Throughout the process of an insurance company writing a policy, they analyze the chances of financial risks over the length of the contract.
The insurance term earned premium represents any premiums collected by an insurance company for the part of the insurance policy that has expired.
The insured party pays the premiums, and they are usually paid in advance while the policy is in effect.
Although premiums are often paid in advance, the insurance company doesn’t immediately record premiums as an earning.
As the insurer is covering you- the insured- throughout your policy period, the company assumes the premium payments made by the insurer are’ unearned premiums’ while the policy is active. Once the policy has expired, the insurers can record it as ‘earned premiums’ or simply as a profit.
Imagine if you bought a car and insured it, and then your vehicle is hit and damaged. The insurer will need to pay some money towards the repair of the damaged car.
This is why insurance companies will refer to any premiums on an in-date policy as unearned and earned once the policy has expired. If the contract has expired, and the insurance company is no longer considering any financial risks, that’s when the premiums become earned.
How Do Insurers Calculate Earned Premiums?
Over time the insurer changes the premium status from unearned to earned, which happens at an even rate throughout the duration of the policy. The insurance companies’ obligations to insure the policyholder ceases once the policy has ended or expired.
There are two methods that an insurer adopts to calculate earned premiums:
The Exposure Method:
The exposure method focuses on how premiums are exposed to losses over a given period. The method of working out the exposure level can be complicated. The reason is that it involves examining the portion of unearned premium exposed to loss over time.
Typically, an insurer will calculate this by determining the level of risk scenarios- from high-risk to low-risk. It’s done by analyzing historical data. After a thorough examination, they add the resulting exposure to the premiums earned.
The Accounting Method:
Unlike the exposure method, the accounting method is a lot easier to calculate and is the most commonly used method for earned premiums. The method is used to show earned premiums for the majority of insurers’ income statements.
To calculate, insurers will divide the total amount of premium by 365 and then multiple the rest by the days that have passed. For example, an insurer receiving a premium of $2000 on a policy that has been running for 200 days would have an earned premier of $547.95.
Formula: Premium Amount/365 X Days policy has been in effect.
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