Net premium is the amount received or written on insurance policies when premiums are incurred or paid, and return premiums are deducted from gross premiums.
Net premium can be referred to as the present value of policy benefits less the present value of premiums payable in the future. Hence, net premium does not consider any expenses expected in the future for policy maintenance.
Net premiums are also called benefit premiums.
Net premium is the resultant amount after the gross premium is adjusted for the expenses related to the maintenance of insurance policies.
The net premium of a policy does not consider future expenses and is sometimes called a benefits premium.
Net premium also helps to determine the amount of state taxes owed by insurance companies.
Net Premium Formula
PV = Present Value
The net premium calculation is based on the net loss function. The company experiences losses if the present value of the benefits paid is more than the present value of the future premiums received by the company. On the other hand, it earns money if the present value of benefits is less than the present value of future premiums.
If the company does not include expenses, then the loss function is called the net loss function. The expenses associated with the insurance policies include legal expenses for settlement, commission to agents selling the policies, taxes, and administrative expenses.
Gross Premium, Net Premium, and Earned Premium
Gross premium and net premium are used to define the income that insurance companies earn for taking the risks associated with insurance contracts. Policyholders pay premiums to cover the insurance bought as a form of protection from financial loss.
Gross premium is the amount expected to be received by the insurer over the life of the policy term. Suppose that for a one-year car insurance policy, a policyholder pays $5,000. This implies that the gross premium for that year is $5,000.
Net premium is referred to as income earned by insurance companies less the expenses associated with the policy. Insurance companies generally buy reinsurance policies that help protect the insurers by paying claims against large and disastrous losses.
The reinsurance policy amount paid is subtracted from the gross premium to get the net premium, which will be more than the gross premium if the present value of the expense loading is more than the future expense value.
Earned premium applies to the portion of the insurance policy that has already expired. Insurance policies are usually paid in advance; however, insurers can earn premiums in installments throughout the term of the policy.
As net premium indicates the amount the insurer has already secured in coverage, insurance policies paid in regular installments can affect the net premium.
Net Premiums and Tax Rules
Like all other businesses, insurance companies are liable to pay federal tax and provincial tax. The premiums received or written on insurance contracts are also subject to premium taxes imposed by the federal and state governments.
The premium taxes imposed by states on gross premiums are a form of sales tax. The maximum premium tax is 4%, while the most common one is 2.5%. In addition to the state premium tax, municipalities may impose a premium tax.
Furthermore, the state premium taxes increase the price of insurance products, resulting in a decrease in demand. Net premium is calculated from the gross premiums and expenses incurred for maintaining the policy. Hence, both the net premium and gross premium are important in the calculation of taxes owed the insurance companies.
Insurance companies may be allowed to add back unearned premiums and expenses to lower the gross premium, thus reducing the taxes payable. The estimation of allowed added back expenses is determined by the legal and other expenses related to the policy.