Piling up the premium

The relationship between brokers, insurers and third party premium finance companies started in the late 1980s. Premium funding now accounts for around £4bn in premiums, though this still represents only 16% of the £25bn UK general insurance market.

One of the biggest factors for brokers choosing premium finance is the competitiveness of rates. With interest rates at an all-time low, many customers believe a direct loan or overdraft is the cheapest way to pay for insurance but this is often not the case. The drop in interest rates has ensured low monthly payments on premium finance too, and the corporation tax relief on the finance charge (for a commercial client) means financing premiums can work out cheaper than paying upfront.

Base rate

The current Bank of England base rate is 3.5%. This has come down in recent months - this time last year it was 4%. Companies or individuals still see the rate of a loan or overdraft inflated above this minimum rate.

Many factors affect finance and agreement terms, including each company's credit rating, so it is difficult to give a standard percentage rate for premium funding comparable to high-street lender rates. For example, the type of insurance and the responsibility for non-payment affect the repayments.

The delay before repayment, loan amount, length of agreement and return of premium after default also affect the rates.

Rates also vary between personal and commercial lines insurance. Key to this is who shoulders the responsibility of chasing up late payment and, ultimately, who is responsible for payment defaults. Two categories determine the burden of responsibility: recourse and non-recourse lending.

Recourse lending is traditionally used for personal lines business and means that brokers are liable if the customer defaults on payment. Some premium finance providers are prepared to offer non-recourse lending for personal lines but this results in a higher finance rate. Brokers are usually able to get a pro-rata return of premium from insurers if customers default, however, ensuring they do not lose out. Furthermore, brokers usually take cash deposits from personal lines customers so they should be ahead of the game.

Non-recourse lending is traditionally reserved for commercial lines and if there is a default of payment the finance provider takes the full credit risk. This is because the finance provider has the option to underwrite the credit risk and in cases such as employer's liability there is no option for a return of premium.

It seems reasonable to conclude that for commercial lines deals where the finance house shoulders the responsibility, the net rate will be higher.

However, personal lines funding has always been slightly more expensive because financing for personal lines business is more volume-orientated, with much lower amounts financed per deal. Additionally, there is a much higher likelihood of changes with personal lines clients, including change of address, change of bank account details or defaulting.

Time delay

Another variable is the number of days' delay before payment. The standard is 28 days but brokers can usually name a period from between 10 days to two months. The general rule of thumb is the quicker the payment to brokers, the more expensive the loan. This is because the later the finance company pays brokers, the less time it has to loan the money out, thus reducing its net outstanding loans.

The actual time period of the finance agreement also affects the loan rate. Again, the norm is for approximately ten months but the loan could range from three months to 12 months.

The finance company must determine when a return of premium is due. For example, if personal lines clients default brokers can cancel the policy and get a return of premium from insurers to pay the finance house. For commercial lines, the arrangements vary. There is usually no cancellation clause for professional indemnity and other liability classes of insurance.

If customers default, the premium finance company bears the loss. If there is no return of premium, the finance company will want to underwrite the risk and the net rate may be higher to cover the risk.

Most finance houses offer special promotions and volume overriders for loyal brokers and those who place large amounts of business with them.

Finance companies take factors into account before agreeing to a net rate but brokers can get some idea of the deals they could expect from averages.

For example, with a non-recourse commercial lines policy worth £10,000, with 28 days payment delay to brokers and re-payment spread over 10 monthly instalments, brokers could expect the percentage rate to be about 3.5% - the current bank base rate. A company or individual would not be able to get a loan at this rate, however, usually paying 2-3% above it. This allows for brokers to add 1-2% commission on top of the net rate and still remain competitive.

Brokers can also look to premium finance providers for funding for alternative debts and business expenditure. For example, some premium finance companies provide brokers with loans for capital expenditure such as cars, premises and company acquisitions.

The rates for these alternative loans vary according to the length of the agreement and the company's financial standing. For business acquisitions the loan can be for a longer time period than normal premium financing of 10 months. These loans will, however, probably be slightly more expensive, as they are based on unsecured lending as opposed to a pro-rata return of premium should there be payment default.

Discount debts

Brokers could also consider using factoring, in which a company buys at a discount the debts owed to a broker. The third party company then collects the premiums itself. If, for example, a broker offers premium funding but wants to withdraw from the market (if interest rates are low and the broker makes little profit) then it could sell its loan book to another company, which would collect the outstanding payments.

Given the specialist nature of factoring, this kind of finance is usually provided by specialists but they will often have a link to a premium finance company. This is not surprising given that the majority of premium finance providers are subsidiaries of banks, insurance companies or brokers that often already provide factoring.

This also goes some way to explain why specialist financing has been targeted at the insurance market. All players are from a financial background and the insurance market is a natural extension to their core banking and financial services. Historically, there was also an identifiable gap in the market, heightened by the growth in direct debit payments in the late 1980s.

Of course, instalment payment plans are not new to the market and many insurers have been providing their own instalment schemes for years. Insurance companies, however, are only able to offer finance for their own insurance policies. If a customer has three or four difference policies, with different insurers, they need to arrange separate direct debits. An attraction of premium funding, therefore, is that all the direct debits can be consolidated into one monthly payment.

Brokers are also able to protect their clients' bank details from insurers.

This eliminates the threat of insurers sending out renewal confirmation direct to clients and avoids any embarrassment should brokers wish to change insurer.

Rising costs

Insurance is also regarded as a necessary evil for most companies. Indeed, the rising cost of protection led to many businesses looking for alternative methods to pay for this vital business expense and switched-on brokers and premium finance companies were quick to spot this business opportunity.

A final point that has recently been raised in conjunction with premium funding is whether the recent laws on late payment had any effect on premium finance companies. As part of its package of measures to combat late payment the government introduced the Late Payment of Commercial Debts (Interest) Act 1998. This gave small firms with 50 or less employees a statutory right to interest for the late payment of commercial debts. This statutory right to interest and other new entitlements came into force from 7 August 2002 and entitles business owners and managers to claim reasonable debt recovery costs.

This legislation, however, has no effect on the premium finance market.

Premium funding is undertaken by direct debits taken automatically on an agreed date, therefore eradicating the need to issue invoices and chase-up payment.