Revenue recognition in Insurance Sector
Revenue recognition in the insurance sector is little daunting at first sight. However, you can grasp the concept easily if you ponder on the below content. There are 3 key items to understand in this article. These are GWP, UPR and EP. Details are below.
Gross Written Premium (GWP)
GWP is the amount which has been charged to the customer for issuance of a policy (but not necessarily recognized as a revenue). GWP is booked once an insurance company issues insurance policy (or in more technical words, when an underwriter underwrites the policy).
In most of the cases, the insurance policies are issued for 1 year. GWP is full policy premium and is booked at full insurance premium for the policy. For example, if a health insurance policy is issued worth $ 1,000.00, the insurance company shall pass following accounting entry.
Debit: Gross Written Premium
Credit: Customer account
It is worth noting that GWP account will not be considered as revenue for the entity. Rather the revenue is determined/considered GWP net off UPR (read below).
Gross Unearned Premium Reserve (GUPR)
Gross UPR refers to the portion of the GWP which has not yet been recognized as income in the statement of comprehensive income. Therefore, it is referred to as ‘unearned premium’ or UPR.
You will appreciate the fact that insurance premium is recognized as income with the passage of time. As the time passes/days pass, premium is transferred from GWP to EP. Because insurance premium relates to a particular period (normally 1 year). So the full premium cannot be recognized as income/earned premium upon receipt. It is similar to rental income. Rental income is also recognized as earned income with the passage of time.
Debit: Unearned Premium account (P&L)
Credit: Unearned Premium Reserve account (Balance sheet)
Gross Earned Premium (GEP)
This is the amount of the premium which has been recognized as a revenue in the books of the accounts of the insurer.
There are two ways to calculate net earned premium.
- Earned premium is calculated by subtracting Unearned Premium Reserve (UPR) from GWP. In it’s simplest terms, subtract any GWP which is not yet earned from total GWP to reach at the earned premium.
- Second way is to calculate proportionate GWP on a timely basis to reach at EP. Let’s say that a policy is booked on 1 January amounting to $1,000. Now, with the passage of every month, 1 month GWP would be recognized as earned premium. So gradually, UPR shall keep decreasing and EP would keep increasing, with the passage of time. By the end of the year i.e., 31 December, full $1,000 would be recognized as earned income/earned premium.
Whatever the approach you follow to reach at earned premium, the amount of answer should be same. These are just two different approaches to arrive at the same figure.
Now, let’s take a look at a detailed example of how figures are recognized over a period of 1 year in insurance income. The company’s financial year runs from 1 January till 31 December. Let’s take the example of an insurance policy which is issued on first day of the company’s financial year i.e., 1 January for a gross premium of $1,000.
On the first day, GWP amount would be booked as $1,000 and this amount will remain same throughout the year in this account. GWP amount will not change at any time during the year. This amount once booked, would remain same for this policy (unless there is any addition, deletion or other adjustment which we are not discussion in this article).
So, the accounting entry on morning of 1 January will be:
Debit: Client account (B/S) $1,000
Credit: Gross Written Premium (GWP) account (P&L) $1,000
However, at this point of time, full premium amount is unearned. Therefore, a reserve of the same amount shall be created as follows:
Debit: Unearned Premium account (in P&L) $1,000
Credit: Unearned Premium Reserve account (in B/S) $1,000
However, on the end of first day, 1 day’s premium shall be recognized as income because 1 day has passed and now insurer is entitled to reverse 1 day’s premium from its UPR reserve. This will lead to recognition of 1 day’s income as earned premium. The amount of 1 day’s premium is $2.74 ($1,000 / 365 * 1).
Debit: Unearned Premium Reserve (B/S) $2.74
Credit: Unearned Premium (P&L) $2.74
On the end of the day of 1 January, UPR reserve amount in the balance sheet will be $997.26 ($1,000 minus 2.74).
After 3 months, on 1 April, a total of 91 days premium would be recognized as income. These days is calculated as this: 31 days January + 28 days February + 31 days March + 1 day April = 91 days.
The accounting entry will be debit:
On 1 October, company recognize premium of 274 days out of 365 days of the premium. These are calculated as follows: 31 days January + 28 days February + 31 days March + 30 days April + 31 days May + 30 days June + 31 days July + 31 days August + 30 days September + 1 days October = 274 days.
At the end of the year, on the evening of 31 December, full policy premium of $1,000 would be recognized as earned premium. There would not remain any amount in the unearned premium for this policy.
Reinsurance Ceded Premium
Ceding literally means giving up, leaving it out or surrendering something. From the term ‘ceded premium’ it seems that this premium has been just given to someone else. This is not fully wrong. This was the premium which was an insurance company’s collection from the policy holder but the insurance company rendered it to someone else.
Ceded premium is the premium which an insurance company to another insurance company (a reinsurance company, more appropriately) to share the risk of an insurance contract. This means that a part of the insurance risk has been transferred to another insurance company (a reinsurer) in return for the ceded premium.
Let’s take a simple example of reinsurance ceded premium:
Let’s say that an insurer Conservative Insurance Company underwrites a policy for a Big Fat LLC client. Total policy premium is $1,000 and sum insured is $50,000. Now, Conservative Insurance Company feels that this is a big risky policy and they want to transfer some of the risk to Helper Insurance Company by transferred them 25% of the premium and 25% of the risk.
So, in this case, reinsurance ceded premium will be $2500 (25% of $100,000). The accounting entry to record RI GWP will be as follows:
Debit: RI GWP account (P&L) $250
Credit: Reinsurer’s account (B/S) $250
If you think that Reinsurance Ceded Premium has only 1 name, then think again please because it is also referred to as “Reinsurance Premium” or “ceded premium” or “R.I premium” or “reinsurer’s share of premium” or “Reinsurer’s Share of Gross Written Premium” or simply “RI GWP”. All these terms are used interchangeably for the same thing.
The more an insurance company cedes premium to its reinsurers, the less risky it’s business becomes. However, it also loses money in the sense that it has to share the premium with someone else (with reinsurer). But reinsurance is very common in insurance sector and it may not be wise to retain all the risks of every policy with you.
Net Written Premium
Gross Written Premium minus Reinsurance ceded premium is equal to net written premium.
Reinsurer’s Share of Unexpired Risks (RI UPR)
Reinsurer’s Share of Unexpired Risks or RI UPR refers to the portion of the premium which is paid/to be paid to the reinsurer but which has not yet been recognized as expense in the insurer’s books of accounts.
At the time of policy issuance, a reserve shall be created for RI UPR for the full amount of RI GWP. Let’s continue the above example of $1,000 policy and 25% reinsurer’s share. On 1 January, below entry shall be passed for RI UPR immediately upon policy issuance which will be equivalent to RI GWP:
Debit: RI UPR account (B/S) $250
Credit: RI UPR account (P&L) $250
The above entry shall ensure that on policy issuance, RI GWP and RI UPR are equal and there is no expense on this arrangement. However, as first day will pass, 1 day’s RI UPR shall be reversed leading to recognition of 1 day’s RI GWP as incurred expense.
Debit: RI UPR account (P&L) $0.685
Credit: RI UPR account (B/S) $0.685