Unearned premium - Unearned premiums are distinguishable advance premiums, which are premiums charged before the valuation date but which also provide insurance for periods starting after the valuation date. The Code does not further describe unearned premiums, but the 1959 Law regulations provide a description of unearned premiums as any sums which cover the cost of bearing the insurance risk for the duration for which the premiums are paid in advance. This term includes all unearned premiums for the purposes of determining whether an insurance company is a life insurance company are also taken into account in the Section 816 Qualification Fraction denominator (E. Robbins, R. Bush 2014, p. 151).
- The unearned premium reserve represents the premiums paid to the company for not provided insurance. If the plan is cancelled before the term of coverage has expired, the policyholder can receive a refund based on the unearned premium balance. The unearned premium fund is a short-term loan (because most plan coverage periods are one year or less), with no unique characteristics of risk. As the insurance period expires, funds issued from the unearned premium provision are used and transferred to the loss reserve to offset costs, expenditures, and taxes (G. Dionne 1992, p. 143).
How to remedy overstatement of the result of contributions for the year
To address the obvious overstatement of the year-written premium income, insurance companies used the notion of unearened premiums, as far as potential payment is concerned, the part of every premium earned in the year that applies to the next year. The unearned premiums will be a benefit allowance and included in expenditure in the year of receipt; in the next year the same sum will be treated as income and the unearned premiums of the next year will be deducted. For stock-in-trade, this method is much like that and is meant to serve much of the same purpose-allocating income to the right year (P. Harris, D. Cogan 2017, p. 139).
Minimum of unearned premium reserve
The total smallest unearned premium reserve which applies beyond the valuation date to the premium period is based on the net value model premium if contract reserves are necessary and on the gross model premium if contract reserves are not required. The unearned premium reserve shall be at least comparable to the present value of the claims for the duration beyond the valuation date indicated by the unearned premium to the degree not otherwise given. Where the value of the contract is at least equal to the net unearned premium reserve. The test is done as a whole, not on a contract-by-contract basis individually (E. Robbins, R. Bush 2014, p. 319).
Example of unearned premium
The explanation of the unearned premium on the basis of the earned premium (S. Clerk, T. Wickens 2014, p. 328-329):
- The premium earned is the part of the actual premium relating to the reporting period coverage. For example, if a new annual plan with a 120-unit premium goes into effect on April 1, and GFS is being planned for a calendar year, the calendar year premium received is 90.
- The unearned premium is the amount of the real premium received relating to the duration of the previous reporting period. In the example just given, an unearned premium of 30, intended to provide exposure for the first three months of the next reporting period, will be available at the end of the reporting period.
Advantages of Unearned Premium
Unearned premiums provide a number of advantages to insurance companies, including:
- Improved cash flow: Unearned premiums allow insurance companies to collect a lump sum of money upfront that can be used to pay expenses and other obligations as they come due. This can help to provide stability to the financial position of the company.
- Reduced risk: By collecting premiums in advance, insurance companies can reduce their risk of non-payment from clients. This helps to ensure that the company is not stuck with unpaid premiums.
- Increased efficiency: Unearned premiums can help insurance companies to streamline the collection process, as they can simply collect all of the premiums upfront before the policy period begins. This can help to reduce administrative costs and increase efficiency.
Limitations of Unearned Premium
Unearned premiums, while a useful and necessary calculation for the insurance industry, are not without their limitations. The following are the most common limitations associated with unearned premium:
- Unearned premiums do not take into account the cost of providing the insurance coverage. This means that the unearned premium calculation does not accurately reflect the actual cost of providing the insurance coverage and may not provide a true picture of the financial health of the insurance company.
- Unearned premiums also do not take into account any changes in the insurance industry or the market conditions. This means that the unearned premium calculation may not be an accurate reflection of the insurance company’s current financial situation.
- Unearned premiums also do not factor in any claims that may arise in the future. This means that the unearned premium calculation may not be an accurate reflection of the amount of money that an insurance company is likely to pay out in claims.
- Unearned premiums also do not take into account the risk associated with providing insurance coverage. This means that the unearned premium calculation may not be an accurate reflection of the amount of risk that an insurance company is taking on.
The following are some other approaches related to unearned premium:
- Premium Reserves - Premium reserves are an accounting method that companies use to balance out their premium income and expenses. Premium reserves are the amount of money set aside to cover future losses and expenses associated with the policies the company has written. Insurance companies will use the accrual method to set up a premium reserve account and hold money in it to pay future claims.
- Premium Deferrals - Premium deferrals are the process of postponing the payment of premiums until a future date. This is a common practice in the insurance industry and it allows customers to pay their premiums at a later date if they cannot pay them at the time of purchase.
- Premium Refunds - Premium refunds are a method used by insurance companies to return money to a policyholder if they have paid too much in premiums. Premium refunds are typically granted when a policyholder cancels their policy before the end of the coverage period or when the policyholder has overpaid their premiums.
In summary, there are several other approaches related to unearned premiums, including premium reserves, premium deferrals, and premium refunds. These approaches are used to balance out premium income and expenses, postpone payments, and return money to policyholders.
- Clerck S., Wickens T. (2014)., Government Finance Statistics Manual: Manual, International Monetary Fund, Washington, D.C., p. 328-329
- Dauber N., Shim J., Siegel J. (2012)., The Complete CPA Reference, John Wiley & Sons, p. 200
- Dionne G. (1992)., Contributions To Insurance Economics, Springer Science & Business Media, New York, p. 143
- Flood J. (2015)., Wiley GAAP 2015: Interpretation And Application Of Generally Accepted Accounting Principles, John Wiley & Sons, p. 1227
- Harris P., Cogan D. (2017)., Studies In The History Of Tax Law, Tom 8, Hart Publishing, US and Canada, p. 139
- Pohl S., Iranya J. (2018)., The ABC Of Reinsurance, VVW Gmbh, p. 113
- Robbins E., Bush R. (2014)., Tax Basis Assets And Liabilities Of U.S. Life Insurers, ACTEX publications, Winsted, p. 151, p. 319
Author: Wiktor Woźny