Following on from our glossary series of insurance terms and methods in which we outlined Claims Loss Ratio and Combined Ratio, I would like to take a look at the concept of Earned Premium and give you a few examples as to the usage, importance and pitfalls when working with it.
In this article I investigate Earned Premium in the following ways:
- What is Earned Premium?
- Why is Earned Premium important? Why bother?
- Calculating Earned Premium
- More advanced calculations.
- Common mistakes and how to avoid them
Most insurance policyholders would probably assume that when they pay a premium their Insurers can immediately class this as premium income and incorporate this into their company accounts.
In reality Insurers to do not do this as they only class a premium as being Earned when it is based on the amount of time which has actually elapsed under a contract for an insurance policy.
Whilst policyholders pay premiums for their insurance up front, the Insurer must earn the premium by exposing itself to the risk on behalf of the Insured.
Within the accounting systems used by insurers the Earned premium can be counted as part of the profit for a given accounting period while the unearned premium cannot.
For this reason, it is very important for insurance companies and their agents to put software in place to easily calculate Earned Premium.
Earned premium is also often used to calculate Insurers’ loss ratio where total losses for a period are divided by the Earned premium for the corresponding period.
Without determining Earned Premium, the true profitability of any insurance operation cannot be determined, which is why the savvy insurer doesn’t leave home without his Earned Premium report.
To determine Earned premium, we need to look at the length of the policy, and determine how much time has already elapsed.
Earned Premium = Total Premium / 365 * Number of Days Elapsed
For example if a 365 day policy with a full premium payment at the commencement of the insurance has been in effect for 180 days, 180/365 of the premium can be considered as being Earned. This will also mean that 185/365 of the premium would have to be considered unearned.
The same rules apply for policies with a term of more than one year, if someone paid a premium for two years of home insurance and 18 months has elapsed the Insurance company has Earned three quarters the premium.
Note that in leap years you will need to use 366 and not 365 in the formula above.
Instead of using days elapsed it’s also possible to use whole months to calculate Earned Premium. So for instance, if 3 whole months of a two year (24 month) policy have elapsed, the calculation would be as follows. Thanks for George for pointing this out in the comments!
Earned Premium = Total Premium / Full Policy Term in Months * Number of Months Elapsed
i.e. Earned Premium = Total Premium / 24 * 3
There are two different methods for calculating earned premiums, an accounting method and an exposure method.
The accounting method is highlighted above and is the more commonly used and is frequently used by Insurers in their corporate income statements.
Under the exposure method, Earned premiums are calculated based on the percentage of total premium that was exposed to loss during the period being calculated and does not take when the premium was actually collected into account.
It’s easy to calculate Earned Premium providing you have the right tools. Often we’ve seen mistakes made during manual calculation of Earned Premium or through oversights in Excel spreadsheets. We would always recommend using software to avoid mistakes and make Earned Premium a cornerstone of automatic reporting across your entire operation, but maybe we’re biased!
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