The business of financing insurance premiums has been in existence for more than 50 years and provides premium finance companies with a safe and consistent return on capital. A variety of banks provide revolving credit facilities to premium finance companies that are secured by the underlying premium finance receivables. There are estimated to be more than 1,000 licensed premium finance companies nationwide. However, a handful of commercial banks, either directly or through premium finance company subsidiaries, control a large percentage of the $30 billion in commercial premium originations.
What is Insurance Premium Financing?
There are two separate and distinct types of insurance premium financing – the financing of property and casualty insurance policies and the financing of life insurance policies. This article focuses strictly on the financing of property and casualty policies.
Upon the sale of a property and casualty policy, the insured can choose to pay the policy in full, pay in installments based upon terms offered by the insurance company, or finance the policy through an insurance premium finance company. Many insurance companies either do not provide their own installment programs or they may offer installment programs with undesirable terms or flexibility, creating the need for premium financing.
When a policy is financed, the borrower generally pays a down payment of 15 percent to 25 percent of the policy premium, and the balance of the premium is financed by the finance company. Under the terms of the finance agreement, and as provided under state finance statutes, the premium finance company has a lien on the insurance policy and has the right to cancel the insurance policy in the event of a default by the borrower. Upon cancellation of the policy, the insurance carrier, which was paid the total premium at the inception of the policy, must refund the unearned premium to the finance company. The finance company applies the unearned premium against the loan balance which usually pays off all or substantially all of the balance due. Most insurance premium finance agreements are originated by retail insurance agencies.
The vast majority of insurance policies financed are for commercial risks but there are also certain markets where personal lines policies, such as homeowners and automobile insurance, are premium financed. Premium finance loans can range from less than $1,000 to multi-million dollars. The average premium finance loan can range from several thousand dollars for small premium finance companies to $25,000 or more for larger premium finance companies.
Advantages of Premium Finance
- Safety: there are multiple sources of repayment. In addition to the insured, the insurance company is responsible to pay the unearned premium in the event of default, and in many cases a state guaranty association guaranties payment of the unearned premium should the insurer become insolvent
- Higher than average returns – smaller premium finance loans can have APR’s in the mid to high double digits; APR’s will decrease as the loan size increases but will generally be attractive
- High fee income – late fees are regulated under state statute and generally equate to 5 percent of the installment; certain states also provide for cancellation fees and origination fees. Fees can equate to 20-30 percent of finance charge revenue
- Simple Process to Collect Delinquent Accounts – policies are generally cancelled upon 10 days’ notice of default to the insured and most insurance companies refund the unearned premium within 60 days.
- Limited Term – loans generally provide for between 8 to 10 monthly installments
- Minimal Bad Debts – bad debts are generally minimal and mostly consist of the write-off of uncollected finance charges and fees
Regulatory
The majority of states have specific statutes which govern the financing of insurance premiums, including licensing requirements, caps on finance charges, calculations of delinquency and other fees, rules governing policy cancellations, finance agreement requirements as well as other aspects of premium finance. Most states provide that banks can operate in the premium finance business under their banking license and do not need to obtain a premium finance license. Many states, either through their Department of Insurance or Department of Banking, conduct periodic regulatory audits of premium finance licensees.
Revolving Credit Arrangements
Lenders will generally enter into a revolving credit arrangement with the premium finance company and will advance a certain percentage of eligible receivables. Ineligible items include loans that are past-due beyond pre-specified time frames. Additionally, there may be ineligibility criteria established for loans that have an excessive number of installments, loans for policies issued by lower rated insurance companies, or if there is a concentration of loans with a particular insurance company. Interest rates are generally based upon LIBOR. There also are certain financial covenants including leverage limitations and profitability requirements.
Risk Factors
As in any industry, there are certain risk factors which affect the profitability of the finance company and the collectability of the receivables:
- Timely Cancellation of Finance Agreements – the collateral value of a policy diminishes with the passage of time so it is critical that the underlying policies of contracts in default are cancelled on a timely basis. This system is controlled by the company’s premium finance management software.
- Liberal Loan Terms – the premium finance company’s “equity” in a loan is affected by the down payment percentage as well as the number of installments. If these terms are not within appropriate guidelines, then upon the cancellation of a policy the return premium from the insurance company may not be enough to cover the outstanding balance
- Insurance Company Insolvency – in rare instances an insurance company may be placed into receivership by a state regulatory authority which may cause the cancellation of all policies. The return premiums of most insurance companies are guaranteed by a state guaranty association (subject to limitations), which will pay the return premium to the premium finance company. However, there may be a delay of several months to a year or more before the finance company receives the funds. Certain insurance companies are not covered by a guaranty association, however most of these companies are usually highly rated so insolvency is not usually an issue.
- Auditable Policies - the premiums of certain insurance policies, like workers compensation, are subject to audit provisions. This means that the insurance company has the right to audit the policy to determine if the initial premium was calculated correctly. If not, then the premium shortage would be deducted from the return premium.
- Non-Refundable Policies – in very infrequent cases, certain insurance policies may be fully earned which means that there is no return premium in the event of policy cancellation.
- Issues with Agencies – certain problems may arise with insurance agencies which may cause a loss to the finance company: policy premiums not calculated correctly; failure to remit down payments or unearned commissions; not submitting finance agreements on a timely basis or improperly created agreements, creation of fraudulent finance agreements.
- Additional Premiums – after an agent binds an insurance policy, the insurance carrier has the right to review the policy premium to determine if it was calculated properly. If not, the insured may be subject to the paying of additional funds. This is not that uncommon and the finance company usually finances this additional premium. However, if the insured fails to finance or pay the additional premium, the insurance company may cancel the policy and the shortage may be deducted from the unearned premium.
As with any industry, the correct underwriting guidelines, company policies, internal controls and management reporting systems need to be in place to help to prevent or minimize any losses that may occur. Insurance Premium Finance is a well-established industry with a long history of profitability. With the correct controls and loan guidelines in place, it can be a very profitable addition to a lender’s portfolio.