After reviewing hundreds of financial statements of property and casualty (P&C) insurance agencies, we have found that accountants often do not understand how agencies operate, which can lead to misleading and often inaccurate accounting practices.
One of the primary purposes of an Income Statement is so the owner of a business can accurately analyze the sales and expenses and to show the owner whether the company made or lost money during the period being reported. The purpose of a Balance Sheet is to report the financial position of a company at a certain point in time with regards to its assets and liabilities. To create these statements accurately and so they have meaning to an agency owner, is to first understand what constitutes sales revenues in a P&C agency.
P&C Sales Revenues
Clients of insurance agencies can be billed two different ways, and these are typically defined as direct bill (or company bill) and agency bill. Most personal lines of insurance are handled as company bill in that the insurance company sends the bill to the customer and the customer makes the payment directly to the insurance company. For example, car and home owner insurance bills come directly from the company that is insuring the car or the home and the premium is paid directly to that company by the policy holder. Once the bill is paid, the company then sends a commission payment to the agency that sold the policy.
Often with commercial or business insurance, the agency that sells the policy will bill the customer directly and it is up to the agency to make the payment to the insurance company. Most state laws require insurance agencies to set up a trust (escrow) account to temporarily hold these funds for the insurance company until the company is paid either by electronic transfer or by a check sent from the agency. For example, if the agency bills a client for a $1000 premium, then the $1000 payment is deposited into the agency’s trust account. If the agency is entitled to a 15% commission from the account, then $850 will be paid from the trust account to the company and $150 will be paid from the trust account to the agency’s operating account.
When creating an income statement for a P&C agency, it is recommended that only commission payments, broker fees and other contingent income be included as sales revenues. Any amounts paid to the insurance company from the trust account should be treated as a pass through for accounting purposes. This practice will best reflect the true operation of the agency and will eliminate common accounting errors. It will also provide the agency owner with a more accurate depiction of the operation of the agency.
Cost of Goods Sold (COGS)
Most P&C agencies do not account for COGS sold because there is no inventory sold by an agency. Some accountants may choose to show commission payments made to the agency’s producers on the COGS line, but they are usually handled as regular expenses. For retail agencies, it is best to not include a COGS entry and for any agency engaged in any wholesale operations, the COGS entry should be the commissions paid to the outside agents.
The largest expenses incurred in most P&C agencies are payroll and commissions paid to the producers. These expenses can account for 30% to 50% of the commission revenues received by an agency. A “best practice” is to break out the payroll and commissions as separate expenses so the agency owner can better understand the costs associated with sales and service.
The Balance Sheet
While many small businesses are not required to maintain a balance sheet for income tax purposes, it is highly recommended for an insurance agencies because they may handle funds that create a large legal liability for the agency owner.
Under Assets on the balance sheet, the accountant should include both the operating account balance and the trust account balance, and these should be kept separate bank accounts. Under Liabilities on the balance sheet, a separate entry should be made for the amounts due to the Insurance Companies from the trust account.
By following this practice, the agency owner will have a better understanding of the status of the trust account, and it will help eliminate practices that will result in an illegality.
Operating Accounts and Trust Accounts
While some states may not require an agency to maintain a separate trust account, it is highly recommended that two separate accounts be maintained. The Internet is filled with stories of agency owners being prosecuted and losing their licenses for improperly using trust funds to make payments in their operating accounts. If an agency owner does not have sufficient cash reserves to cover slow periods, it is recommended that agency owners establish a line of credit with their local bank to cover any shortages during slow periods and not risk their livelihood by tapping the trust account.
Common Errors Made by Accountants and Bookkeepers
Many accountants and bookkeepers use the deposits from the monthly bank statements to determine the sales revenue entries for the accounting program. In most situations this is a satisfactory method. Unfortunately it is not satisfactory in all cases! The revenues for an insurance agency can vary significantly from month to month due to irregular cyclicality of the renewals and new sales. For example, it is not uncommon for an agency to have a three or four month period of very good revenues followed by a period of significantly lower revenues. Since most insurance agencies file as Sub-chapter S corporations, LLCs or sole proprietorships, they may drain the operating account of the excess revenues of during the peak months and make deposits from a savings account or line of credit during the slow months. Unfortunately the deposits made during the slow months can be accidentally entered as sales revenues by the accountant, resulting in an error. We have actually had clients that paid income taxes on their own funds due to this type of error.
To prevent this type of error from occurring, both the accountant and the business owner should compare the monthly deposits to the monthly commission statements received by the agency.
Tracking Monthly Commissions
Most P&C agencies receive monthly commission statements in the mail each month or they can access the commission data online from the insurance company’s website. It is also common for agency owners to ignore these statements and to toss them when they are received.
By not analyzing these statements on a monthly and annual basis, the agency owner will have a more difficult time understanding the true operation of the business.
It is highly recommended that the agency owner review all of the commission statements on a monthly basis. The statements should also be reconciled to the agency management system and the accounting system. If the agency does not have one of the more sophisticated management systems to track monthly commissions, it is recommended that all of the monthly commissions be entered into a simple spreadsheet as depicted below.
For policies sold through a wholesaler, the agency may not receive a monthly statement, but by entering the wholesaler data into a spreadsheet, the agency owner will have a very true depiction of his real total revenue each month.
It is also a best practice to file all of the commission statements and to keep them for at least 36 months. To prevent the accumulation of a great deal of paper, the statements can be scanned and filed electronically as pdfs.
All of the practices highlighted in this article and based on common errors or situations that our team has encountered when reviewing agency financial statements. By incorporating the best practices listed above, an agency owner and their accountant will have a better understanding of the state of the business as well as a system to prevent common accounting errors. In addition, when the agency owner is ready to sell, these best practices will help the a prospect buyer better understand the makeup of the book of business and this can lead to better price and terms for the current owner.
Please contact us for a paper copy of this article if you would like to share it with your bookkeeper or accountant.
Posted by: Michael Mensch, CBI, M&AMI and Managing Partner