurance agencies and a modern system that has inadequate accounting, the accounting has to take precedence, because agencies have the fiduciary responsibility of accounting for third parties’ monies.

Agencies can survive, even do well, with inadequate accounting for decades. But a reckoning day always arrives, and so will the day of accountability and consequence for bad accounting. That day is usually the day of a sale, whether a voluntary sale or upon a death your family has to deal with.

A good business appraiser will not value the agency at full value, and a knowing buyer will not pay full value if they do not have confidence the seller has clear title to the assets being sold and/or if the agency is not in full compliance with the applicable laws. Period.