The concept of how to record planned future earnings has been a problem that particularly impacts the insurance industry. Since the early 1980s, two methods have been traditionally used. Both are legal, but, according to Ernst and Young, the insurance giant in New York, the "eastern" method is preferred and is used primarily for tax purposes. The earned premium is what the firm expects to be paid over the course of the policy minus expected losses. How this is figured differs according to method.
The Western Method
An insurance firm can create an asset for itself. This is when it sells someone a policy. Like retail firms that are recording future sales as present income, an insurance company can decide whether the asset is "created" when the policy is billed, or when the income is actually realized. When the policy is written up, in the western method, no asset is created. Since no income or loss has yet been realized by the firm, nothing of financial significance is reported except that a policy was drawn up. As that point, the firm's balance sheet looks worse than it is.
The Eastern Method
A slightly more common method of figuring earned premiums is to consider the asset created upon the first billing. This means that real money has been made while the principle is still exposed to loss. In this case, at the first billing, the insurance firm then creates an "asset" for itself. It figures all future payments, or premiums, against any expected losses. The asset is recorded as realized income on the firm's balance sheet and must be taxed.
If the policy recorded on the eastern method is canceled, the asset then becomes false. It must be adjusted on the balance sheet of the firm both in terms of assets and liabilities attaching to the policy. At the same time, the western method is considered more accurate for day to day accounting, since no asset is created and no liabilities are figured on the sale of the policy. According to Ernst and Young, the IRS prefers the eastern method since all unrealized income is taxed. The western method is permitted, but only for those firms that have been using it for some time. A firm on the western method may go to the eastern, but a firm using the eastern method may not adopt the western.
The eastern method provides a method of figuring earned premiums because it takes all future payments as a single lump assets as against estimated losses. Over time, the eastern method will balance out, since unexpected or high losses will balance against policies that record no claims at all. Assuming the cancellation rate is low, the eastern method provides a far more accurate measure of the health of the firm since it speaks to its present clientele and their future commitments. The IRS seems to think that using the western method might serve as a way to hide income and hence discourages it -- the method can give a false picture of the firm and its clientele.
- "Federal Income Taxation of Property and Casualty Insurance Companies"; The Ernst & Young Corporation; 1996
- USA Coverage: Earned Premium
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