Prepaid insurance refers to premiums for insurance that are paid in advance. A premium is a regular, recurring payment made to a provider for the benefit of having insurance coverage. Typically, premiums are paid monthly.
Insurance providers may allow a business to pay multiple monthly premiums in advance, in the form of one lump sum. The payment may represent six or twelve months of premiums. For the insurance company, it generates more working capital and greater customer retention.
In exchange, the insurance company usually offers the customer a discount on the premium price, so the business saves money on the policy.
Prepaid insurance also creates other benefits for the business. It is considered a prepaid asset, which is a way to express these benefits in accounting terms. An asset is any resource that has monetary value.
A prepaid asset is a type of asset that has economic value to the business because of its future benefit.
Prepaid insurance is considered a prepaid asset because it benefits future accounting periods. It relieves them of the monthly premium expense, and in doing so, reduces their costs, while at the same time still conferring the benefit of having coverage for the business.
Prepaid insurance is also considered an asset because of its redeemable value. Any remaining prepaid portion of the premium could be redeemed or refunded to the business if the business cancels the policy before the period covered by those premiums has expired.
For example, if a business had purchased six months of insurance and decided to cancel the policy after two months, it could redeem the value of the four remaining unused months of coverage. In other words, it could get a refund of the premiums for those four months. This is a source of future cash revenue for the business. In this way, prepaid insurance has economic value, not unlike an investment in stocks or bonds, that can be redeemed at a later time.
Prepaid insurance is recorded in the general ledger as a prepaid asset under current assets. A current asset is a financial resource that can be easily liquidated, or converted to cash, in a year or less. In contrast, a non-current or fixed asset, like real estate, cannot be easily liquidated in a year or less.
The full value of the prepaid insurance is recorded as a debit to the asset account and as a credit to the cash account. Each month, as a portion of the prepaid premiums are applied, an adjusting journal entry is made as a credit to the asset account and as a debit to the insurance expense account.
In this way, the asset value of the prepaid insurance will be reduced to zero at the end of the time period which was paid for in advance. Similarly, the expense will reach the total of the prepaid amount at the end of that same period.
For example, if a business prepaid its insurance one year in advance, and the premiums were equal to $1,000 per month, it would make one payment of $12,000 to the insurance carrier (12 months X $1,000/month = $12,000).
That payment would be recorded as a prepaid asset of $12,000. It would be entered into the general ledger as a debit of $12,000 to the asset account and a credit for the same amount to the cash account.
Each month, the business’s accounting department would make an adjusting journal entry of $1,000, representing the amount of one month’s premium payment in the general ledger. It would be entered as a credit in the asset account and as a debit to the insurance expense account.
At the end of twelve months, the asset account would show a balance of zero for the insurance premium and a total of $12,000 in the insurance expense account.
Prepaid insurance is important because a business should correctly record all of its transactions and resources to have accurate financial statements.
Recording prepaid insurance as an asset and adjusting that asset as the policy is consumed on a monthly basis ensures that the business is accurately recording the true value of the policy over time, and in particular, how paying for the policy in advance affects the business’s finances from one month to the next.
The most important calculation regarding prepaid insurance reflects the unexpired portion of the policy.
If a business has paid for six months of insurance in advance and two months have passed, the remaining unexpired portion of the policy would be expressed as 6-2 = 4.
The business’s records would show four months of insurance policy as a current, prepaid asset.
Prepaid insurance is considered a debit on the asset account because it is a resource that will diminish over time.
As the policy is consumed from month to month, the policy’s value for those months will be recorded as a credit, and the entries in the two columns will eventually cancel out or total zero.