What Is an Earned Premium?
An earned premium is the portion of an insurance premium that an insurer has “earned” by providing coverage for a completed period of time. Because insurance premiums are usually paid in advance, insurers initially record those payments as a liability (unearned premium) and then recognize revenue gradually as the coverage period expires. When the coverage for a given portion of the policy term has passed, the corresponding premium is considered earned.
Key takeaways
– Earned premium = premium revenue recognized for the portion of the policy period that has already elapsed.
– Unearned premium = premium collected in advance for future coverage (a liability until recognized as revenue).
– Two common ways to measure earned premium: the accounting (time-proportion) method and the exposure method.
– Proper recognition affects financial statements, loss and combined ratios, reserve calculations, and reinsurance accounting.
– Cancellations, endorsements and claims affect how much premium is earned vs. refundable.
Why earned premium matters
– For insurers: Earned premium is the top-line revenue that drives performance metrics (loss ratio = losses / earned premium; combined ratio). Accurate measurement affects profitability, capital planning, regulatory reserves and tax reporting.
– For policyholders: Determines how much premium is refunded upon cancellation and whether coverage was in place when a claim occurred.
– For auditors/regulators: Ensures premiums and liabilities are recognized consistently and that reserves are adequate.
Earned vs. unearned premium — the difference
– Unearned premium (UPR) is a liability on the insurer’s balance sheet representing prepaid coverage that has not yet been provided.
– As the policy period elapses, a portion of UPR is reclassified to earned premium (revenue) on the income statement.
– Example: A 12‑month policy with a $1,200 annual premium. After three months, earned premium = $1,200 × (3/12) = $300; unearned = $900.
How insurers calculate earned premium
1) Accounting (time-proportion) method — most common
– Formula: Earned premium = Total premium × (Days elapsed in term / Total days in term).
– Example: $1,000 premium, 100 days elapsed (out of 365): Earned premium = $1,000 × (100/365) = $273.97.
– Use when coverage is generally uniform over time and booking date is known.
2) Exposure method — used when risk exposure varies over the term
– Concept: Allocate premium based on exposure to loss (e.g., mileage for auto, occupancy for property, seasonal risk patterns), not just elapsed days.
– Steps (high level):
a. Define exposure units relevant to the line of business (miles, payroll, square footage, etc.).
b. Determine exposure across the period and how exposure maps to loss potential (use historical loss experience).
c. Allocate premium to periods based on proportion of total exposure in each period.
– Use when risk is not evenly distributed across the policy term (seasonal risks, staged projects, policies with varying limits or exposures).
Journal entries — typical flows
– When premium is received (upfront):
Debit Cash
Credit Unearned Premiums (liability)
– As coverage elapses and premium is earned:
Debit Unearned Premiums
Credit Premium Earned (revenue)
– If a claim occurs, losses and loss reserves are recognized as expenses and liabilities; unearned premium may be adjusted if the policy is cancelled or modified.
Practical examples
– Prepaid six‑month auto policy, $600 total, cancelled after two months (pro rata refund):
Earned = $600 × (2/6) = $200; Refund = $600 − $200 = $400.
– Short‑rate cancellation (insurer applies a penalty): insurer may keep more than the pro rata portion — the precise refund depends on the insurer’s short‑rate schedule or policy terms.
Practical steps for insurers — how to calculate and manage earned premiums
1. Capture accurate policy data: policy inception and expiration dates, total premium, endorsements, cancellations, and prorata rules.
2. Choose recognition method: time-proportion for most retail policies; exposure method for lines where risk is concentrated.
3. Automate daily/monthly accruals: compute days in force and move the correct portion from unearned premium to revenue each accounting period.
4. Maintain unearned premium ledger: track UPR balances at policy level and in aggregate for financial reporting and regulatory filings.
5. Reconcile: monthly reconcile premium receivables/cash, UPR ledger and general ledger; resolve timing differences.
6. Adjust for mid‑term changes: when endorsements change coverage or premium, reallocate earned/unearned amounts as of the endorsement effective date.
7. Monitor refund/cancellation procedures: apply pro rata vs short‑rate rules correctly and document retained premiums.
8. Coordinate with claims and underwriting: if a major claim indicates future loss patterns, test for premium deficiency and book a premium deficiency reserve if required.
9. Reinsurance accounting: recognize ceded earned premium on the same pattern as direct earned premium where the reinsurance contract transfers risk.
10. Controls & audit trail: retain calculations, source data and approvals to support audited financials and regulatory exams.
Practical steps for policyholders — what to do if you cancel or change a policy
1. Check your policy terms: identify whether refunds are pro rata or short‑rate and any cancellation fees.
2. Request written confirmation of cancellation date and refund amount.
3. Ask for a refund calculation: total premium, earned portion, amount retained and refund.
4. If a claim was filed during the policy period, verify whether coverage applied on the date of loss and whether the insurer adjusted premium accounting.
5. If you disagree, escalate to the insurer’s customer service and, if needed, to your state insurance regulator or ombudsman.
Special considerations and complications
– Endorsements and mid‑term adjustments: increase/decrease of coverage requires reallocation of premiums; often prorated by effective date.
– Installment payments and revocation: if premium payments stop, insurer may cancel mid‑term and compute earned portion to date.
– Premium deficiency reserve: under accounting guidance, if expected future losses + expenses exceed remaining unearned premium and related reinsurance recoverables, insurers may need to recognize a reserve (a liability and expense).
– Commissions and acquisition costs: acquisition expenses (commissions) may be deferred and amortized against earned premium (varies under accounting standards).
– Reinsurance: ceded earned premium must be recognized consistent with the underlying risk cession.
– Tax treatment: tax rules vary jurisdictionally; revenue recognition for tax purposes may differ from financial accounting recognition.
Impact on key insurance metrics
– Loss ratio = Incurred losses ÷ Earned premium. If earned premium is understated, loss ratios will look worse (higher). If overstated, loss ratios may look artificially better.
– Combined ratio = (Incurred losses + Expenses) ÷ Earned premium. Accurate earned premium recognition is vital for meaningful underwriting performance analysis.
Audit and regulatory checkpoints
– Insurers should maintain policies that document premium recognition method(s), assumptions used for exposure allocations, and controls for reconciliations.
– Regulators generally require insurers to maintain adequate unearned premium reserves and follow prescribed methods for reporting.
Conclusion
Earned premium is the portion of premium revenue corresponding to coverage already provided. Proper recognition—from policy administration through accounting and reserves—is essential for accurate financial reporting, sound underwriting metrics, and fair treatment of policyholders when policies change or are cancelled. Insurers should use robust systems and controls to calculate and reconcile earned premium; policyholders should understand how cancellation and endorsement rules affect refunds.
References
– Investopedia: “Earned Premium.” https://www.investopedia.com/terms/e/earnedpremium.asp
– General insurance accounting principles (ASC 944 — Insurance, U.S. GAAP) — for guidance on insurance revenue and reserve recognition (consult the standard and a qualified accountant for application to specific circumstances).