What is Prepaid Insurance?

Prepaid insurance is premium payments made to insurers in advance for insurance coverage or services. As it is not consumed, insurers keep prepaid insurance as current assets on balance sheet. Prepaid insurance is charged to the expense side when the insurance cover comes into effect. Insurance premiums are generally paid in advance for an entire year. Premiums can cover for more than one year in some cases.

How does Prepaid Insurance Work?

Prepaid insurance refers to the premium expense made in advance by the proposer. The proposing firm will record the transaction as a prepaid expense, as the actual contract may begin later.

For example, cab companies may pay a premium for a full 12 months’ coverage in advance and record the payment as a prepaid expense in their books. The coverage may come into force from the next financial year.

The insurance company on the other hand will record all the premiums collected before the commencement of the contract as current assets. The reason is usually due to the short gap of only a few months at maximum before the contract begins and the premium is consumed.

What are the Characteristics of Prepaid Insurance?

Prepaid insurance is a type of insurance where the premium amount is paid well in advance of the coverage period.

Examples of Prepaid Insurance

An example of prepaid insurance could be an exporting firm which sends goods to various countries. The firm is working on advanced orders received from its buyers and has a roaster for the number of goods to be shipped. The firm can pay an insurer an advance premium for all the goods they expect to manufacture and ship through the year.

However, the insurance cover for the goods will not start until they are manufactured. For instance, the manufacturer is producing 20,000 t-shirts per month and expects to produce 200,000 t-shirts throughout the year. The total value of the goods is Rs 4 crores the firm ships the t-shirts every three months.

So, the stored goods must be insured for at least 3 months before they are shipped. The firm decides to pay Rs 50,000 as an advance premium for the whole year. While one contract for the quarter will commence immediately, three other contracts will commence at a gap of 3, 6 and 9 months from now.

Thus, the insurer will register the entire premium as a current asset and will continue to deduct premium amounts every quarter. The premiums for each quarter may change based on the declared stored quantity by the firm.