An unearned premium arises due to the fact car insurance companies require advance payment of all premiums. Even if one chooses the installment option, premiums are payable in advance. If one opts for monthly premiums, the sum payable becomes due on the 1st of the month. One will have to pay the monthly premium on May 1st to enjoy coverage until May 31st. The premium will become due again on June 1st and must be paid to extend policy coverage until the end of June. Auto insurance coverage commences from the payment date and continues up to the date the next payment or premium is due. On day zero, the entire premium received by the company is unearned premium.
Let us assume an imaginary car insurance policy where coverage for 365 days costs $1200. The daily premium earned by the insurance company amounts to $3.30. The total premium earned upon the expiration of 240 days will be $789. The unearned premium will be $3.30 x 125 days (365 days - 240 days) or $411.
Car insurance companies keep track of unearned premiums carefully because they represent the amount against which the company may have to pay a claim to the insured. If no claim has been filed for 240 days by the insured, the premium for 240 days, less administrative expenses on the policy, constitutes profit earned by the insurer. There always is a possibility of loss on unearned premiums.
The unearned premium is the car owner's money in the hands of the insurer and must be refunded if the policy is terminated before the original tenure of the policy ends. If the policy has been in force for half of its original tenure when it is terminated by the insured, the remaining half of the premium should be refunded to the car owner.
Most insurance companies charge cancellation fees when policies are terminated in advance. Car owners must compare the fee deducted with the refund amount before deciding to terminate the policy in advance. Losing up to 10% of the money as a cancellation charge is reasonable. Anything more and it makes sense for the car owner to wait before terminating the policy prior to its due date.
Determining the unearned premium on any policy can become complicated if riders and other payments are not considered. This may reduce the unearned premium on the policy and may also reduce the refund amount due after deduction of charges.
It is advisable to go through the terms and conditions of the policy to understand how this figure is calculated and how the amount will be refunded. Most companies follow the direct deposit method to refund the unearned premium.