A liability for unearned premium revenue is recognized at the inception of a contract. If the entire contractual premium is received at inception (i.e., an "upfront" contract), the initial unearned premium revenue liability is measured as the amount received.
For contracts where premium payments are received over the period of the contract (i.e., an "installment" contract), a receivable for future premiums is established at inception, and the initial unearned premium revenue liability is measured as the amount of the premium receivable. The premium receivable is determined as the present value of contractual premiums due or, if certain criteria are met, as the present value of premiums expected to be collected. Under either method, the discount rate should reflect the risk-free rate at the inception of the contract.
The discount on the premium receivable is accreted through earnings over the contractual period or the expected period that the insured obligation will be outstanding. The unearned revenue liability is not accreted with interest because, unlike the premium receivable, it is not a financial instrument. The liability is instead a stand-ready obligation of the insurer which is measured at the consideration received at inception of the contract. ASC 944
does not prescribe where the accretion of the premium receivable should be recorded in earnings. Accretion may be classified as part of premium revenue, investment income, or a separate line item in the income statement, with disclosure of the company's accounting policy.
In certain instances, the expected period of risk may be less than the contractual risk period due to expected prepayments of the insured obligation. This may occur when insured obligations are contractually prepayable, as is often the case with structured securities including securitizations relating to securitized mortgage loans. An expected contract period may be used to determine the initial receivable and unearned premium revenue liability only if a homogeneous pool of assets underlying the insured financial obligation is contractually prepayable. In that circumstance, prepayment assumptions may be used to determine an expected contract period if prepayments are probable and their timing and amount can be reasonably estimated. Companies should develop and maintain sufficient documentation to support the assertions that an insured obligation has a homogenous pool of underlying assets that are contractually prepayable, and that expected prepayments are probable and their timing and amount are reasonably estimable. The use of prepayment assumptions to determine an expected contract period is an accounting policy decision that must be elected for similar types of contracts. It is not available as a contract-by-contract election.
Use of an expected contractual period is not appropriate for individual callable insured financial obligations because an underlying pool of homogenous assets does not exist. Therefore, incorporating expectations of a future "refunding" of a traditional municipal bond to replace it with a new financial obligation, which is often done to obtain a lower interest rate, is not permitted.
When premiums are received in installments and the period outstanding is estimated based on expected prepayments, the premium receivable asset and unearned premium revenue liability are adjusted when prepayment assumptions change. The premium receivable asset is recalculated based on current prepayment assumptions and the current risk-free rate, and an adjustment is made for the difference between this revised balance and the balance based on original assumptions. An equal adjustment is made to the unearned premium revenue liability, resulting in no effect on earnings at the time of the adjustment. The revised unearned premium revenue liability is recognized in earnings using a newly computed constant rate. ASC 944-310-55-1
provides an example of a change in prepayment assumption.
When premiums are received in installments and contractual, rather than expected, obligation payments are used to measure the unearned premium liability, the premium receivable asset and unearned premium revenue liability are adjusted to reflect any expected reduction in premium receivable because of early principal payments as they occur. The premium receivable asset is recalculated based on remaining contractual principal and the current risk-free rate, and an adjustment is made for the difference between this revised balance and the balance based on original contract terms. An equal adjustment is made to the unearned premium revenue liability, resulting in no effect on earnings at the time of the adjustment.
This guidance applies to early principal payments of insured obligations relating to contracts with installment premium payments, and it equates the adjustment to the unearned premium revenue liability with the adjustment made to the premium receivable asset. ASC 944
does not provide specific guidance on how early principal payments of insured obligations relating to contracts with single premiums paid at inception (and, therefore, no premium receivable asset) should affect the unearned premium revenue liability and related premium revenue recognition. We believe that premium revenue should be recognized in proportion to the amount of insurance protection provided, and insurance protection provided is assumed to be a function of the insured principal amount outstanding. Therefore, if the principal amount outstanding has decreased, an acceptable approach would be to record a credit to earnings for the difference between the existing unearned premium revenue liability and the amount of unearned premium revenue liability that would have existed had the early principal payment been known at inception of the contract (i.e., a retrospective cumulative catch-up type of adjustment). This adjustment to the unearned premium revenue liability would be reflected in premium revenue.
Premiums receivable should be adjusted for uncollectible premiums with a corresponding adjustment to earnings. Uncollectible premiums must also be considered in the recognition and measurement of the claim liability. The guidance assumes that the contract cannot be cancelled because of non-payment of premium. Therefore, adjustment for uncollectible premiums represents a current-period bad debt expense that should not be offset by an adjustment to the unearned premium revenue liability. The unearned premium revenue liability represents the insurer's stand-ready obligation to perform under the contract. As this obligation is not reduced by non-payment of premium, no adjustment should be made to the unearned premium revenue liability. However, in certain limited situations, the contract may provide for a reduction in the claim payment amount to the extent of any uncollectible premium, which would be netted in the claim liability.