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What Is an Earned Premium?
Earned premium refers to the portion of an insurance premium that an insurer has collected for the time a policy has been in effect. When a policy is first issued, all premiums are considered unearned because the coverage period has not yet passed.
As time goes on and the insurer provides coverage, those premiums transition from unearned to earned. Insurers calculate earned premiums using methods such as the accounting or exposure approach to accurately track revenue over a policy’s life. This distinction between earned and unearned premiums is crucial for managing revenue and assessing policy performance.
Key Takeaways
- Earned premiums are recognized as revenue by insurance companies only after the coverage period they relate to has expired.
- Unearned premiums are initially recorded by insurers because they represent the portion of coverage yet to be provided; if the policy ends early, these must be refunded to the policyholder.
- Insurance companies calculate earned premiums using two main methods: the accounting method, which allocates premium amounts daily, and the exposure method, which fits premiums to risk exposure scenarios.
- Understanding the distinction between earned and unearned premiums is crucial for both insurers managing their financials and policyholders recognizing their financial rights.
Earned Premiums Explained: How They Work
An earned insurance premium is commonly used in the insurance industry. Because policyholders pay premiums in advance, insurers don’t immediately consider premiums paid for an insurance contract as earnings. While the policyholder meets their financial obligation and receives the benefits, an insurer’s obligation begins when it receives the premium.
When the premium is paid, it is considered an unearned premium—not a profit. That’s because, as mentioned above, the insurance company still has an obligation to fulfill. The insurer can change the status of the premium from unearned to earned only when the entire premium is considered profit.
Important
The earned premium for a full year policy, paid up front and in effect for 90 days, would be for those 90 days.
Say the insurance company records the premium as an earning, and the time period hasn’t elapsed. But the insured party files a claim during that time period. The insurance company will have to reconcile its books to unwind the transaction listing the premium as an earning. Therefore, it’s practical to delay recording it as earned in case a claim is filed
Methods to Calculate Earned Premiums
There are two different ways to calculate earned premiums: The accounting method and the exposure method.
The accounting method is the most commonly used. This method is the one used to show earned premium on the majority of insurers’ corporate income statements. The calculation used in this method involves dividing the total premium by 365 and multiplying the result by the number of elapsed days. For example, an insurer who receives a $1,000 premium on a policy that has been in effect for 100 days would have an earned premium of $273.97 ($1,000 ÷ 365 x 100).The exposure method ignores the booking date of the premium.
Instead, it looks at how premiums are exposed to losses over a given period of time. This complex method examines unearned premium exposure to loss during the calculated period. The exposure method involves the examination of different risk scenarios using historical data that may occur over a period of time—from high-risk to low-risk scenarios—and applies the resulting exposure to premiums earned.
Comparison: Earned Premiums vs. Unearned Premiums
While earned premiums refers to any premiums paid in advance that are earned and belong to the insurer, unearned premiums are different. These are premiums collected in advance by insurance companies who are required to give them back to policyholders if coverage is terminated before the period covered by the premium is over.
For example, if you prepay for a six-month car insurance policy. If you get into a car crash and total your vehicle in the second month of the policy, the insurance company keeps the premiums paid for the first two months. These are the company’s earned premiums. The insurance company returns the remaining four months’ premiums to the insured. Because they are unused, these are called unearned premiums. Similarly, if a policyholder pays $200 per month for a 12-month insurance policy and decides to terminate coverage after three months, the insurance company keeps $600 as earned premiums and refunds $1,800 to the policyholder as unearned premiums.
The Bottom Line
Earned premium represents the portion of an insurance premium that the insurer has collected for coverage already provided during a policy’s term. Unlike unearned premiums, funds for future coverage, earned premiums are recognized as revenue once the coverage period has passed.
Insurers typically calculate them using either the accounting or exposure method, both of which ensure accurate financial reporting. Understanding how premiums shift from unearned to earned helps policyholders plan their finances and ensures transparency in how insurers account for obligations and revenue.
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