What is Net Premium?
Net premium is an insurance-accounting measure that represents the policy value before expenses are loaded in. Practically, it is the expected present value (PV) of the policy’s future benefit payments minus the expected PV of future premiums. Net premium is used in actuarial reserving, pricing and for certain tax calculations; it does not reflect acquisition, administrative or other policy expenses.
Key takeaways
– Net premium = PV of expected benefits − PV of expected future premiums (no expense loadings).
– Gross premium includes expense loadings (the amount insurers add to cover commissions, administration, claims handling, etc.).
– The difference between net and gross premium depends on the expected expense loadings and the expected future expenses.
– Net and gross premiums are important for state premium tax computations and regulatory reporting.
– Policyholders pay premiums; “net premiums earned” differs from “net premiums written” (see definitions below).
Sources: Investopedia; IRS (Premium Tax Credit overview).
Understanding net premium (how it’s calculated)
1. Project future cash flows:
– Estimate the insurer’s expected benefit outflows for the policy (claims, death benefits, etc.).
– Estimate the policyholder’s expected future premiums (premiums still to be paid under the contract).
2. Discount to present value:
– Choose an appropriate discount rate (consistent with accounting/actuarial rules and regulatory guidance).
– Compute PV(benefits) and PV(future premiums).
3. Compute net premium:
– Net premium = PV(benefits) − PV(future premiums).
Notes:
– This calculation intentionally excludes future expenses (commissions, administration, legal costs). Those are handled separately when calculating gross premium or tax‑adjusted premium measures.
– Actuaries typically include margins for adverse deviation/contingencies when setting pricing or reserves.
Net premium vs. gross premium — what’s the difference?
– Net premium: excludes expenses; focuses solely on benefit cash flows and premiums.
– Gross premium: incorporates expense loadings—the extra amount charged to cover commissions, administrative costs, taxes, profit margin and other expenses.
– The numerical difference between net and gross depends on how large expense loadings are relative to expected future expenses; different accounting and tax rules govern what expenses can be included or deducted.
Why net premium matters (tax and regulatory importance)
– Many states tax insurers’ premium income. Tax rules vary: some states tax gross premiums written; others permit deductions for unearned premiums, ceded reinsurance, or certain expense items.
– Net premium is an actuarial baseline that regulators and insurers use to determine reserves, price products, and calculate taxable premium amounts when allowed by law.
– Properly documenting assumptions (discount rates, expense expectations, morbidity/mortality) is critical for regulatory reviews and tax compliance.
Estimating allowable “added-back” expenses (practical methods)
When regulators permit insurers to reduce gross premium for taxes by adding allowed expense amounts back to net premium (or otherwise accounting for expenses), insurers typically estimate allowable expenses using one of these methods:
1. Flat loading (fixed amount)
– Add a fixed dollar amount per policy to represent expenses.
– Simple and predictable; works best when many components of expense are fixed or not strongly correlated with premium size.
2. Percentage loading
– Add a set percentage of the premium (e.g., 10% of premium) to represent commissions and variable expenses tied to premium volume.
– Works best when expenses (commissions, some administration) scale with premium.
3. Combination (fixed + percentage)
– Add a fixed base amount plus a percentage of the premium.
– Most realistic for many products: some costs are flat (billing systems, regulatory filings), some scale with premium (commissions).
Practical considerations when choosing a method:
– Review expense drivers: if commissions dominate and scale with premium, give more weight to percentage loading. If significant fixed administrative or legal costs exist, include a fixed component.
– Use historical expense data segmented by product line.
– Maintain documentation and rationale—state regulators may review the method and assumptions.
Who pays net premium?
– Policyholders pay premiums. Premium rates are set based on underwriting class (individual vs group), expected benefits, administrative and acquisition costs, and insurer pricing strategy. Net premium refers to the actuarial value derived from expected benefits and premiums, but the actual cash collected comes from policyholders.
Net premiums written vs. net premiums earned (difference clarified)
– Net premiums written: the total dollar amount of premiums recorded on policies issued by the insurer after deducting commissions and reinsurance ceded—a measure of new or renewed business written in a period.
– Net premiums earned: the portion of written premiums that apply to the expired portion of policies during a period—the revenue recognized for coverage provided during the period.
Example: If a 12‑month policy is written on July 1 and the insurer records the entire premium as written, only half of that premium will be “earned” by year‑end (six months of coverage).
What is a Premium Tax Credit (PTC)?
– The Premium Tax Credit is a U.S. federal refundable tax credit that helps eligible individuals and families pay premiums for health insurance purchased through the Health Insurance Marketplace. It is calculated based on household income, family size and the cost of benchmark plans. For details and eligibility, consult the IRS guidance on the PTC. (See sources below.)
Practical steps for insurers (how to compute and use net premium)
1. Gather data:
– Historical claims by product, premiums, lapse rates, mortality/morbidity experience, expense allocations, reinsurance terms.
2. Project future cash flows:
– Model expected policy benefits (claims), policyholder behavior (lapses, surrenders), and future premium receipts using realistic assumptions.
3. Select discount rates and contingency margins:
– Follow applicable actuarial standards and regulatory requirements for discounting and margins.
4. Calculate net premium:
– Compute PV(benefits) and PV(future premiums) → net premium = PV(benefits) − PV(future premiums).
5. Estimate allowable added‑back expenses:
– Choose a method (flat, percentage, combination), justify with expense driver analysis, and document.
6. Derive gross premium or taxable premium base:
– Apply expense loadings as allowed by accounting or tax rules to move from net to gross premium for pricing, reserving, or tax reporting.
7. Validate and document:
– Sensitivity tests, peer reviews, and internal/external audit trails; preserve all actuarial and expense assumptions for regulatory review.
8. File and reconcile:
– Report premiums (written and earned) on statutory filings and tax returns; reconcile any differences with accounting records.
Practical steps for consumers (how net/gross premium affects you)
– Know what you pay: the premium on your bill is what you owe; insurers determine that price using net premium as one input plus expense loadings and taxes.
– If purchasing marketplace coverage, check eligibility for the Premium Tax Credit (IRS) which may reduce your out‑of‑pocket premium expense.
– For questions about premium composition or cancellations/refunds, contact the insurer or your state insurance department.
Example (simple numeric illustration)
– PV of expected benefits = $1,000
– PV of expected future premiums = $200
– Net premium = $1,000 − $200 = $800
– If the insurer expects expense loadings (to cover commissions, admin) of $120 (PV), then a simple gross premium view might add $120 → gross = $920. The exact tax/reporting treatment of that $120 depends on state and accounting rules.
Importance of net premium — bottom line
Net premium is a core actuarial measure used to value insurance obligations without the noise of expense allocations. It helps insurers price products, set reserves and determine taxable premium bases when combined with allowed expense adjustments. For policyholders, net/gross distinctions determine how premiums are built but do not change who ultimately pays (the policyholder). Because state tax and accounting rules vary, insurers must carefully estimate and document expense add‑backs and follow applicable laws.
Sources and further reading
– Investopedia. “Net Premium.” https://www.investopedia.com/terms/n/net-premium.asp
– Internal Revenue Service. “The Premium Tax Credit — The Basics.” https://www.irs.gov/credits‑deductions/advance‑premium‑tax‑credit‑aptc
If you want, I can:
– Walk through a detailed worked example with discounting and expense-loading choices.
– Draft a checklist for state‑level tax compliance relating to premium calculations.