Trust is important when building relationships with your clients. But another kind of trust is just as critical to agency health: the trust ratio. If your internally generated financial reports don't mention trust ratio, then you're not managing your financials adequately. If your financial adviser has never mentioned your agency's trust ratio, then the picture of your agency's health has a huge, gaping hole. The trust ratio measures whether the agency has spent someone else's money. Once an agency is out of trust, they either have to find cash somewhere else to get back into trust, or continue to pay their carriers with other customers' money–like a Ponzi scheme. The state and federal governments have laws prohibiting spending money that does not belong to you, especially if you are holding that money in trust. Almost all independent agencies hold money in trust for their clients and carriers, so even if an agency is not required to establish a separate trust account, the agency must still be in trust. Trust ratio is cash plus collectible premiums receivable, minus premiums payable and binder bill or pre-bill. Trust ratio must be 1.0 or greater and a ratio of 1.1 or greater is even better. Based on my experience, at least 40 percent of agencies are out of trust. This means a large proportion of agencies are not managing their balance sheets well. The credit crisis will eliminate many of these agencies, just as it is eliminating banks and firms that have not managed their balance sheets well.
Beware the "expert" who ignores the trust ratio, especially in the following situations:
1 Agency buy-sell agreements: If an agency is out of trust, its value is diminished, a critical distinction to consider in agency buy-sell agreements. Most agreements ignore the impact of the trust ratio and many agencies with poorly written agreements have a huge problem–they just don't know it yet. The issue will come to light when an out-of-trust agency's buy-sell is triggered and one partner must pay the other partner more than the agency is worth. The situation for the buying partner is exacerbated because not only is he short on his trust ratio, but now he has to make payments (over-payments, actually) to his ex-partner. Many agents in this situation discover they don't have enough money to pay their carriers, their partners and their employees in the same month.
2 Agency valuations: Because an agency's trust position affects its value, correctly analyzing and addressing the trust ratio is critical to proper agency valuations. The lack of such analysis could totally disqualify the appraiser if his or her appraisal is contested in court. It is that important. 3 Agency cluster agreements: Trust money is frequently left out because many attorneys do not understand that trust money is a joint and several liability. The carrier could care less which cluster member is not paying its premiums. From the carrier's point of view, the contract is with the cluster and it want its money. A well-written cluster agreement addresses the importance of all members staying in trust because an out-of-trust cluster member could damage the entire cluster. 4 Financial reviews: Several firms offer financial benchmarking data to CPAs for industries including independent agencies. Some CPAs use this data as a "value-added" service to clients. But many of these services do not include the trust ratio as financial benchmark. Profitability and productivity are meaningless if the agency achieves its numbers by spending money that belongs to others. Bernie Madoff was a rich man because he spent money that did not belong to him. Other CPAs conduct standard financial reviews without relying on such benchmarks. Unfortunately, accounting standards do not specifically require a balance sheet test if a firm is spending money it should be holding in trust for others, so most CPAs do not test the trust ratio. If your agency's trust ratio is not part of your CPA's analysis, then you may have to provide him or her with information on this important ratio. If your CPA is unwilling to listen, then it's time find a different CPA. Along these lines, I believe an accounting standard that requires a balance sheet for testing if all firms are correctly holding enough money in their fiduciary accounts would be a remarkable improvement for our economy. 5 Shareholder distributions: If your accountant advises the shareholders to "clean out" the cash at year-end without regard for the trust ratio, your accountant does not have a clue about proper insurance agency financial management. The reality is this: It is illegal to make distributions if the result is the agency's trust ratio decreases below 1.0. If the trust ratio dips below this minimum, it means the accountant has effectively advised the shareholders to take money that does not belong to them. This issues also applies to the shareholder agreement because it should address whether or not distributions can be made (hopefully not) if the agency is out of trust.
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