What Is an Earned Premium? Process and How It Works in Insurance (2024)

What Is an Earned Premium?

The term earned premium refers to the premium collected by an insurance company for the portion of a policy that has expired. It is what the insured party has paid for a portion of time in whichthe insurance policy was in effect, but hassince expired. Since the insurance company covers the risk during that time, itconsiders the associated premium payments it takes from the insured party asunearned. Once the time has expired, it can then record it as earned or as a profit.

Understanding Earned Premiums

An earned insurance premium is commonly used in the insurance industry. Because policyholders pay premiums in advance, insurers don't immediately consider premiums paid for an insurance contract as earnings. While the policyholder meets their financial obligation and receives the benefits, an insurer's obligation begins when it receives the premium.

When the premium is paid, it is considered an unearned premium—nota profit. That's because, as mentioned above, the insurance company still has an obligation to fulfill. The insurer can change the status of the premium from unearned to earned only when the entire premium is considered profit.

Say the insurance company records the premium as an earning, and the time period hasn't elapsed. But the insured party files a claim during that time period. The insurance company will have to reconcile its books to unwind the transaction listing the premium as an earning. So it makes more sense to hold off on recording it as an earning in the event that a claim is filed.

Special Considerations

There are two different ways to calculate earned premiums: The accounting method and the exposure method.

The accounting method is the most commonly used. This method is the one used to show earned premium on the majority of insurers' corporate income statements. The calculation used in this method involves dividing the total premium by 365 and multiplying the result by the number of elapsed days. For example, an insurer who receives a $1,000 premium on a policy that has been in effect for 100 days would have an earned premium of $273.97 ($1,000 ÷ 365 x 100).

The exposure method does not take into account the date a premium is booked. Instead, it looks at how premiums are exposed to losses over a given period of time. It is a complicated method and involves examining the portion of unearned premium exposed to loss during the period being calculated. The exposure method involves the examination of different risk scenarios using historical data that may occur over a period of time—from high-risk to low-risk scenarios—and applies the resulting exposure to premiums earned.

Earned vs. Unearned Premiums

While earned premiums refers to any premiums paid in advance that are earned and belong to the insurer, unearned premiums are different. These are premiums collected in advance by insurance companies who are required to give them back to policyholders if coverage is terminated before the period covered by the premium is over.

Say, for example, you take out an automobile insurance policy and prepay for a six-month term. If you get into a car crash and total your vehicle in the second month of the policy, the insurance company keeps the premiums paid for the first two months. These are the company's earned premiums. But the remaining four months' worth of premiums are returned to the insured party. Because they are unused, they are called unearned premiums. Similarly, if a policyholder pays $200 per month for a 12-month insurance policy and decides to terminate coverage after three months, the insurance company keeps $600 as earned premiums and refunds $1,800 to the policyholder as unearned premiums.