Insurance Expense

Insurance expense is the portion of the cost of insurance policies that relates to the current accounting period. Businesses buy many kinds of coverage, including property, general liability, product liability, vehicle, business interruption, cyber and directors' and officers' insurance. Premiums are usually paid in advance for six or twelve months, so at the time of payment the cost is an asset, prepaid insurance, because it gives a right to future coverage. As each month of coverage passes, that part of the cost is used up and is recognized as insurance expense on the income statement.

The treatment is a straightforward application of accrual accounting: the expense is recognized in the periods that benefit from the coverage, not when cash is paid. Employee health and life insurance are normally recorded separately as benefit costs rather than as general insurance expense, and premiums for insurance on factory assets are usually treated as manufacturing overhead.

When a business pays an annual premium, it debits prepaid insurance, a current asset shown among prepaid expenses, and credits cash. At the end of each month, or at least at each reporting date, an adjusting entry moves the expired portion to expense by debiting insurance expense and crediting prepaid insurance.

For example, on 1 October a company pays $18,000 for a one-year property and liability policy. The monthly cost is $18,000 divided by 12, or $1,500. At its 31 December year end, three months have expired, so the company records insurance expense of $4,500 for the year and reports prepaid insurance of $13,500 on its balance sheet. The remaining $13,500 will be expensed during the following January to September. If the company forgot the adjustment, it would overstate assets and understate expenses, overstating profit by $4,500.

Some businesses use an alternative approach, debiting insurance expense for the full premium on payment and then adjusting at period end to move the unexpired part back to prepaid insurance. The result is the same once the adjustment is made. Businesses that pay premiums monthly may simply record each payment as an expense.

Where insurance expense appears depends on what the coverage protects:

• Insurance on factory buildings, production equipment and inventory is part of manufacturing overhead and becomes part of the cost of inventory under absorption costing.
• Insurance on delivery vehicles, showrooms and sales staff travel is usually a selling expense.
• General liability, office property, cyber and directors' and officers' insurance are typically included in general and administrative expenses.
• Insurance on buildings under construction may be capitalized as part of the cost of the asset until it is ready for use.

Insurance expense is the cost of the coverage itself. When an insured loss happens, the company records the loss and, separately, a receivable for the expected insurance recovery when the recovery is probable. If a warehouse fire destroys inventory with a book value of $200,000 and the insurer agrees to pay $170,000 after a $30,000 deductible, the company writes off the inventory, records a $170,000 insurance claim receivable, and recognizes a net loss of $30,000. If the recovery exceeds the book value, the gain is generally recognized only when the claim is settled.

Some companies choose to self-insure certain risks, setting aside reserves rather than buying policies. In that case there is no premium, but losses must be estimated and accrued as they occur, including those incurred but not yet reported. Rising premiums, which have increased sharply in recent years for property in areas exposed to natural disasters, have pushed more companies toward higher deductibles and self-insurance.

Insurance can be a significant cost for businesses in construction, transport, healthcare and manufacturing, so managers track it against budget and compare quotes at each renewal. For tax purposes in the United States, ordinary business insurance premiums are generally deductible, but amounts paid more than a year in advance may need to be deducted over the coverage period. Understanding insurance terms and each policy also helps accountants decide whether a loss is covered and how it should be recorded in the financial statements.