Understanding Tax Treatment for Unearned Premiums in Insurance

Insurance companies primarily generate revenue through the premiums paid by their customers. These premiums represent the cost of purchasing various types of insurance, such as medical, auto, home, or life coverage. Determining the premium cost is based on the level of risk associated with each type of coverage, which is calculated by actuaries. The total premiums customers are required to pay during a specific period are known as written premiums. Insurance premium revenue is earned over the term of the policy.

• Unearned premiums represent an insurance company’s liability for the unexpired portion of policies in-force.
• Advance premiums represent an insurance company’s liability for premiums received for future policy periods.

For tax purposes, insurance companies are required to reduce the deduction for the unearned premium and advance premium liabilities by 20% on the tax provision.

Why is the Deduction for Unearned Premium and Advance Premium Reduced?

The Tax Reform Act of 1986 (the Act) envisioned creating a more uniform tax structure for insurance companies, changing several rules related to their taxation. Congress determined that deferring unearned premium income while currently deducting premium acquisition costs attributable to unearned premiums resulted in a mismatch of an insurance company’s net income and expense for tax purposes.  

Rather than defer the deduction for premium acquisition costs attributable to unearned premiums, Congress elected to reduce the tax deduction for unearned premiums and advance premiums by 20%. The acceleration of income that is typically generated by the 20% reduction of unearned and advance premiums is intended to be roughly equivalent to denying the current deductibility for the portion of the insurance company’s premium acquisition costs allocable to the unearned premiums.

Tax Implications of Unearned Premium and Advance Premium

In the U.S. Internal Revenue Code (IRC) section 832(b)(4) calculates the unearned and advance premium tax deduction at 80%. 

The tax rule for unearned premiums can sometimes present an unexpected scenario for insurance companies experiencing growth. As the unearned premium balance increases, the required tax adjustment may result in a tax liability even if a company’s book income is low. The tax impact, however, represents a temporary timing difference. It is tracked in the deferred tax inventory and eventually the adjustment will be favorable to the taxpayer when the unearned premium balance decreases.

Understanding how unearned premiums can impact an insurance company’s tax provision is essential to prevent unexpected surprises. Contact the Johnson Lambert tax team today with your tax inquiries.