What Are Unearned Premiums?
Let me explain what unearned premiums are directly to you. An unearned premium is the amount of premium that covers the remaining time on your insurance policy. In simple terms, it's the part of the premium you paid that the insurance company hasn't 'earned' yet because the policy hasn't expired.
You'll see unearned premiums listed as a liability on the insurer's balance sheet. That's because if you cancel the policy, they have to pay that portion back to you.
Take this example: If you have a five-year insurance policy that's fully prepaid at $2,000 per year, at the end of the first year, the insurer has earned $2,000, and the unearned premium stands at $8,000.
Key Takeaways
- Unearned premium is the portion of the policy premium that has not yet been 'earned' by the insurance company because the policy still has some time before it expires.
- Provisions in the insurance contract govern the terms for unearned premium.
- In certain circumstances, an insurance company may not have to issue a refund for unearned premium.
Understanding Unearned Premiums
You need to understand that unearned premiums are the parts of total premiums an insurance company collects in advance. If you end your coverage before the term is up, these may be returned to you. This could happen if your insured item is a total loss and you no longer need coverage, or if the insurer cancels the policy.
Consider this scenario: You pay your auto insurance premium for a full year in advance, but four months in, your vehicle is completely destroyed. The company keeps one-third of the premium for the coverage provided and returns the remaining two-thirds as unearned premium.
The terms for unearned premiums are set by provisions in your insurance contract, and they must comply with regulations in the area where the coverage applies. There might be a specific formula required for calculating the unearned amount.
Remember, the premium you pay isn't immediately counted as earnings by the insurer. In some cases, they don't have to refund unearned premiums—for instance, if you falsified information on your application. Your policy will outline the conditions for getting back the unearned portion.
Insurers might not return unearned premiums if you terminate coverage without a good reason, like switching to another provider. I advise you to wait until near the end of your current coverage period before switching companies.
However, if you can prove the provider didn't honor the policy terms, they should refund any unused premium portion.
Unearned Premium vs. Earned Premium
Let me contrast unearned premium with earned premium for you. Earned premium is the pro-rated amount of prepaid premiums that the insurer has 'earned' and now owns. It represents the total premiums collected over a period that correspond to coverage already provided.
In other words, earned premium covers the time the policy was in effect but has now passed. Since the company covered the risk during that period, they count those payments as earned.
Example of Unearned Premium
Because canceling a policy often involves refunds, unearned premiums show up as liabilities on the insurance company's balance sheet.
Here's an example: An insurance company receives $600 on January 27 for coverage from February 1 to July 31. As of January 31, that $600 isn't earned yet. They record it in their cash account and as a current liability in the unearned premium revenue account. As they earn the premium over time, they move the earned amount from liability to revenue on their income statement.
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