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Context: insurance, accounting, actuarial science

Unearned premiums, along with outstanding claims, is a component of policy liability for an insurance company. Unearned premiums refer to the portion of the premiums that a policyholder has been paid to the company, but has not been earned by the company in an accounting sense.

Two concepts are needed in order to understand why unearned premiums exists:

  1. At least traditionally, policyholders pay the insurance company an amount of money at the beginning of the year (called the policy year) for insurance protection over the next twelve months. Although pay-by-the-month insurance now exists in the market, the same principle applies: policyholders pay at the beginning of a period for coverage over a period.
  2. In accural accounting systems, money received does not equal to money earned. Money is earned only when a measurable stage of completion of a transaction.

Concept 2 means that premiums are not earned at the beginning of the period, when the policyholder pays the money, but rather earned throughout the period covered by the insurance policy. Generally, this means that premiums are earned equally throughout the year: if the policyholder paid x, then x/12 is earned each month. However, sometimes this is not the case.

Consider bushfire insurance. Given that more bushfires (and hence more claims) occur during the summer months, then the insurance company would earn more of the premium received in the summer months than in the winter months. In this case, unearned premiums would decrease faster during the summer months (as more is earned) than in the winter months.

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