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4.2 Premium recognition and unearned premium liability
Publication date: 30 Sep 2020
us Insurance guide
Insurance entities charge premiums as compensation for providing insurance protection over the contract period. Written premium is the total amount that a policyholder is required to pay under the insurance contract absent a cancellation. Earned premium is the amount an insurance entity has recognized as revenue for the coverage provided under the insurance contract to date. Premium revenue is typically earned over the contract period in proportion to the amount of insurance protection provided, with an unearned premium liability recognized representing the unexpired portion of premiums in force as of a particular financial statement date.
In certain commercial lines policies, the amount of premiums can change during the contract period due to endorsements, audit premiums, retrospective premium adjustments, and cancellations. The same principle of recognizing premium revenue in proportion to the amount of insurance protection provided applies to the premium adjustments.
- Endorsements are amendments to existing insurance contracts that change the scope or terms of the original insurance policy. Endorsements may include lowering or raising the coverage limits and/or deductibles as well as the addition or removal of insured risks (e.g., adding a new insured vehicle to an automobile policy), which will typically affect the policy premiums. Endorsements may also be needed for certain administrative changes (e.g., changing the insured’s mailing address), which would typically not affect the policy premiums.
- Audit premiums are adjustments to the policy premium to accurately reflect the insurance exposure under the contact. Periodic premium audits are performed on policyholders’ records (e.g., employee payroll data for a workers’ compensation insurance policy or vehicle count for a commercial automobile insurance policy) in order to update the existing premium estimate to reflect the premiums for the actual exposures under the contract.
- Retrospective premium adjustments are adjustments to the premiums subsequent to the effective date of the contract, and typically subsequent to the coverage period, based on the actual claims experience of the contract.
- Cancellation is the termination of an existing policy prior to the expiration date of the contract. Cancellations may be initiated by the insurance entity because of nonpayment by the insured or may be requested by the insured when insurance protection is no longer needed. Policy premiums refunds upon a cancellation will typically be based on the number of days the insurance policy was effective, subject to a cancellation penalty if applicable.
4.2.1 Written premium and unearned premium
Although not explicitly required by ASC 944, many insurance entities present written premium as an income statement line item reflecting the sales effort in the period along with the change in unearned premium in order to reconcile to premium revenue earned.
4.2.1.1 Premiums payable in installments
When premiums are paid at the inception of a contract, an unearned premium liability is recognized. There is no specific authoritative guidance on the timing of balance sheet recognition for uncollected written premiums or unearned premiums for contracts with premiums payable in installments. In practice, many insurers writing annual contracts with periodic installment payments present all contractual premiums, regardless of whether earned or due as of the balance sheet, as a premium receivable with a corresponding written premium and unearned premium liability. An alternative view is that because the premium receivable is conditional (the policyholder has the right to cancel the policy and discontinue future payments), written premium and unearned premium should not be recorded until each installment payment is due. Based on existing diversity in practice and the lack of specific authoritative guidance, either view is acceptable as long as the policy decision is applied consistently.
Example IG 4-1 demonstrates the two alternatives for the recognition of written premium and unearned premiums for contracts with premiums payable in installments.
EXAMPLE IG 4-1
Recognition of written premium and unearned premium liability for contracts with premiums payable in installments
Recognition of written premium and unearned premium liability for contracts with premiums payable in installments
Insurance Company enters into a one-year automobile insurance policy effective on January 1, 20X1 with an annual premium amount of $1,600 that is payable in quarterly installments of $400 starting at contract inception with no finance charge.
How may the written premium and unearned premium liability be recognized at contract inception and at March 31, 20X1?
Analysis
Method 1: Premium receivable recorded with offsetting unearned premium liability for total written premium
At contract inception (January 1, 20X1), Insurance Company would record the following journal entries.
Dr. Cash |
$400 |
|
Dr. Premium receivable |
$1,200 |
|
Cr. Unearned premium liability |
$1,600 |
|
Dr. Change in unearned premium* |
$1,600 |
|
Cr. Written premium* |
$1,600 |
|
* Optional income statement entry to record written premium as a separate financial statement line item, which nets to zero |
||
At March 31, 20X1, Insurance Company would record the following journal entry.
Dr. Unearned premium liability |
$400 |
|
Cr. Earned premium (or Change in unearned premium*) |
$400 |
|
* Optional financial statement line item utilized when recording written premium |
||
On the balance sheet as of March 31, 20X1, Insurance Company would have cash or investments of $400, premium receivable of $1,200 and unearned premium liability of $1,200 related to this policy (ignoring any claim activity). On the income statement for the period ending March 31, 20X1, Insurance Company would have earned premium of $400.
