Accounting for prepaid insurance with fully quoted annual premiums

August 13, 2013

Organizations purchase insurance to obtain protection from unforeseen events and to “share” the cost of potential losses with other entities. Insurance can cover business, auto, health and workers’ compensation losses, among others. In this article, we will look at situations when insurance companies quote an annual premium for coverage and how this is accounted for.

1. Example of fully quoted annual premiums recorded as prepaid assets

Assume an insurance company provides a quote for an annual coverage for business interruption insurance to Company ABC. The quote indicates the annual premium is $120,000 with $10,000 payable monthly on the 15th of each month.

Even though this appears to be a simple transaction from an accounting standpoint, it may not be so. And here is why. Some companies account for the full quoted premium at the beginning of the coverage period by recording a prepaid asset of $120,000 and an insurance accrual of $120,000.  As payments are made monthly, 1/12th of the $120,000 is (a) amortized as insurance expense (to record insurance expense for the month) and (b) is removed from the insurance accrual (to reflect the fact that a monthly payment has been made). Companies utilize this way of recording insurance premiums to keep track of how much premium has been amortized to expense and how much of remaining annual premium is kept in the accrued liability account. The table below shows how this way of recording insurance premium amounts affects the balance sheet:

Company ABC
Balance Sheet as of Beginning of Month 1

Current assets

   

Current liabilities

 

Prepaid insurance

$120,000

 

Insurance accrual

$120,000

 

Company ABC
Balance Sheet as of End of Month 1

Current assets

   

Current liabilities

 

Prepaid insurance

$110,000

 

Insurance accrual

$110,000

 

Company ABC
Balance Sheet as of End of Month 2

Current assets

   

Current liabilities

 

Prepaid insurance

$100,000

 

Insurance accrual

$100,000

The journal entries which the company records are show below.

When an annual insurance quote is obtained at the beginning of Month 1:

Account Titles

Debit

Credit

Prepaid Insurance

$120,000

 

     Insurance Accrual

 

$120,000

When the first payment is made on the 15th of Month 1:

Account Titles

Debit

Credit

Insurance Accrual

$10,000

 

     Cash (or Accounts Payable)

 

$10,000

When the second payment is made on the 15th of Month 2:

Account Titles

Debit

Credit

Insurance Accrual

$10,000

 

     Cash (or Accounts Payable)

 

$10,000

The monthly payments continue until Month 12 at which point the prepaid insurance and insurance accrual are reduced to zero. At any point in time, management can see how much is left to be paid in monthly premium payments for the coverage year.

Unfortunately, this approach of recording insurance premiums creates inflates assets and liabilities because the company only pays $10,000 per month.  The company does not have a prepaid asset at the end of a month because the company only pays for the current month and that entire payment should be expensed when paid. Further, the company does not have a liability at the end of a month because any incurred insurance costs for that month is paid during the month.

The company should only record prepaid assets when they exist or record liabilities when there is an obligation. A more appropriate way to record insurance amounts would be as follows:

When an annual insurance quote is obtained at the beginning of Month 1:

No entry should be recorded as this point because the company has not made any payments and has not incurred any liabilities as of yet. The payment will take place on the 15th and a liability will be incurred as time passes during the month (i.e., as insurance coverage is being provided).

When the first payment is made on the 15th of Month 1:

Account Titles

Debit

Credit

Insurance Expense

$10,000

 

     Cash (or Accounts Payable)

 

$10,000

When the second payment is made on the 15th of Month 2:

Account Titles

Debit

Credit

Insurance Expense

$10,000

 

     Cash (or Accounts Payable)

 

$10,000

This correct approach results in no prepaid asset or insurance accrual.

In the end, however, note that either approach would result in the correct amount of insurance expense recorded in the income statement. It’s the balance sheet which will have differences under the two approaches described above.

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