What is prepaid insurance?
The term prepaid insurance refers to payments made by individuals and businesses to their insurers in advance for insurance coverage or services. Full annual premiums are usually paid upfront, but in some cases can cover more than 12 months. When they are not used or expire, these payments show up on an insurance company’s balance sheet. as current assets.
How does prepaid insurance work?
Prepaid cost is the expense paid by a company or individual before use. Prepaid insurance is considered a prepaid cost. When a person buys prepaid insurance, the contract usually covers a period in the future. For example, many auto insurance companies operate prepaid programs, whereby insured parties pay their premiums in full over 12 months before coverage begins. The same goes for many health insurance companies: they would prefer to be paid upfront before they start covering. Some insurers prefer that insured parties pay under a prepaid schedule, such as auto or medical insurance.
This is how an insurance company accounts for prepaid insurance. As mentioned above, premiums or payments are recorded in one accounting period, but the contract is not applied until a future period. An insurance company’s balance sheet is referred to as prepaid cost as a current asset until it is depleted. This is because most prepaid assets are spent within a few months of signing up. When insurance coverage becomes effective, it is transferred from an asset and charged to the costs side of the company’s balance sheet. However, insurance coverage is often spent over multiple periods. In this case, the company’s balance sheet may record the corresponding charges as expenses.
If an insurance claim is not filed, the policyholder generally renews the prepaid insurance shortly before the expiration date on the same terms and conditions as the original insurance contract. However, premiums may be slightly higher to account for inflation and other operating factors.
key takeaways
- Prepaid insurance is payments made to insurers in advance for insurance coverage.
- Insurance companies have prepaid insurance as current assets on their balance sheet because they don’t run out.
- When insurance coverage takes effect, it becomes an asset and is charged to the cost side.
- Policyholders may renew coverage shortly before the expiration date under the same terms and conditions as the original insurance contract.
Special Considerations
Prepaid insurance is generally considered a current asset because it is converted to cash or used up in a relatively short period. But if a prepaid cost is not incurred within a year of payment, it becomes a long-term asset, which is not uncommon. Paying the cost of insurance is similar to cash at the bank: as that money is used, it is withdrawn from the account each month or accounting period.
Example of prepaid insurance
To illustrate how prepaid insurance works, let’s say a business pays an insurance premium of $2,400 on November 20 for the six months December 1 through May 31. Payment is entered on November 20 with a debit of $2,400 for prepaid insurance and a credit of $2,400 in cash. As of November 30, none of the $2,400 had been spent and all of the $2,400 will be reported as prepaid insurance. But that changes once coverage begins. On December 31, an adjusted entry will show the debit insurance cost for $400 (the amount due or one-sixth of $2,400) and credit the prepaid insurance by $400. This means the debit balance on insurance is $2,000 prepaid on December 31. This equates to five months of unspent insurance at $400 per month or five-sixths of the cost of the $2,400 insurance premium.
