d3sign / Getty Images When your insurance provider receives your premium payment, they might not record the cash as revenue immediately. Instead, they may need to wait until they’ve completed the services they agreed to provide in exchange for the premium, such as covering certain risks for you during the policy term. For example, if you pay your car insurance premium in full at the beginning of an annual policy, your insurer won’t recognize the revenue until some of the term has passed.
How Earned Premium Works
Most authorized insurers in the United States must follow Statutory Accounting Principles (SAP). These are closely related to Generally Accepted Accounting Principles (GAAP) and use the same fundamental framework. These accounting principles generally require that insurance companies recognize revenues from premiums when they earn them, not necessarily when you pay them. That can happen at different times, depending on whether the policy in question is a short-duration contract or a long-duration contract. Short-duration contracts provide coverage for a fixed period, usually no more than three to five years. These include most property and liability insurance contracts, such as homeowners insurance and liability auto insurance. Insurers earn premiums from short-duration contracts by providing coverage for the financial risks outlined in your policy throughout its term. As each day in the term passes, the insurer records a little more of your premium as revenue. For example, if a policy has a 100-day term, the insurer would earn 1% of the total premium each day until coverage expires. Long-duration contracts have a much longer (sometimes indefinite) coverage period that can last for decades. Most life insurance policies fall into this category, including permanent policies and term policies. For long-duration contracts, insurers earn their premiums on the dates they’re due.
How To Calculate Earned Premium
Here’s an example of an earned premium calculation. Say you have an insurance policy with a $2,000 premium. The first half is due on Jan. 1, the first day of coverage, and the second is due on July 1. You make the first payment on time. If your policy is a short-duration contract, the insurer would record earned premium as the term passes. By March 31, after three of the 12 months (25%) of your policy term, the insurer would record 25% of the annual premium as revenue. That’s $500 in earned premium, even though you’d already paid $1,000, because the insurer won’t have earned the other $500 until June 30 (halfway through the policy term). If your policy is a long-duration contract, the insurer would record premiums as revenue on the payment due dates. When you paid 50% of the annual premium on Jan. 1, they would have recorded your $1,000 as earned premium. They would not earn any additional premiums from you until your next due date in July.
Earned Premium vs. Unearned Premium
Unearned premium is the opposite of earned premium. It represents the portion of the premiums you’ve paid that your insurer can’t yet record as revenue. For short-duration contracts, that would be because the corresponding portion of the coverage period hasn’t yet expired. For long-duration contracts, it’s because the payments aren’t due yet.
