What is prepaid insurance?
The term prepaid insurance refers to payments made by individuals and companies to their insurers in advance for insurance coverage or services. Full annual premiums are generally paid in advance, but in some cases they can cover more than 12 months. When unused or expired, these payments show up on an insurance company’s balance sheet. as a current asset.
How prepaid insurance works
Prepaid cost is the expense that a business or individual pays before use. Prepaid insurance is considered a prepaid cost. When a person purchases prepaid insurance, the contract generally covers a period of time in the future. For example, many auto insurance companies operate prepaid programs, whereby insured parties pay their full premiums over a 12-month period before coverage begins. The same is true for many health insurance companies – they would prefer to be paid in advance before they start to cover.
Some insurers prefer that the insured parties pay according to a prepaid program, such as medical or auto insurance.
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This is how an insurance company accounts for prepaid insurance. As mentioned above, the premiums or payment are recorded in an accounting period, but the contract does not apply until a future period. The balance sheet of an insurance company is called a 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 takes effect, it is transferred from an asset and charged next to costs on 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 are not depleted.
- When insurance coverage goes into effect, it goes from an asset and is charged next to costs.
- Policyholders can renew coverage shortly before the expiration date on the same terms and conditions as the original insurance contract.
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Special Considerations
Prepaid insurance is generally considered a current asset, because it is converted to cash or used in a relatively short period of time. But if a prepaid cost is not incurred within the year after payment, it becomes a long-term asset, which is not uncommon. Paying the cost of insurance is similar to cash in the bank: As that money is used, it is withdrawn from the account in each month or accounting period.
Prepaid insurance example
To illustrate how prepaid insurance works, suppose a business pays an insurance premium of $ 2,400 on November 20 during the six-month period from December 1 to May 31. Payment is entered on November 20 with a $ 2,400 prepaid insurance debit and a $ 2,400 cash credit. As of November 30, none of the $ 2,400 has 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 cost of the debit insurance for $ 400 (the amount due or one-sixth of $ 2,400) and will credit the prepaid insurance at $ 400. This means that the debit balance on the insurance is of $ 2,000 prepaid on December 31st. This equates to five months of unspent insurance at $ 400 per month or five sixths of the cost of the $ 2,400 insurance premium.
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