Researching accounting literature is never easy, and it often requires reference to multiple sources to find the answer. A good example of this is accounting for policy fees under Statements of Statutory Accounting Principles (SSAPs).
Easy to Get It Wrong.
The concern with accounting for policy fees is that it is very easy to get wrong, and here is the reason why: an insurance policy promises to indemnify a policyholder upon the occurrence of a loss, and for that promise of indemnification, the policyholder pays a premium. Often, a policyholder is asked to pay a policy fee designed to offset the cost to the insurer of setting up and issuing the policy. There is no insurance risk associated with the charge of a policy fee. As a result, policy fees may not be viewed as insurance revenue but as a cost offset or other income not associated with the risk of insurance. The setup and issuance of a policy and a policyholder is part and parcel to the business of insurance, and should not be separated from the charge for insurance risk.
Insurers may view policy fees as the income of another party, such as a producing agent, and not recognize policy fees at all. For example, an MGA may receive a commission and retain 100% of any fees derived from the insured business. The agent is an extension of the relationship between insurer and policyholder, such that any fees and charges are levied by the insurer through the agent. This differs from a brokerage relationship where a fee may be charged by the broker on his/her own behalf.
There are several significant issues that can arise due to improper recording of policy fees:
- Premium Tax. Insurers are to identify charges to the policyholder and subject them to premium tax. Failure to properly classify policy fees can lead to underreporting of premium tax and exposure to penalties and fines.
- Loss Ratio. Understating written premium by excluding policy fees will result in lower earned premiums, altering loss and expense ratios. Additionally, non-recognition of policy fees as premium similarly alters leverage ratios.
- Commission Expense. If policy fees are not recognized when they are retained by producers, in addition to incorrect premium tax and loss ratios, both written premium and commission expense are understated. When an insurer records that policy fee as premium, there should be a corresponding charge to commission expense. If it does not occur, the result is a decreased commission expense ratio.
There might be other presentation matters arising from improper classification of policy fees. Regulators from state departments of insurance may also call into question the proper recognition of policy fees. Unless the insurer is thinly capitalized and dependent upon achieving certain ratios, the greatest exposure is in the area of premium tax.
The appendix from the NAIC Annual Statement Instructions makes a clear reference to policy fees, indicating they are to be included with a line of business premium or other income. It further refers to SSAP No. 53 Property Casualty Contracts – Premiums, which defines premium but never makes mention of policy fees. It does, however, state what may be included in “other income”. Essentially, installment or finance charges may qualify as other income, whereas all other fees, including policy fees are premiums.
The guidance on determination of taxable premium is particular to the state of production and may be found in state tax codes and other guidance issued by governing authorities. For instance, California insurers should consider Bulletin No. 80-6 Brokers’ Fees and other Similar Fees, published by California Department of Insurance. Though it is over 35 years old, it remains relevant guidance. This has always been a rather important bulletin because it discusses broker/agent differences and brings all charges to policyholders, with the exception of broker fees, under premium tax. Conceptually, an insurance company receives an exemption from paying state income taxes in lieu of paying premium tax on all top line revenues.