Understanding Earned Premiums: Your Pathway to Maximizing Insurance Revenue
What is an Earned Premium?
An earned premium refers to the portion of the insurance premium that the insurer has collected for the part of the policy that has expired. Essentially, it’s the amount paid by the insured party for the duration in which the insurance policy was active and the risk was covered by the insurer. Following the expiration of this period, the premium is recognized as earned and considered profit.
How Earned Premiums Work
In the insurance industry, earned premiums play a critical role. Policyholders generally pay premiums in advance, but these are not immediately recognized as revenue by insurers. When a premium is first paid, it remains unearned because the insurance company has ongoing obligations to fulfill. Insurers transition the premium from ‘unearned’ to ’earned’ only after the coverage period expires and no claim has been filed.
Consider a one-year policy paid up front that has been in effect for 90 days. The earned premium would correspond to the coverage provided during those 90 days.
If an insured party files a claim during the active period, any premiums prematurely recorded as earnings would require reconciliation. Thus, insurers generally prefer to wait until the risk period lapses to record such premiums as earnings.
Key Insights
- An earned premium reflects the premium for the time period during which the insurance policy was active.
- Insurers can account for earned premiums as revenue only after the coverage period ends.
- The calculation of earned premiums can be done using either the accounting method or the exposure method.
Unveiling Calculation Methods for Earned Premiums
There are two main methodologies for calculating earned premiums: the accounting method and the exposure method.
Accounting Method
This widely-used method involves spreading the total premium over the days in the coverage period. For instance, dividing a $1,000 premium by 365 days and then multiplying by the days elapsed (say, 100 days) results in an earned premium of $273.97.
Exposure Method
The exposure method adjusts earned premiums based on the period’s risk exposure. Unlike the accounting method, it looks at the proportion of unearned premium exposed to different risk scenarios. This advanced calculation uses historical data to apply varying degrees of exposure to premiums.
Earned vs. Unearned Premiums: Know the Difference
Earned premiums become insurer’s revenue post coverage period, while unearned premiums are those yet to provide coverage and hence need to be returned if the policy is terminated early.
For example, consider an auto insurance policy paid in advance for six months. If a total loss occurs in the second month, the premiums for the first two months are earned. The remaining four months are unearned premiums, and they must be refunded to the insured party. Similarly, if a policyholder decides to terminate a 12-month policy three months into it, the insurance company would retain the premiums for the three months as earned and refund the remaining nine months as unearned.
Related Terms: accounting method, exposure method, insurance, revenue recognition, unearned premium.
