What is an Earned Premium?
An earned premium is the portion of an insurance premium that applies to the expired portion of an insurance policy.
How Does an Earned Premium Work?
For an earned premium example, let's say John purchases a life insurance policy from Company XYZ. The annual premium on the policy is $600 and is paid in advance each January. It is now the end of June. Company XYZ will record $300 of the $600 it has received from John as an earned premium; the other half is recorded as an unearned premium. In July (and each month thereafter), Company XYZ will subtract 1/12, or $50, from the unearned premium reserve and record it in its earned income account. In other words, because half of the policy has elapsed, Company XYZ has earned half the premium even though it has physically received 100% of the premium.
In some cases, insurers do not calculate premiums in a pro rata fashion. This is often the case for policies covering seasonal risks (like snowmobiles), warranty policies (where the age of the insured item actually increases the risk of a claim), or performance bonds (where the risk of having to financially guarantee the insured increases over time). In those cases, actuarial calculations are sometimes required in order to match the revenue timing with the risk timing.
Why Does an Earned Premium Matter?
Generally, insurers must recognize premiums as revenue in proportion to the amount of insurance provided. Thus, earned premium is important because it is essentially the only portion of an insurance company's premiums received that can be recognized as income; unearned premiums cannot. This is because the insurer still shoulders risk associated with the remaining portion of the insurance policy.
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