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Premium Financing Explained
by Kelly Troy on June 8th, 2010
As someone who works daily with commercial and ‘non-standard’ lines of insurance, it is very common for me to get phone calls or emails from customers asking why a company they have never heard of is sending them a premium bill instead of the actual insurance company that issued the policy.
The answer is premium financing, also known as premium funding.
This is a little longer article, but in order to understand the reasons why premium financing is often used, it is equally important to understand the concept of ‘non-standard’ insurance markets in order to put the need for premium financing into context.
STANDARD INSURANCE
Most people are familiar with ‘normal’ insurance, such as for a home or automobile, whereby the insurance company issues the policy and then either sends a monthly bill or drafts the premium on a monthly basis from the customer’s account or credit card. This type of insurance is referred to as ‘standard’ lines insurance because it is very commonplace, routine, relatively low-risk, and ‘standard’ in the day-to-day world of insurance. Generally speaking, it’s personal ‘cookie cutter’ insurance with the only difference being who the customer is and what limits of coverage were purchased. Common examples of ‘standard’ policies include most automobile, homeowner’s, umbrella, motorcycle, and boat policies. Well-established companies such as Travelers, Safeco, and others who are ‘standard’ insurance companies issuing this type of coverage are designed for regular billing cycles and regular premium installments paid directly to the company itself. Once a policy is issued and the initial premium payment is made, the remaining balance is then broken into equal installments and paid by the customer over the course of the remaining policy period. In addition, these policies are ‘unearned premium’ policies, which simply put, means that any premiums paid to the insurance carrier but not yet ‘earned’ are returned to the customer in the event that the policy cancels or is terminated.
As an example, let’s assume you purchased a six-month automobile policy for a total of $600 and you paid the premium in full when the policy was issued so that you did not have to make monthly payments. Halfway (3 months) into the policy you sell your vehicle and cancel the policy. Although you paid for the entire six-month term, you were only actually insured for the three months prior to requesting a cancellation. This means that the insurance carrier had not yet ‘earned’ the additional three months of premium ($300) which you and prepaid when the policy was first issued and they must, therefore, return this ‘unearned’ premium money to you on a pro-rata basis.
This makes perfect sense and most people understand this type of billing and, once explained, they also understand the concept of ‘unearned premium’ refunds for these policy types.
‘NON-STANDARD’ INSURANCE
However, when dealing with commercial insurance and/or higher-risk policies, the legalities, rules, and billing parameters relating to insurance change.
Many insurance risks which cannot be written in the standard market for any number of reasons, such as most vacant property, general liability, professional liability, commercial coverages, and similar needs, pose a much higher risk of claims and larger payouts to insurers and they usually require detailed manual underwriting. These are not ‘cookie cutter’ policies that can be easily issued online and each one represents a completely different risk to the insurer. Because these types of risks don’t fit into a normal (or ‘standard’) box like a home or auto policy and because each customer may have unique coverage needs and a unique level of risk, these policies are issued in the ‘non-standard’ market (also referred to as ‘surplus lines’).
Agents writing ‘surplus lines’ business are required to have a special license (which most don’t have) and the insurance companies doing business in the non-standard market are not the same companies that you are familiar with in regards to normal personal-lines insurance. In fact, although they may have billions of dollars in assets and hundreds of years in business, you probably haven’t heard of many of them. Although there are hundreds of others, Lloyd’s of London is the most well-known ‘surplus lines’ or ‘non-standard’ insurer.
The laws and regulations governing these ‘non-standard’ insurers are different (and often more stringent) than the laws and regulations governing ‘standard’ companies and these non-standard insurance companies often charge a policy fee and they are also required to charge state tax. I would go into the many differences between these insurers and their ‘standard’ counterparts, but that is for another article.
PREMIUM FINANCING / FUNDING
Now, about premium financing…
When issuing a policy with a non-standard insurer, such as general liability or coverage for a vacant home, the companies doing business in this area of the insurance marketplace require that the entire premium be paid in full at the time the policy is issued. There are no monthly or quarterly billing options and all the money is due immediately. Period.
Given the fact that many of these policies may be $10,000 or more, that often presents a bit of a financial problem to many clients. Even for an investor who has a new home which needs vacant dwelling coverage, an $800 or $1,500 insurance bill might be a tough check to write depending upon what other debts he or she may have as well as the available cash flow. Enter premium financing.
Because of the situation that arises when the insurance company needs payment in full but the client may not have the financial resources to pay the entire amount due, special premium finance companies have been created to allow insurance customers to make regular installment payments while at the same time making sure that the carrier is paid as required.
These companies specialize in the funding or financing of insurance premiums, just as other companies finance cars, homes, and boats. Because of the legal and regulatory issues relating to ‘surplus lines’ insurance (which were previously alluded to), the customer makes the initial down payment to the finance company (usually 25% plus taxes and fees) and the finance company then pays the premium balance, in full, to the insurance carrier on the customer’s behalf. The customer in turn begins making regular installment payments to the financing company.
Before we go much further, you should know that the reason that finance companies require at least 25% of the premium as a down payment (plus all taxes and fees) is because most of these non-standard policies have a 25% ‘minimum earned premium’ clause written into them from the carrier from the date the policy is bound. To prevent against a customer canceling a policy and leaving the finance company financially responsible to the insurance carrier for this minimum earned premium due, they simply require that it be paid up front before the financing agreement will be activated. The is true across all premium financing companies.
The way that the financing companies make a profit is by charging interest on the ‘loan’ that was paid to the insurance company on behalf of the customer. This is no different than an automobile loan, although the interest rate for premium financing is usually between 16% and 25% regardless of which company is used. Don’t let the interest rate shock you. While this sound like a high rate of interest, the fact is that most policies are only a few thousand dollars or less and the actual interest paid over the term of the policy is often between $50 and $100 a year. This is about the same as if you were paying monthly on a standard company with a $5.00 monthly service charge and it sure beats writing a $3,000 check all at once.
In summary, premium financing is a very common practice and it is not at all unusual in the surplus lines or non-standard marketplace. Also, most financing companies are very similar to one another with the same interest rates and funding process.
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