What Is a Compensating Balances Plan?

A compensating balances plan is a type of insurance policy for businesses that allows the insured party to withdraw a portion of the premiums paid for the policy. The premiums that are available for withdrawal are deposited into a separate bank account. The insured has access to the account as a source of working capital.

Key Takeaways

  • A compensating balances plan is a business insurance policy that deposits a portion of the premium into a bank account for the policy holder's use.
  • This reduces the business' insurance costs while giving it access to operating capital.
  • The account earns little or no interest. A business might be better off opening a separate account.

Understanding the Compensating Balances Plan

Compensating balances plans are an alternative to conventional insurance, in which the insured pays a premium that covers only the cost of the insurance.

When a business purchases a compensating balances plan from an insurer, the insurer deducts its costs, such as service charges, taxes, and administrative expenses, as well as its profit. The money remaining after these deductions is deposited into a bank account for the use of the insured business.

The purpose is to give the insured business access to a low-cost source of funds to maintain its operations.

Advantages and Disadvantages of a Compensating Balances Plan

Working capital, the money a business needs on hand to manage its day-to-day operations, fluctuates. Businesses need cash on hand, through a line of credit or a savings account or both, to cover the dry periods.

A compensating balances plan essentially becomes a savings account funded through the insurance policy for the business. That gives it a cheaper source of financing than it can obtain through arranging short-term debt or bank loans.

An Alternative

On the downside, the business generally earns little or no interest on the money deposited into an account by the insurer. The business may be better served by setting up a separate account on its own at a financial institution that pays higher interest for deposits.