What is an Earned Premium?
An earned premium refers to the portion of the insurance premium that corresponds to the period of coverage that has already elapsed. It represents the revenue that an insurance company recognizes for the coverage provided up to a specific point in time.
Key Learning Points
- Earned premiums are recognized as revenue over the coverage period, ensuring that income matches the services provided
- Unearned premiums are recorded as liabilities since they represent future coverage obligations
- Proper accounting of earned and unearned premiums ensures transparent and reliable financial reporting, crucial for the stability of insurance companies
- The Accounting method calculates earned premiums based on the number of days the insurance policy has been in effect, providing a straightforward approach
- The Exposure Method data-driven method estimates premiums using historical data, risk assessment, and payout probability
Understanding Earned Premium
Premiums are a primary revenue source for insurance companies, particularly in the property and casualty (P&C) sector. According to accounting rules, premiums are recognized as they are earned over the coverage period.
For example, if an insurance policy with a $1,000 premium is written halfway through the year and covers 12 months, only $500 would be recognized as earned by the end of that year. This is because the coverage spans both the current and the following year. Therefore, premiums are matched to the coverage period, resulting in $500 earned in year one and $500 in year two. The remaining unearned portion is recorded as a liability.
What is an Unearned Premium?
The unearned premium represents the portion of the premium that has been received but not yet earned because the coverage period is still ongoing. This amount is treated as a liability on the balance sheet, similar to deferred income, and is referred to as the unearned premium reserve.
There are instances where the unearned premium may need to be returned to the policy holder if there is an event whereby the policy is either cancelled or no longer required. This may be the result of a house sale or if a car is written-off after an accident so no longer in use.
Methods for Calculating Earned Premium
There are two main ways to calculate earned premium – the most commonly used is the Accounting Method and there is also the Exposure Method.
Accounting Method
The accounting method calculates earned premium by taking the number of days since the beginning of an insurance contract and multiplying this figure by the premium earned each day. This method is the most common and accurately reflects the revenue generated from specific contracts. For instance, if a policy premium is $365 and the coverage period is one year, the daily earned premium would be $1.
Exposure Method
The exposure method is more complex and data-driven, using historical data to estimate the value of insurance contracts. It considers the risk of payout and the estimated collection of premiums. This method relies on extensive data analysis to determine the amount of premium earned based on the likelihood of claims and payment patterns.
An example of this would be calculating the risk that a payout of $2,000 will be required in the future. If that risk was deemed to be 5% and the policy costs $120, then the following calculations can be done:
- $120 premiums paid per month x 95% = $114 of premium is expected to be earned
- $2,000 potential payout x 5% = $100 is the expected payout value
- $114 – $100 = $14 is the expected profit for the insurance company (per month)
Examples
Example 1: Single Policy
Consider an insurance company that writes a policy for $1,000 with a one-year coverage period starting halfway through the year. By the end of the year, only $500 would be recognized as earned premium, with the remaining $500 recorded as unearned premium.
Example 2: Unearned Premiums
In a scenario where an insurance company writes $100 in premiums on the last day of year one for a two-year coverage period, the entire $100 remains unearned at the end of year one. During years two and three, the premium is earned equally at $50 per year, reducing the unearned premium reserve from $100 to zero by the end of year three. This example highlights the process of recognizing earned premiums over the coverage period.
Download the Excel template used to calculate the Unearned Premium in the free resources section.
Earned and Unearned Premiums in Financial Statements
To ensure accurate revenue recognition, premiums must be matched to the period of coverage. Unearned premiums are recorded as a liability under the unearned premium reserve on the balance sheet. As the coverage period progresses, portions of this reserve are transferred to earned premiums, reflecting the revenue accurately over time. This method ensures that the financial statements of the insurance company accurately represent its obligations and earned revenues. This maintains a clear distinction between written premiums, earned premiums, and unearned premiums.
Conclusion
Earned premiums reflect the portion of income that matches the coverage period already provided, ensuring that revenue is recognized appropriately. Conversely, unearned premiums represent future obligations and are recorded as liabilities. Utilizing methods like the accounting and exposure methods helps align premiums with the coverage period, ensuring transparent and reliable financial reporting. This accurate accounting practice supports the financial stability and integrity of insurance companies.
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