Prepaid insurance is a key financial term often used in accounting and insurance. It refers to the portion of an insurance premium that is paid in advance for future coverage.
Businesses typically record prepaid insurance as an asset on their balance sheets because it represents a service (insurance protection) that will be consumed in the future.
What is Prepaid Insurance?
Prepaid insurance refers to an insurance premium paid before coverage starts. Generally, premiums are paid yearly, and the coverage is valid for that particular year. However, some insurance companies allow customers to pay premiums for multiple years. The premium collected in advance is called ‘prepaid insurance’.
The insurance company records the advance payment as a ‘current asset’ in its balance sheet until the coverage kicks in. The insured person records it as a prepaid expense in their books of accounts.
Is Prepaid Insurance an Asset- Key Highlights
Here are some essential features of prepaid insurance that you must know before understanding its calculation and accounting.
- Advance Payment: Prepaid insurance is an expense paid by the insured person before it becomes due.
- Accounting Treatment: Until the insurance coverage starts, the advance payment is recorded as a 'prepaid expense' on the asset side of the insured person's balance sheet. The insurance company records it under 'current assets' in its balance sheet until the coverage is consumed.
- Amortization: According to the matching principle used in accounting, an expense is recorded when the corresponding benefit of that expense is enjoyed. So, the prepaid insurance recorded in the balance sheet is amortized based on the coverage's applicability.
- Renewal Premium: The premium paid in advance is used to renew the policy.
Benefits of Prepaid Insurance
Prepaid insurance offers several advantages to help individuals and businesses manage their finances more effectively.
- Cost Savings: Some insurance providers offer discounts for prepaid insurance premiums, which can help you save money compared to paying in installments.
- Improved Cash Flow Management: Prepaying insurance can help businesses and individuals allocate funds more efficiently, avoid frequent smaller payments, and improve overall cash flow planning.
- Uninterrupted Coverage: Prepayment of insurance premiums eliminates the risk of missing payments and losing coverage. You get continuous protection for the entire prepaid period.
- Simplifies Accounting: Prepaid insurance is recorded as an asset and expensed gradually, ensuring accurate financial reporting and reflecting the true cost over time.
Also read: Tax Benefits in Life Insurance
How to Calculate Prepaid Insurance?
You must calculate the prepaid insurance amount to record the correct expenses and maintain proper financial records. Here's a step-by-step guide explaining how to calculate prepaid insurance.
- Determine the total insurance premium: Find out the total amount paid for the insurance coverage.
- Identify the coverage period: Determine the length of the insurance coverage, typically in months or years.
- Calculate the monthly expense: Divide the total insurance premium paid by the number of months in the coverage. This will provide you with your monthly insurance expense.
- Record the expense for the current year: Multiply the monthly insurance expense by the number of months remaining in the current accounting year. This amount will be reflected in your profit and loss account as a business expense.
- Record the prepaid amount: The difference between the insurance payment made and the insurance expense for the current year is your 'prepaid insurance'. This amount will be reflected in your balance sheet as an asset.
How to Calculate Prepaid Insurance?
This prepaid insurance calculation example will help you understand the above method better.
B Ltd paid an insurance premium of ₹1,20,000 on 1 April 2024, which was for two financial years. The company's monthly insurance expense is ₹5000 (₹1,20,000 divided by 24 months). The company would record ₹60,000 (₹5000 x 12 months of financial year 24-25) as a business expense. The balance ₹60,000 would be recorded as prepaid insurance for the next financial year.
Bottom Line
Paying your insurance premium in advance can be beneficial due to the discounts offered by insurance companies. It also results in better financial and cash flow management. However, you must learn how to calculate prepaid insurance to track insurance costs effectively. Individuals and businesses can ensure that their financial records reflect true expenses over time by understanding how to properly account for prepaid insurance.
FAQs on Prepaid Insurance
What is the accounting equation for prepaid insurance?
The accounting equation for prepaid insurance follows the basic formula: Assets = Liabilities + Equity. When prepaid insurance is recorded, it increases assets and is later expensed over time, impacting the profit, which is a part of equity.
How to expense prepaid insurance?
Prepaid insurance is recorded as a current asset. The insurance premium related to each accounting period is expensed in that period.
How do you calculate the value of prepaid insurance?
Divide the insurance premium paid by the months it covers to compute a monthly insurance cost. To calculate your insurance expense, multiply this monthly cost by the number of months in the current accounting period. The balance payment is the prepaid insurance.
What type of account is prepaid insurance?
Prepaid insurance is classified as a current asset on the balance sheet. It represents a benefit (insurance coverage) that a company will receive in the future.
Is Prepaid Insurance a Current Asset?
Prepaid insurance is usually considered a current asset. However, if the prepaid amount extends beyond one year, the portion used after one year may be classified as a long-term asset.