# How to calculate Earned Premium example

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.

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.

## Why is Earned Premium important? Why bother?

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.

Alternative method:

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

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.

## Common mistakes and how to avoid them

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!

## Feedback

As ever we absolutely thrive on your questions and feedback. Leave us a comment below!

1. Julie Kippin says:

Must admit I thought that the premium was earned as soon as it was paid – very useful article

2. Sam Davies says:

Not what I thought at all – presumably unearned is the part for the year that is still to run then ?

1. Yes Sam, exactly that. Obviously for policies with a term shorter or longer than a year, Unearned Premium is still the part of the premium for the whole period that is left to run, whether that’s 2 years, 5 years or 7 days.

3. George says:

I have also seen earned premium calculated with the 1/24 method. Can you add this to your article and explain how that would work?

1. Thanks George, well spotted! I’ve updated the article with an ‘Alternative Method’ in section 3. Let us know what you think.

4. Benny says:

How does agent commissions and policy expenses affect earned premiums? Example a a 1500 premium is paid for long term insurance.. The agent get 50% commission and the policy cost to execute is \$300. After the year is up, would the earned premium be \$1500, \$750, or \$450?

1. Liza says:

that´s the question i’m looking the answer for as well!! somebody knows? i think it depends for what purpose u calculate it? For reserving calculation (IBNR) as an exposure measure u’d better not sustract expenses and comission not to bias the exposure, for Loss ratios, comission ratios, expence ratios or combined ratios – as well – it doesn´t make sense! In your example, Comission ratio is 750/1500=50%, not 750/(1500-750), expense ratio is 300/1500, etc.

2. Wayne James says:

It depends on the length of policy duration, for long-term insurance you would expect the premium to earn very slowly using a formula that is specific to the risk and duration of the policy. In your example however you only have \$750 to start with and to earn as premium but you would probably have deferred commission and released this over the term of the policy using exactly the same earnings rule.

5. Ben Thompson says:

How do you calculate earned premium for a mid term adjustment? Do you still divide by 365 days ?

1. Hi Ben,

No, you would use the effective date of the alteration as the base date not the original inception date of the policy.

So for that policy you would earn premium on the original and the extra charge for the MTA

Colin

6. Naomi says:

How would you work out from the annual accounts whether the majority of business is written in the first half or second half of the year? Is there a calcualtion?

1. Wayne James says:

You can’t, you would have to know how the business’ contracts are written which is very specific and different across companies, also depends on how the business is written, via coverholders or direct etc…

2. Wayne James says:

Forgot to mention, if the company published interim accounts you could find out easily…

7. bill says:

since claims are lagging, how would you adjust for this – say on a quarterly basis to calculate loss ratios ie loss/earned premium.

would you use reserved, paid…?

Hey, please elaborate 1/24 method for general insurance policy? Also, how to apply 1/24 for calculation of earned pertaining to previous year?

9. AZIZ says:

Unearned contributions reserves in takaful insurance

10. Nani says:

How to difference between earn premium and direct premium. Pls explanation and example.

1. Wayne James says:

Being careful about terminology here… The earned loss ratio is the claims incurred divide by the earned premium, in this context I take claims incurred to mean the amount charged through profit and loss, actuaries will tell me that incurred claims only means paid plus outstanding claims but I mean it to include the charge for claims expected to come through int relation to the expired risk period, which means for those that are interested to include IBNR.

11. Jacolene says:

Hi. Unearned premium reserve. Is it only when we have received the actual money in advance that we have a liability.

1. Wayne James says:

No. You can have an unearned premium reserve even when you have collected no cash. The written premium reflects a contractual entitlement to premium and can be written well before receipt of any money, the unearned premium reserve is calculated against the written premium according to rules around the risk type and duration. If other words, if you are showing gross premium in your income statement that relates to risks extending beyond the reporting period then you should have an unearned premium reserve in the balance sheet to effect the unearned, or unexpired portion of the premium.

12. travor says:

What happens in a period of tight liquidity and debtors are generally high? This has the effect of earned premiums having not been collected by the insurer and might never be collected actually because if the period under cover passes a client can choose to go to another insurer.

13. Laurie says:

I’m not sure I agree your 1/24 method. It doesn’t refer to 24 months, it’s on a year. If you only have premiums in months rather than days, you assume half the premiums are in earned in each half month. January premium therefore is 1/24 unearned, 23/24 earned at the end of the calendar year. Conversely December premiums are only 1/24 earned at the end of December.

14. Daniel says:

Thta’s assuming that risk is uniform over the year (policy duration).

But how could be earned (unearned) premium calculated assuming that the underlying risk is not uniform?