Creating an in-house finance company allows agents to offer competitive payment terms based on individual needs. This is the first of three articles by Chris Farfaras on forming a captive premium finance company.
Agents and managing general agents continue to reap the benefits of a growing excess and surplus lines market, while standard line carriers are pulling back from business that they were either not prepared to handle and/or hadn't priced at a profit. This hard market trend has, for the most part, resulted in increased commissions from higher premiums. If you speak to agents about these good times, however, you'll find that every rosy situation has its not so rosy side. In this case it's client retention. Agents might be earning more commission, but they're also working harder than ever to retain their client base.
Let's face it: Clients facing a double or triple-digit percentage increase in premium from one year to the next need not only constant attention, but also new products and services that will make their lives easier. Agents can provide some relief by capitalizing on an often-overlooked area of their business: Controlling the billing terms offered to their clients through an in-house premium finance company. Most agents and managing general agents that arrange financing for their clients do so by choosing an outside finance company. They're investing their sales and marketing dollars to close the deal and then allowing others to take a piece of the action.
Agents already offer a myriad of insurance products and services to their clients, so captive financing fits nicely within their business model. Furthermore, no one knows the needs and financial wherewithal of a policyholder better then the agent placing the risk.
Creating an in-house finance company allows an agent to offer competitive payment terms based on individual needs that can make the difference between winning and losing the deal.
The income from the insurance financing transaction averages two to three equivalent commission points to an agency's bottom line. Instead of making 10% or $1,000 commission on a $10,000 premium, agents can earn $1,200 to $1,300 or more. Consider the number of financed policies that your agency has the chance to place each week, month, and year and we're talking about a considerable income spike. This new venture becomes an additional profit center that will help the overall value of the agency for years to come.
HOW DOES PREMIUM FINANCING WORK?
Premium financing is used in place of inflexible carrier installment plans or if the only option is payment of the annual premium in full. The latter is usually the case with the E&S market. By signing a finance agreement, the insured agrees to have the premium finance company advance the annual premium to the insurer on their behalf. The insured then receives a payment plan from the finance company that includes premium and interest payments. If the insured fails to pay installments when due, the premium finance company has the right to request cancellation of the policy from the insurer.
HOW DOES YOUR FINANCE COMPANY GENERATE INCOME?
A finance company generates income by borrowing money at a certain interest rate from one source (i.e. a bank, private investor, etc.) and lending that money at a higher rate to policyholders who request financing. Profits from premium financing also include late fees and other incidental charges. The costs of forming and running a premium finance company include interest expense (the cost of borrowing the money), day-to-day administration and overhead, licensing, and accounting expenses. With proper financial modeling and a commitment to promote the financing transaction, the income generated by a portfolio of premium financing loans can yield a considerable return on investment.
Past experience shows that at a minimum, a captive Commercial Lines premium finance operation with average premiums of $3,000 could realize anywhere from $20,000 to $30,000 in income per year for each million dollars of financing. This number will vary depending on a variety of factors, including the difference between the rate charged for funds and the rate paid for funds (the “spread”), late fee income, and how the agency chooses to administer the book of business.
WHY CAPTIVE FINANCING?
The most obvious reason for captive financing is clear: You (the agent) paid 100% of the cost to bring a deal in the door, but failed to retain 100% of the potential income from that deal. In other words, you've left money on the table. Second, the recent growth in premiums comes with the downside realization that insureds are strapped for cash to pay for their insurance; and if they can't pay for it, they might choose not to purchase it or purchase less of it — not a good outcome for the insured or the agent. Empowered with the ability to make decisions about your own finance company (as opposed to having terms dictated to you), your agency can solve an important problem in a hard market.
HOW DO YOU GET STARTED?
Like every business, premium financing has minimum requirements. The total amount of premium that could be financed needs to be at a certain level to meet the start-up and ongoing costs of owning a premium finance company. The size of this minimum also depends on the total number of loans that would be financed in a given year and the interest rates charged for each premium range. These factors can help make the financial forecast much clearer in terms of understanding the return one can expect. Companies can run a financial pro-forma for you for free to help you in this process.
Once you've decided to proceed, the first task should be the acquisition of capital. You might be able to work with your local bank or lending institution, or even have a servicing/software vendor introduce you to lending sources that specialize in this niche market. You can take comfort in the fact that interest rates today (as of June, 2004) are at an all-time low since 1958, with indications that the Fed might reduce rates again.
While you're securing your financing you'll want to start the licensing process. You'll need to secure licenses in each state where you plan to write business. Although many states share basic licensing requirements, other states have more complex requirements. It's advisable to contact a consultant or your legal counsel to help prepare for some or all of the licenses that you might require. Doing this will allow you to keep concentrating on your business while your finance company is being formed. Third-party premium finance administrators and software development firms usually offer licensing services with their suite of products.
You should research more about a Financial Analysis Company before you start a premium finance company. The benefits of forming a captive finance company are summarized below. The next step is to determine the direction in which you choose to run this new company.
BENEFITS OF FORMING A CAPTIVE PREMIUM FINANCE COMPANY
- Commissions - Earned up front as soon as the down payment is collected from the insured, instead of over the life of the policy as the insured makes payments (as with direct bill).
- Increased Profits - Agency revenue equating to a 2% to 3% increase in commission per loan can be obtained by a captive premium finance operation.
- Cash Flow for your Insured - You determine the billing terms on a case-by-case basis, depending on the risk. You have 100% control in offering more flexible payment terms for your insureds.
- Control - Costly cancellations and rewrites can be avoided by monitoring your accounts and offering flexible payment dates, terms, or holds when needed.
The next article on this series will concentrate on the pros and cons of outsourcing your new premium finance company to a third-party service provider compared to licensing the software from a vendor and running the finance company in-house.