Compensating Balances Plan

What Is a Compensating Balances Plan?

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

The term compensating balance may also refer to a minimum bank deposit that a business agrees to maintain as a condition for receiving a favorable interest rate on a loan.

Key Takeaways

  • 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.
  • This is one way of several ways that a business can get access to cash that has been set aside for dry periods.
  • Alternatives include a revolving credit line or a seasonal loan.

Understanding a Compensating Balances Plan

Compensating balances plans are an alternative to conventional business insurance policies, which have 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, including service charges, taxes, administrative expenses, and the insurer's profit. The money remaining is deposited into a bank account for the use of the insured business.

The business gets a low-cost source of funds to help keep its operations going.

Advantages of a Compensating Balances Plan

Most businesses experience seasonal fluctuations in the revenues they bring in and the expenses they pay out. They need cash on hand to get them through the dry periods, and they usually get it by obtaining a line of credit, maintaining a savings account, or both.

A compensating balances plan essentially serves as a savings account funded through the insurance policy for the business.

Some businesses might find that they can obtain a cheaper source of financing through an insurance policy than they can obtain through a bank credit line or loan.

Disadvantages and Alternatives to Compensating Balances Plans

The business generally earns little or no interest on money deposited into an account by the insurer. There are alternatives to consider.

  • The business can independently open a bank account that pays a higher interest on its deposit.
  • It can create a restricted cash account. This involves setting aside a sum of money that is not available for routine use but can be accessed to keep the business running in dry periods.
  • 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.