With a traditional asset-secured loan, a borrower puts up collateral as security for the money being borrowed. For example, when a person purchases a house with a mortgage loan, the underlying security - in this case, the house - is used as collateral. A premium finance loan is a bit different because the unused portion of the insurance premium is what is used as collateral by the lender. This is possible because the insurance premium is funded up front by the premium finance company but the insurance is utilized daily over the policy term. At any given time there is unearned premium available to collateralize the premium finance loan.
How Unearned Premiums are Recouped
A typical insurance policy is issued for one year. In most cases, each day the coverage is in force, 1/365th of the policy premium is used. If the insured fails to pay the finance company, the finance company has the authority to direct the insurance company to cancel the policy. This authority is granted in a “Power of Attorney” clause typically stipulated in a premium finance agreement. If a policy is canceled, the earning of the insurance policy ceases. The unused portion of the insurance premium is sent back to the finance company (because the policy premium was originally paid in advance by the finance company). The finance company can then apply that money to the balance of the loan.
Upon cancellation of the policy, there are several methods used in determining the unearned amount of the insurance premium. Moreover, there are several factors that go into determining which method of earning is used. Some states govern the earning schedule for all insurance policies written in that state. Some insurance companies determine the earning schedule based on who requested the cancellation: the insured or the insurance company.
The following are the more common methods used in the industry:
- Pro-Rata— In the pro-rata earning schedule, the policy is earned equally each day. Using an example of a 365-day policy, 1/365th of the policy is earned each day. If the policy was in force for 265 days, then 100/365 of the policy is unearned. This unearned portion is what is returned in the event of cancellation.
- Short Rate— The short rate method of cancellation allows for an accelerated earning of the policy premium. There are typically two methods of calculating the short rate earning schedule. One calculation is based upon a table that indicates the percent of the premium that is earned for each day the policy is active. The second method is to calculate 90% of the pro-rata earning. This provides for a 10% acceleration in the earnings.
Insurers Can Stipulate a Minimum Earned Premium
Another important aspect to consider is something called a minimum earned premium. Frequently, insurance carriers will set a minimum amount of the annual policy premium they will retain even if the policy is only in force for a short period of time. Insurance carriers do this to cover the costs of placing the risk and to ensure that they retain an adequate amount of premium to offset overhead costs and claims. A common example of this is a 25% minimum earned premium. This means that even if cancellation occurs very early in the policy term (after one month, for example), the unearned premium will never be less than 75% of the annual policy premium. This has a material impact on the collateral if the premium is financed.
Policy Cancellation and Unearned Commissions
The calculation of unearned commission coincides with the unearned premium calculation. An insurance agent is typically paid a commission by the insurance company for writing the policy. This commission is earned by the insurance agent using the same method that the insurance policy is earned. In the event of cancellation, that commission has not been earned in full, and the unearned portion is refundable to the finance company.