What Is Net Premium?
Let me explain net premium to you directly—it's an accounting term in the insurance industry, calculated as the expected present value (PV) of an insurance policy’s benefits minus the expected PV of future premiums. This calculation doesn't include future expenses for maintaining the policy.
You should know that net premiums, along with gross premiums, are what insurance companies use to figure out their state tax obligations.
Understanding Net Premium
An insurance policy's net premium value isn't the same as its gross premium value, which does account for future expenses. The difference between net premium and gross premium is the expected PV of expense loadings minus the expected PV of future expenses. So, if the value of future expenses is less than the PV of those expense loadings, the policy’s gross value ends up less than its net value.
Keep in mind that some states' tax laws let insurance companies reduce their gross premium by accounting for expenses and unearned premiums.
Net Premium Tax Laws
Since the net premium calculation skips expenses, companies have to determine how much expense they can add back without taking a loss. They must account for expenses like commissions to agents, legal costs from settlements, salaries, taxes, clerical costs, and other general expenses.
Commissions usually vary with the policy’s premium, but general and legal expenses might not tie directly to the premium.
Estimating Allowable Added-Back Expenses
To estimate those allowed expenses, a company can add a fixed amount to the net premium—what we call flat loading—or add a percentage of the premium, or even combine a fixed amount with a percentage.
When you're comparing policies with different net premiums, adding a fixed amount leads to the same proportion of expenses to premiums as long as expenses vary proportionally to the premium. The method you choose depends on how general and legal expenses relate to commissions on the premium.
Most policy calculations include a margin for contingencies, like when investment returns from premiums are lower than expected.
Importance of Net Premium
Net premiums and gross premiums are key for calculating what an insurance company owes in taxes. State insurance departments tax company income, but tax laws might allow reductions by factoring in expenses and unearned premiums. In the United Kingdom, insurers use an annual premium equivalent (APE) to determine premium revenue.
For instance, if Ohio taxes gross premiums written by its insurance companies but excludes amounts deducted for reinsurance and unearned premiums from canceled policies, that's how it works in practice.
Who Pays Net Premium?
Policyholders are the ones who pay the insurance premiums, whether they're individuals or part of a group. These premiums cover the costs of insurance for individuals or businesses.
What Is the Difference Between Net Premiums and Net Premiums Earned?
Net premiums include written premiums minus commissions and ceded reinsurance—it's a measure of the dollar amount of policies written. Net premiums earned, on the other hand, measures the actual dollars received from premiums sold.
What Is a Premium Tax Credit?
A premium tax credit (PTC) is a refundable credit that helps families pay for health insurance premiums bought through the Health Insurance Marketplace.
The Bottom Line
Net premiums are a crucial metric for insurance companies to determine their tax obligations and stay compliant with tax laws. By using both net and gross premiums, companies can manage their accounting more effectively.
Key Takeaways
- Net premium is an insurance industry accounting term.
- The formula to arrive at the net premium is the expected present value (PV) of an insurance policy’s benefits minus the expected PV of future premiums.
- Net premium and gross premium are useful in calculating the amount of state taxes an insurance company needs to pay.
- Some states' tax laws allow insurance companies to reduce the amount of their taxable gross premium by adding back expenses.
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