Difference Between Earned Premium and Unearned Premium in Insurance?
In the world of insurance, the terms “earned premium” and “unearned premium” are essential concepts that represent different stages of the insurance payment process. Understanding these terms can help policyholders better grasp how insurance companies manage the payments they receive and how coverage is provided over time.
This article delves into the difference between earned and unearned premiums, provides examples, and explains why these concepts are critical for both insurance providers and their customers.
What is an Earned Premium in Insurance?
An earned premium is the portion of the total premium paid by the policyholder that has been “earned” by the insurance company, meaning that the coverage for that time period has already been provided. Essentially, it is the amount that corresponds to the portion of the policy that has elapsed.
Insurance premiums are typically paid upfront, either as a lump sum or in installments, but the insurer earns the premium gradually as time progresses and the policy remains in effect. Until the coverage for a specific period is provided, the premium is considered “unearned.”
For example, if an insurance policy costs $1,200 for a year, the insurer doesn’t “earn” that full amount on day one. Instead, the premium is earned over the course of the year. After six months, half of the premium ($600) is considered earned, because the insurer has provided coverage for six months of the contract period.
Why Earned Premiums Matter
Earned premiums are a critical component of an insurer’s revenue recognition process. They represent the money that the insurance company can recognize as income because they’ve provided a service — insurance coverage — during a specific period. This is important for accounting and financial reporting because it accurately reflects the amount of revenue the company has generated by fulfilling its obligations to policyholders.
Additionally, earned premiums offer insights into an insurer’s financial health. High earned premiums indicate that the insurer has successfully provided coverage for significant periods, while low earned premiums might suggest underperformance in terms of active policies.
What is an Example of an Earned Premium in Insurance?
To better understand the concept, let’s look at a specific example.
Imagine you have a car insurance policy with an annual premium of $1,200, which you pay upfront. This payment covers your vehicle for 12 months. Let’s break down how the premium becomes earned over time:
- Month 1: At the end of the first month, 1/12th of the premium is considered earned because you’ve received one month’s worth of coverage. This amount would be $100 ($1,200/12).
- Month 6: After six months of coverage, the insurance company has earned 50% of the premium. In this case, $600 of the premium has been earned, leaving $600 as unearned.
- Month 12: By the end of the year, the insurer will have fully earned the $1,200 premium because they have provided coverage for the entire policy period.
In this case, the insurance company earns the premium progressively over the course of the policy, and the amount earned reflects the period of time for which they have provided coverage.
What is Unearned Premium Insurance?
Unearned premium refers to the portion of the insurance premium that the insurer has collected but has not yet earned because the policy period is still ongoing. Since insurance premiums are usually paid at the beginning of a policy term, insurers receive money in advance for coverage that will be provided in the future. Until the time that coverage is provided, this money is considered “unearned.”
How Unearned Premiums Work
Let’s return to our previous example of a $1,200 annual car insurance policy. At the start of the policy, the insurer has received the full $1,200 payment, but they haven’t yet provided any coverage. Therefore, at the start of the policy, the entire $1,200 is considered unearned.
Each month, a portion of the premium is gradually “earned” as the insurer provides coverage. By the end of the first month, $100 is earned, and $1,100 remains unearned. By the end of the sixth month, $600 is earned, and $600 is unearned.
The key idea here is that the unearned premium represents a liability for the insurer because it is money they’ve collected in advance for a service they have not yet provided. If the policy is canceled or terminated early, the insurer may need to return the unearned portion of the premium to the policyholder.
Refund of Unearned Premiums
One of the main reasons why unearned premiums are so important is because they represent a financial obligation to the policyholder in case of cancellation. If a policyholder decides to cancel their policy before the end of the term, the insurance company is generally required to refund the remaining unearned portion of the premium.
For example, if the policyholder cancels their $1,200 annual policy after six months, the insurer would keep the $600 in earned premium for the time they provided coverage, but the remaining $600 would typically be refunded to the policyholder.
This practice ensures that policyholders aren’t paying for insurance coverage they didn’t receive, and it also ensures transparency and fairness in the relationship between the insurer and the insured.
Accounting for Unearned Premiums
In accounting terms, unearned premiums are classified as a liability on an insurance company’s balance sheet. This is because the company has received payment in advance but still has an obligation to provide services (coverage) in the future.
For insurers, accurately managing and reporting unearned premiums is critical for both regulatory compliance and financial performance. It helps provide a clear picture of how much revenue the company has yet to earn and how much coverage they still need to provide under their existing policies.
Key Differences Between Earned Premium and Unearned Premium
The primary difference between earned and unearned premiums lies in the timing of when the coverage is provided.
- Earned premium is the amount of the premium that corresponds to the coverage that has already been provided.
- Unearned premium is the amount that corresponds to the future coverage period, which has not yet been provided.
In simple terms, as the policy progresses, the unearned premium gradually becomes earned. Once the policy period is complete, the entire premium is considered earned.
Conclusion
The concepts of earned and unearned premiums are fundamental in the insurance industry and play a crucial role in both the financial management of insurance companies and the experience of policyholders. Earned premiums represent the amount the insurer has earned by providing coverage, while unearned premiums reflect the insurer’s obligation to provide coverage in the future.
For policyholders, understanding how these premiums work is essential when considering things like policy cancellation and refunds. For insurers, managing earned and unearned premiums accurately ensures regulatory compliance and financial stability. These concepts together ensure that the insurance system functions fairly and transparently for both parties involved.