Understanding Earned Premiums in the Insurance Industry
In the insurance sector, the concept of earned premium is crucial. It refers to the portion of an insurance policy’s premium that has expired, with the insurance company having covered the risk during that period. Essentially, earned premium represents what the insured party has paid for the time the policy was active but has now elapsed. Until this period ends, the insurer views the collected payments as unearned. It is only after this expiry that the premium is recorded as earned, potentially contributing to the insurer’s profit.
Calculating Earned Premiums: Accounting and Exposure Methods
There are two primary approaches to calculating earned premiums in the insurance industry: the accounting method and the exposure method.
The accounting method, widely used by insurers, involves dividing the total premium by 365 and multiplying the result by the number of days elapsed to determine the earned premium amount. For example, a $1,000 premium paid for a policy active for 100 days would result in an earned premium of $273.97 ($1,000 รท 365 x 100).
Conversely, the exposure method assesses how premiums are exposed to possible losses over a specified time frame. Utilizing historical data, this method evaluates various risk scenarios, from high to low, and applies these exposures to earned premiums.
Distinguishing Earned and Unearned Premiums
Differentiating between earned and unearned premiums is essential in insurance. Earned premiums refer to advanced payments that insurers retain if a policy is terminated early, encompassing the time already covered. On the other hand, unearned premiums are refunded to policyholders if coverage ends prematurely.
For instance, if a policyholder pre-pays for a six-month car insurance term but crashes their vehicle in the second month, the insurer keeps the premiums paid for those two months (earned premiums) while refunding the remaining four months’ worth. Similarly, terminating a monthly $200 payment for a 12-month policy after three months would result in the insurer keeping $600 as earned premiums and refunding $1,800 as unearned premiums to the policyholder.