Definition - What does Earned Premium mean?
The earned premium refers to that portion of an insurance policy’s premium that applies to the expired portion of the policy. Policyholders usually pay their premiums in advance. However, insurance companies do not immediately account for these premiums in their earnings. Rather, they earn the premium at even rates throughout the term of the policy. Therefore, the portion of premium that applies to the expired portion of the policy becomes the earned premium. Similarly, the portion of premium received that applies to the remaining term of the policy becomes the unearned premium reserve.
Insuranceopedia explains Earned Premium
Insurance companies do not treat the premium that policyholders pay as an earning as soon as they receive it. In their view, the payment of the premium often means that the policyholders have fulfilled their side of the bargain and met their obligations. At the same time, they recognize that they still need to fulfill their obligations toward the policyholders. This is why they treat all premiums they receive as unearned premiums initially.
With the passage of time, the insurer incrementally changes the premium status from ‘unearned’ to ‘earned’. This happens at an even rate throughout the term of the policy. Their obligations as an insurer cease once the policy reaches its expiry date. On that date, the entire premium becomes a part of their profits.
Insurers typically calculate earned premiums in the following ways.
- The Accounting Method: Here, insurers divide the total premium by 365 and multiply this by the number of days that have elapsed. For instance, consider a premium of $365 applicable for a year’s coverage. In this situation, the earned premium for 100 days would be $100 i.e. $365/365 x 100 = $100.
- The Exposure Method: This method focuses on the exposure level of premiums to losses over a given period. As such, it involves calculating the portion of unearned premium exposed to loss during the period. Insurers typically calculate this by examining different risk scenarios (i.e. from high risk to low risk) from their historical data. Thereafter, they apply the resulting exposure to premiums earned.