Prepaid Insurance Explained
Prepaid insurance requires you to pay your premium before receiving the financial benefits of the policy. Insurers commonly offer prepayment for many types of insurance, including auto and homeowners insurance.
Insurance companies often offer incentives to customers who prepay their premiums, but this type of plan requires making a large lump-sum payment. Learn how prepaid insurance works, and about its advantages and disadvantages.
- When you prepay your insurance premium, you pay for your policy in full in advance, and receive the coverage over a specified period following the payment.
- Prepaying and monthly installments are the more common ways to pay an insurance premium.
- Prepaying your insurance premium may qualify you for a reduced rate or a discount.
What Is Prepaid Insurance?
Prepaid insurance is coverage you pay for in full before you receive its benefits. For example, if you take out a mortgage to buy a new home, the lender may require you to pay a one-year homeowners premium at closing. When the policy goes into effect, you’ll then get the benefits of the coverage over a 12-month period.
How Prepaid Insurance Works?
In accounting, prepaid insurance is a type of prepaid expense. Other types of prepaid expenses can include:
- License renewals
- Maintenance contracts
- Protection plans
You must pay prepaid expenses upfront before you receive any type of benefit. For example, you might buy a one-year magazine subscription and receive one magazine per month for 12 months.
Important: Prepaid insurance works similarly to many products or services you pay for fully in advance. If you pay a six-month premium for a car insurance policy, the coverage will protect your automobile from the effective date until it’s time to renew the policy
Prepaid Expense Accounting
Prepaid insurance is a future expense, which you must pay upfront and receive its benefits over time. Prepaid insurance is an expenditure. However, once you make the premium payment, the policy’s coverage becomes an asset, which diminishes over time during the coverage period.
If you keep a ledger, enter the prepaid insurance payment as both a debit and credit. Let’s say you purchase a one-year home insurance policy for $1,200. Here’s how you will account for the expenditure and asset.
Throughout the home insurance policy’s term, you will reduce the value of the asset. For example, the $1,200 prepaid policy will reduce in value by $100 each month, which you adjust in your ledger.
Pros and Cons of Prepaid Insurance
Like all financial products, prepaid insurance has both advantages and disadvantages to consider.
- Discounted premiums
- No monthly payment
- Lump-sum payment
- Cancelation hassles
- Lower premiums: Many insures give you the option to make monthly payments for auto and home insurance policies. However, some providers offer a lower rate for paying premiums in full. If you can afford to make a lump-sum payment for a six- or 12-month policy, you could qualify for discounts and/or pay fewer fees, depending on the carrier. Some providers also offer a discount for paying your premium in two payments rather than monthly installments.
- No monthly payments: Another advantage to making one lump-sum payment is that you will not have to worry about making regular monthly payments. You can plan your monthly budget without the additional expense once you’ve prepaid.
- Lump-sum payment: Prepaying an entire premium requires making a large lump-sum payment, which may be difficult for some people, depending on their cash flow. For example, some homeowners may have difficulty paying a $1,500 annual home insurance premium in a single payment. However, many providers offer monthly installment payment plans for car and homeowners insurance.
- Cancellation hassles: Paying monthly premium installments can make the cancellation process easier. For instance, if you decide to switch to a new carrier, you can time the change according to your billing cycle.
Prepaying your insurance premium might complicate the cancellation process. For example, if you pay your $1,500 annual home insurance premium in one payment, then sell your house six months into the policy’s term, the insurer will have to refund the unused premium. Although providers do issue prorated refunds, you may have to wait days or weeks to receive the money.
When canceling an insurance policy, you may incur a cancellation fee.
Alternatives to Prepaid Insurance
While prepayment and monthly billing are standard ways to pay an insurance premium, some auto insurance companies offer pay-per-mile policies.
Note: Pay-per-mile car insurance policies vary by provider. Some charge a daily rate plus a mileage rate. For instance, you might pay $1.50 each day you drive plus $0.06 per mile. Other insurers charge a monthly insurance fee plus mileage. For example, you may pay a monthly fee of $30 plus $0.06 per mile.
Since your mileage varies from month to month, pay-per-mile programs do not offer a prepay option, only monthly billing.
Tip: Pay-per-mile car insurance policies are designed to benefit customers who maintain low annual mileage, such as people who work from home, are stay-at-home parents, or are retirees.
The Bottom Line
Prepaid insurance is when you make one or two large payments in advance and receive the benefits of coverage throughout the policy’s term. It is a simple way to pay for coverage, but requires making a large payment rather than more-affordable monthly installments.
Prepaid insurance is attractive to some policyholders who can afford it because it often offers incentives such as premium discounts. Keep in mind it might take you a bit longer to cancel a policy that was prepaid.
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