The term prepaid insurance refers to payments that are made by individuals and businesses to their insurers in advance for insurance services or coverage. Premiums are normally paid a full year in advance, but in some cases, they may cover more than 12 months. When they aren't used up or expired, these payments show up on an insurance company's balance sheet. as a current asset.
How Prepaid Insurance Works
A prepaid expense is anexpenditurethat a business or individual pays for before using it. Prepaid insurance is considered a prepaid expense. When someone purchases prepaid insurance, the contract generally covers a period of time in the future. For instance, many auto insurance companies operate under prepaid schedules, so insured parties pay their full premiums for a 12-month period before the coverage actually starts. The same applies to many medical insurance companies—they prefer being paid upfront before they begin coverage.
Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance.
Here's how an insurance company accounts for prepaid insurance. As mentioned above, the premiums or payment is recorded in oneaccounting period, but the contract isn't in effect until a future period. A prepaid expense is carried on an insurance company's balance sheetas acurrent assetuntil it is consumed. That's becausemost prepaid assets are consumed within a few months of being recorded.
When the insurance coverage comes into effect, it is moved from an asset and charged to the expense side of the company's balance sheet. Insurance coverage, though, is often consumed over several periods. In this case, the company's balance sheet may show corresponding charges recorded as expenses.
Unless an insurance claim is filed, prepaid insurance is usually renewable by the policyholder shortly before the expiry date on the same terms and conditions as the original insurance contract. However, the premiums may be marginally higher to account for inflation and other operating factors.
Key Takeaways
- Prepaid insurance is payments made to insurers in advance for insurance coverage.
- Insurance companies carry prepaid insurance as current assets on their balance sheets because it's not consumed.
- When the insurance coverage comes into effect, it goes from an asset and is charged to the expense side.
- Policyholders can renew coverage shortly before the expiry date on the same terms and conditions as the original insurance contract.
Special Considerations
Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time. But if a prepaid expense is not consumed within the year after payment, it becomes along-term asset, which is not a very common occurrence. The payment of the insurance expense is similar to money in the bank—as thatmoney is used up, it iswithdrawn from the account ineach month oraccounting period.
Example of Prepaid Insurance
To illustrate how prepaid insurance works, let's assume that a company pays an insurance premium of $2,400 on November 20 for the six-month period of December 1 through May 31. The payment is entered on November 20 with adebitof $2,400 to prepaid insurance and a credit of $2,400 to cash. As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance. But that changes once coverage begins.
On December 31, anadjusting entrywill show a debit insurance expense for $400—the amount that expired or one-sixthof $2,400—and will credit prepaid insurance for $400. This means that the debit balance in prepaid insurance on December 31 will be $2,000. This translates to fivemonths of insurance that has not yet expired times $400 per month or five-sixthsof the $2,400 insurance premium cost.
FAQs
Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time. But if a prepaid expense is not consumed within the year after payment, it becomes a long-term asset, which is not a very common occurrence.
How does prepaid insurance work? ›
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.
What are the benefits of prepaid expenses? ›
Prepaid expenses are expenses that are bought or paid for in advance, and may include things like insurance, rent, utilities, and subscriptions. Individuals benefit from prepaid expenses to make sure they will not miss payments for things like health insurance.
What is an example of a prepayment? ›
Examples of prepayment include loan repayment before the due date, prepaid bills, rent, salary, insurance premium, credit card bill, income tax, sales tax, line of credit, etc.
Which of the following is an example of a prepaid expense? ›
Prepaid expenses are expenses that will occur in the future but are paid for upfront. The most common prepaid expense examples are rent and insurance.
Is prepaid insurance an example of deferred expense? ›
Defining Deferred Revenue and Deferred Expenses
Deferred expenses, similar to prepaid expenses, refer to expenses that have been paid but not yet incurred by the business. Common prepaid expenses may include monthly rent or insurance payments that have been paid in advance.
How do you record prepaid insurance on a balance sheet? ›
How to record prepaid expenses
- Make the payment for the prepaid expense. The first step is to make the payment for the prepaid expense on the company's balance sheet. ...
- Enter it into an accounting journal. ...
- Debit the asset account. ...
- Expense a portion on the income statement. ...
- Repeat the process.
Prepaid insurance is the insurance premium that businesses pay during an accounting period that did not expire within that business period. Accountants view the insurance that businesses prepay as an asset. If companies use the coverage within a year after purchase, prepaid insurance is a current asset.
What is prepaid expenses in simple words? ›
Prepaid expenses are amounts paid in advance by a business in exchange for goods or services to be delivered in the future. They usually relate to the purchase of something that provides value to the business over the course of multiple accounting periods.
Why do people use prepaid? ›
Any money you spend with a prepaid card is deducted from your card balance, not your bank account. You can spend only the amount you load or “prepay” onto the card. You don't need a bank account to use prepaid cards, which is why they appeal to people who are unable to access traditional banking.
Prepaid expenses are payments made for goods or services that will be received in the future. Examples include prepaid rent, insurance premiums, and subscription fees. They are recorded as assets on a company's balance sheet until the benefit is received or the expense is incurred.
What are the two types of prepayments? ›
They can be categorized into two groups: Complete Prepayments and Partial Prepayments. A complete prepayment involves payment for the full balance of a liability before its official due date, whereas a partial prepayment involves payment for only a part of a liability's balance.
Is prepayment an income or expense? ›
Prepaid expenses are not recorded on an income statement initially. Instead, prepaid expenses are first recorded on the balance sheet; then, as the benefit of the prepaid expense is realized, or as the expense is incurred, it is recognized on the income statement.
What has prepayment risk? ›
Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When debtors return part of the principal early, they do not have to make interest payments on that part of the principal.
What type of account is prepaid insurance? ›
Generally, Prepaid Insurance is a current asset account that has a debit balance.
What type of account is prepaid insurance classified as? ›
Asset. Prepaid insurance is an asset account as it represents the advance amount paid by a firm to the insurer for the insurance services of the upcoming fiscal period.
Is prepaid insurance an example of a current asset quizlet? ›
Prepaid Insurance is an example of a current asset. Cash and other assets that may reasonably be expected to be realized in cash, sold, or consumed through the normal operations of a business, usually longer than one year, are called current assets.
Is prepaid insurance an asset quizlet? ›
Prepaid expenses, such as prepaid rent and prepaid insurance, represent assets for a business until they are used.
