What Is Prepaid Insurance?
The term prepaid insurance refers to payments that are made by individuals and businesses to their insurers in advance for insurance services or coverage. Premiums are normally paid a full year in advance, but in some cases, they may cover more than 12 months. When they aren't used up or expired, these payments show up on an insurance company's balance sheet. as a current asset.
How Prepaid Insurance Works
A prepaid expense is anexpenditurethat a business or individual pays for before using it. Prepaid insurance is considered a prepaid expense. When someone purchases prepaid insurance, the contract generally covers a period of time in the future. For instance, many auto insurance companies operate under prepaid schedules, so insured parties pay their full premiums for a 12-month period before the coverage actually starts. The same applies to many medical insurance companies—they prefer being paid upfront before they begin coverage.
Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance.
Here's how an insurance company accounts for prepaid insurance. As mentioned above, the premiums or payment is recorded in oneaccounting period, but the contract isn't in effect until a future period. A prepaid expense is carried on an insurance company's balance sheetas acurrent assetuntil it is consumed. That's becausemost prepaid assets are consumed within a few months of being recorded.
When the insurance coverage comes into effect, it is moved from an asset and charged to the expense side of the company's balance sheet. Insurance coverage, though, is often consumed over several periods. In this case, the company's balance sheet may show corresponding charges recorded as expenses.
Unless an insurance claim is filed, prepaid insurance is usually renewable by the policyholder shortly before the expiry date on the same terms and conditions as the original insurance contract. However, the premiums may be marginally 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 carry prepaid insurance as current assets on their balance sheets because it's not consumed.
- When the insurance coverage comes into effect, it goes from an asset and is charged to the expense side.
- Policyholders can renew coverage shortly before the expiry date on the same terms and conditions as the original insurance contract.
Special Considerations
Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time. But if a prepaid expense is not consumed within the year after payment, it becomes along-term asset, which is not a very common occurrence. The payment of the insurance expense is similar to money in the bank—as thatmoney is used up, it iswithdrawn from the account ineach month oraccounting period.
Example of Prepaid Insurance
To illustrate how prepaid insurance works, let's assume that a company pays an insurance premium of $2,400 on November 20 for the six-month period of December 1 through May 31. The payment is entered on November 20 with adebitof $2,400 to prepaid insurance and a credit of $2,400 to cash. As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance. But that changes once coverage begins.
On December 31, anadjusting entrywill show a debit insurance expense for $400—the amount that expired or one-sixthof $2,400—and will credit prepaid insurance for $400. This means that the debit balance in prepaid insurance on December 31 will be $2,000. This translates to fivemonths of insurance that has not yet expired times $400 per month or five-sixthsof the $2,400 insurance premium cost.