Method 2: Record unearned premium liability as premium is due
Alternatively, at contract inception (January 1, 20X1), Insurance Company would record the following journal entry.
Dr. Cash |
$400 |
|
Cr. Unearned premium liability |
$400 |
At March 31, 20X1, Insurance Company would record the following journal entry.
Dr. Unearned premium liability |
$400 |
|
Cr. Earned premium |
$400 |
On the balance sheet as of March 31, 20X1, Insurance Company would have only cash or investments of $400 related to this policy (ignoring any claim activity). No premium receivable or unearned premium liability would be recorded until the next installment payment is due on April 1, 20X1. On the income statement for the period ending March 31, 20X1, Insurance Company would have earned the same $400 premium as under the written premium method.
4.2.2 Short-duration contracts — premium revenue recognition
ASC 944-605-25-1 provides guidance on the recognition of premium revenue.
Premiums from short-duration contracts shall be recognized as revenue over the period of the contract in proportion to the amount of insurance protection provided. For those few types of contracts for which the period of risk differs significantly from the contract period, premiums shall be recognized as revenue over the period of risk in proportion to the amount of insurance protection provided. That generally results in premiums being recognized as revenue evenly over the contract period (or the period of risk, if different), except for those few cases in which the amount of insurance protection declines according to a predetermined schedule.
As required by ASC 944-605-25-1, premiums are recognized as revenue evenly over the contract period or the period of risk, if significantly different, in proportion to the amount of insurance protection provided. Straight-line recognition over the coverage period is the primary practice. However, in certain seasonal and aggregate excess of loss coverages (i.e., coverage of total claims that exceed a certain threshold in a period), an uneven pattern of insurance protection can be supported, which would result in a different pattern of premium recognition. For example, wind storm protection can be considered seasonal even though most coverage is for the full year. There are two schools of thought on aggregate excess of loss contracts. Some consider the coverage to have risk over the whole period for a yet to be determined portion of each claim in the period and thus recognize premium evenly over the entire period. Others consider the risk covered to be concentrated in the later part of the period when the threshold for coverage is more likely to be exceeded.
Question IG 4-1 addresses premium revenue recognition on a multi-year contract as coverage is partially used by incurred claims.
Question IG 4-1
How is premium revenue recognized for a multi-year short duration contract, when coverage is depleted as losses are incurred? For example, how would premium revenue be recognized for a three-year contract with an annual premium of $500,000, and an aggregate coverage limit of $3,000,000 over the three years?
How is premium revenue recognized for a multi-year short duration contract, when coverage is depleted as losses are incurred? For example, how would premium revenue be recognized for a three-year contract with an annual premium of $500,000, and an aggregate coverage limit of $3,000,000 over the three years?
PwC response
It depends. If no losses occur, premiums should be recognized as revenue on a pro rata basis as the coverage expires (e.g., on a straight-line basis over the three-year period with $500,000 premium revenue recognized in year one). If losses are incurred and the coverage is diminished, premiums should be recognized as revenue proportionate to the coverage used. For example, if a loss of $2,000,000 occurs in year one, two-thirds of total contractual premiums ($1,000,000) should be recognized as revenue in year one.
ASC 944-605-25-2 provides premium revenue recognition guidance for policies in which premiums are subject to adjustment based on claim experience or based on the value of the insured property (e.g., retrospectively rated or other experience-rated insurance contracts). If the ultimate premium can be reasonably estimated, the estimated ultimate premium is recognized as revenue over the contract period. Conversely, if the ultimate premium cannot be reasonably estimated, the cost recovery method or the deposit method is utilized until the ultimate premium becomes reasonably estimable. Under the cost recovery method, premiums are recognized as revenue in an amount equal to estimated claim costs as insured events occur until the ultimate premium is reasonably estimable, and recognition of income is postponed until that time. Under the deposit method, the portion of premiums subject to adjustment is not recognized as revenue and claim costs are not charged to expense until the ultimate premium is reasonably estimable, and recognition of income is postponed until that time. At each reporting period, the estimated ultimate premium is updated to reflect current experience.
4.2.3 Short-duration contracts — premium deficiency
ASC 944-60 requires the recognition of a loss when an entity expects a loss on insurance policies based on current cash flow assumptions in excess of recorded amounts. For short-duration contracts, a loss is recognized when expected claim and claim adjustment costs, expected dividends, unamortized acquisition costs, and maintenance costs for the unexpired portion of the contract exceed unearned premium. See IG 7.2 for further information on premium deficiencies for short-duration contracts.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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