Earned Premium – What the Carrier Has Actually Collected
In plain language: Earned premium is the part of the policy premium that an insurance company has actually earned because it has provided coverage for a certain amount of time. It works like a gym membership: you may pay for a full year upfront, but the gym only "earns" each monthly portion as the month passes.
Technical definition: The earned premium is the amount of the total insurance premium that an insurance company acknowledges as income, proportional to the elapsed time of the policy period. It commonly appears on financial reports such as an income statement and is foundational to measures like the loss ratio and combined ratio.
Understanding earned premium is crucial to smoothing out the financial ebbs and flows within an insurance company. Misunderstanding this figure can lead to miscalculated business performance or even over-paying of claims.
TL;DR
What Is Earned Premium in Insurance?
Earned premium is a combined measure of both time and risk, calculated from the insurance policy's inception to a specified date within the policy coverage period. When an insurance company issues a policy, it receives a written premium, which includes both the earned premium and unearned premium. Unlike the total premium, the earned premium reflects only the portion of the insurance premium that applies to elapsed coverage period.
In the insurance industry, the earned premium is widely used in financial reporting and accounting. It is vital to analyzing an insurance company's performance and profitability, aiding in calculating measures like the net premiums earned and loss ratio.
One point of caution is that earned premiums should not be confused with total premiums or direct premiums written. These broader terms include unearned premiums, which an insurer has collected but has not yet "earned" because the coverage period has not elapsed.
Key Related Terms to Know
Common Questions About Earned Premiums
What's the difference between earned and unearned premiums?
Earned and unearned premiums represent different periods of an insurance contract. Earned premiums are the premiums attributable to the period of time that has already passed, while unearned premiums are those attributable to the future. For instance, if a business insurance policy has been in effect for six months, half the annual premium would be "earned," and the rest "unearned."
How are earned premiums calculated?
The simple method of how to calculate earned premium involves dividing the coverage period into the policy premium. For example, if a policy has a premium of $1,200 for a year, and six months have passed, the earned premium is $600. An alternative exposure method, based on actual risk exposure rather than time, may also be used.
What happens to earned premiums if coverage is canceled early?
If a policy is canceled before it expires, the earned premium is typically the percentage of the premium equivalent to the elapsed coverage period. However, minimum earned premiums can apply, stipulating the minimum amount the company will retain upon early cancellation.
How do earned premiums affect an insurance company’s income statement?
Earned premiums play a significant role in an insurance company's income statement. Recognized as revenues, earned premiums directly impact profitability and provide insight into the company's financial health and risk coverage performance.
Earned Premium vs. Written Premium
Many people get confused between earned premium and written premium. So, let's differentiate them:
Comparison Area | Earned Premium | Written Premium
|
Primary use case | Determining actual income from policies | Determining total potential income from policies |
Typicity | Always portion of policy period | Entire policy period |
Notability | Determines profitability | Determines total sale |
Common confusions | Misunderstanding as total premium | Misinterpretation as earned premium |
Key Implications | Erroneous financial reporting | Overstated potential revenue |
Real Claim Examples Involving Earned Premium
Scenario 1: A small business owner purchased a general liability insurance policy and paid the annual premium upfront. Unfortunately, five months into the policy, they had to close their business due to unforeseen circumstances. As the coverage served for five months, only 5/12 of the total premium became the earned premium.
Scenario 2: A commercial property insurance policy with a total premium of $24,000 was canceled after six months. Instead of taking half of the total premium as the earned premium, the insurance company retained a higher percentage due to a minimum earned premium clause in the insurance policy.
Scenario 3: An insurer recorded all direct premiums written as earned premiums, severely distorting the income statement. They faced a financial audit and hefty penalties due to inappropriate premium accounting, leading to a significant decrease in insurance profitability.
Limitations and Common Mistakes
How to Explain Earned Premium to Clients
Personal Lines client "Earned premium is like the part of your gym membership fee that the club actually 'earns' each month as you use their facilities. It's the portion of your insurance premium that the company has earned by providing you coverage so far."
Small Business owner "The earned premium is the part of your insurance premium that the insurer has truly 'earned' by covering you for a certain number of days or months. It's critical to understanding your insurance costs and policies."
CFO or Risk Manager "For your company's insurance policies, the earned premium is a key financial term. It's the portion of the total insurance premium that the insurance company considers as actual income from the policy so far. Keeping track of it helps assess risk coverage and policy performance."