Trust Accounts: Do they really matter?

An agency valuation I completed recently came in considerably lower than the agency owners expected. The reason? Their balance sheet was very poor and they were materially out of trust: Meaning that their ratio of Accounts Receivable + Cash to Accounts Payable was less than 1. The agency principals were quite upset that I would decrease their value for this reason. They retorted, “We always pay our companies on time, our companies have never been hurt by this, our customers have never been hurt by this, and our CPA has never found fault with this practice. You're the only one who thinks it matters!”

As it happened, this agency was also located in a state that legally required agents to maintain a trust fund. Even so, this is an issue for all agencies regardless of state law. Remember, Michael Segal, principal of Near North Insurance, was convicted in federal court of fraud and racketeering charges in June 2004 for violating his brokerage's trust account. As the U.S. Attorney's office for the Northern District of Illinois stated, “We think it sends an important message to those who are trusted with the fiduciary duty of holding other people's money that there are serious consequences to violating that trust and duty.” (Business Insurance, June 28, 2004 )

Mr. Segal's defense contended that he “was a victim of bad accounting at the brokerage and that no insurer or customer was ever harmed.” (Business Insurance) The latter part of this rebuttal sounds familiar. I've heard the same argument from many agencies. I haven't seen any evidence suggesting that Mr. Segal's companies weren't paid or that his customers were harmed — and yet, he was convicted. The point is not whether the companies or customers were harmed but rather that the money was misused. When customers pay for their insurance, that money should not be used for any other purpose, whether it's to buy other agencies, make payroll, or improve the agency principal's lifestyle. Even if the agency owners must pay higher taxes by leaving money in the agency so that the trust ratio remains above 1.0, the money should remain and the taxes be paid.

I've seen several articles by other consultants estimating that 40% to 50% of all agencies are out of trust. My experience suggests that they're correct. Why should an agency that has obviously misspent its clients' money be valued as highly as one that has not? One way or another, the agency will have to pay the money back. If this isn't done before the sale, every halfway intelligent agency buyer will deduct enough from the price to get the agency into trust upon acquiring it.

I strongly encourage every agency in every state to get into trust as soon as possible. There are several ways to do this. The fastest is to get a long-term loan equal to the deficit and put the cash in the bank and leave it — then pay off the loan.

One alternative is to budget $X per year to the agency's capital account until it is in trust. For example, suppose an agency determines that it should leave $50,000 cash in the agency every year until it gets into trust. To leave $50,000, the agency must record profits of approximately $87,000 at a 34% tax rate. This means that it must adjust its budget accordingly so that its profit at year-end will be at least $87,000 after every single other expense, including all owner compensation. Sometimes this might mean that owners must take pay cuts, which is always hard to swallow. However, another way to think of it in some situations is that the owners wouldn't have made as much in past years if they hadn't paid themselves from the trust funds anyway; so this is just repaying the loan.

My clients noted that their CPA had never advised them about being out of trust, and in fact when the CPA called me to learn about trust ratios, he said that he didn't think they were that important. I can see his point, because insurance agency trust fund questions don't appear on the CPA exam. Also, since the accountant hadn't read state insurance laws, insurance company contracts, insurance agency ethics, or any recent editions of major insurance industry trade press, he could claim ignorance.

Agency owners, beware! Unless you ask your accountant specifically for advice on these issues, they won't advise you on them. Instead, they'll focus on minimizing your taxes, which in turn, will almost inevitably put you further out of trust!

Many agency owners have told me that since their states don't require them to maintain separate trust accounts, being in trust is meaningless to them. Because I'm not an attorney, I can't offer a legal opinion. However, I do know this: Insurance company contracts often require being in trust, ethically it is the right thing to do, and Mr. Segal was convicted in federal court! Nearly everyone reading this probably lives in the U.S. and does business across state lines (since your companies are located in states other than yours). Maybe it's time to reconsider whether being in trust applies to you.