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.
An alternative definition of compensating balance refers to a minimum bank deposit that a business agrees to make in return for a favorable interest rate on a loan.
- A compensating balances plan is a business insurance policy that lets the policyholder withdraw a portion of the premiums paid.
- These insurance premiums are banked separately and the policyholder can access the account as needed.
- It differs from more traditional insurance policies in which the premium paid by the insured only covers the cost of the insurance.
- On the plus side, a compensating balances plan enables businesses to draw from a low-cost source of funds.
- On the negative side, the business earns little to no interest on the funds that the insurer has deposited into an account.
Understanding a Compensating Balances Plan
Compensating balances plans are an alternative to most conventional insurance policies, for 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 of a Compensating Balances Plan
For many businesses, working capital, the money it needs on hand to manage its day-to-day operations, fluctuates throughout the year. 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.
Disadvantages and Alternatives to Compensating Balances Plans
A downside of the compensating balances plan is that the business generally earns little or no interest on the money deposited into an account by the insurer. There are alternatives to consider.
- The business may be better served by independently setting up a bank account that pays higher interest on deposits.
- It can create a restricted cash account. This entails setting aside a sum of money that is not available for routine use but could be available to keep the business running between expected payments.
- It may arrange for a revolving line of credit at a bank, giving it a steady source of working capital that can be repaid promptly from receipts in order to avoid excessive interest fees.
- It can apply for seasonal credit. This is a type of credit line that is particularly common in regions that have a concentration of businesses with seasonal fluctuations in revenue, such as farms, resorts, and tourist destinations.