Pitfalls to Avoid in Running a Captive Premium Finance Company

You've made the decision to form a captive premium finance company. You've also chosen to run your operation either by outsourcing to a third-party vendor or using software to run the operation in house. Chances are that your lending arrangement and state licensing are also in place. You're now ready to get started and you want to book your first loan. Before you open your doors for business, take a moment to consider some important factors in this new frontier of insurance premium financing.

PRICE AND TERMS

Building a sound game plan and understanding the components of your business are critical. The fundamental choice of the right interest rate, for example, is an important factor in determining your overall return. Make sure that you charge an appropriate APR that will not only cover your borrowing costs, administrative overhead, and other expenses, but also provide a healthy return on your investment.

The down payment and installment terms you offer will affect your overall return. For example, playing it safe and offering a 25% down payment and nine installments on your business will keep you above water in most circumstances. In specific cases (i.e. certain coverage types or geographic regions) you might be able to offer a lower down payment; but in other cases, you'll want to require a higher down payment. The same holds true for the number of installments — in some cases, nine or even 10 installments is just fine. In others, seven or eight might be a more prudent decision.

Your outsource service provider and/or lender should be able to provide you with a pro forma income statement that will help you determine the terms to offer and the return you can expect from your business.

TYPE OF COVERAGE AND POLICY PROVISIONS

Believe it or not, one of the most important factors in accurately determining the down payment and number of installments on a loan involves a clear understanding of the provisions of a particular policy. It would be nice if every policy you plan to finance had a 10-day cancellation, no minimum earned premium, no auditable provisions, and was earned on a pro rata basis. As you know, this is seldom the case. What you might not know is how these provisions can affect the financing.

For example, if a policy exhibiting a short rate return instead of pro-rata return, is cancelled, you'll receive 5% less in unearned premium. If you financed a $10,000 policy, this means that your finance company might be as much as $500 short on the loan balance. This difference will come out of your pocket unless you're lucky enough to convince the insured that they need to pay it. In California, for example, the state requires a pro-rata return when a policy is written by an admitted carrier and financed by a California-licensed finance company (however, this is not the case in all states).

Other policies such as Liquor Legal Liability and D&O might have provisions that make the policy either fully earned or have an accelerated earning provision, thus making any expected return of premium lower then you expect. The effect of reduced unearned premium can eat into the profits of your company. There are other policy coverages that you will want to become more familiar with, as well. Consult with your vendor; if they're worth their weight, they should be able to help give you sound advice and feedback in this area.

CARRIER INSOLVENCY

Although the risk of an insurance carrier becoming insolvent is very low, you still need to consider it in running your premium finance company. It's advisable to finance premiums with carriers that have strong A.M. Best or Standard & Poors financial ratings and size.

Most commercial premium finance companies will only consider financing premiums if the insurer has an A.M. Best rating of B+ (Very Good) or better and a financial size of at least V (capital, surplus, and reserve funds between $10 and $25 million). The standards you set for your own company will depend on your risk tolerance.

KNOW YOUR STATE LAWS

Let's say that you're running along smoothly and financing a lot of business when you get a phone call from the state governing body that oversees financing for the state(s) in which you operate. The regulatory body(ies) will want to conduct an onsite audit of your operation. If you've outsourced the servicing, the service provider usually handles the audit. Ensuring that you're charged the correct interest rates, set the correct late fees, and sent back all refunds exactly as required by the statutes will keep the regulators at bay.

Be sure to choose a vendor that has a solid understanding of the laws in the states where you operate. The software, whether you outsource it or keep it in house, must comply with such items as maximum allowable interest rates, minimum and maximum late charges, and when cancellation notices can be mailed to the borrower. However, because it's your responsibility and money on the line, take a little extra time to become familiar with the laws.

SUMMARY

Any endeavor that offers a considerable upside potential for profit requires a solid understanding of the risks and operational requirements involved. Captive premium financing is by no means risk free; but you can greatly mitigate the risk by doing your homework on the vendor with whom you chose to work, the states in which you plan to finance business, and the type of business you'll be financing.

Captive premium finance companies have usually provided their owners with a tremendous return on their initial investment. It's up to you to determine when you're ready to start earning the additional profits from the business for which you've already worked so hard and paid so much to bring in.