What it means
When something goes wrong, a business first records the loss, such as written-off stock or repair costs. If the loss is covered, it will later receive a payment from the insurer, which offsets part or all of that loss.
The deductible, or excess, is the part of the loss the business bears itself, so a recovery is normally smaller than the full damage. Policy limits and exclusions can cut it further, which is why a claim should be checked against the policy before the accounts assume the full amount.
Accounting rules are cautious about the timing. Under US accounting rules, a recovery of a loss already recorded is recognised when it is probable, but only up to the amount of the loss, while any amount above the loss is a gain that is recognised only when it is realised or realisable.
International rules take a similar line and generally require an insurance reimbursement to be virtually certain before it is recorded as an asset. The recovery is usually shown separately from the loss rather than netted off without disclosure, so readers can see both the size of the event and the protection it received.
If the amount is material, the notes to the accounts will explain what happened, how much was claimed and how much was received. There are also tax effects.
In many systems, insurance proceeds that exceed the book value of a destroyed asset create a taxable gain, though rules often allow the gain to be deferred if the money is used to replace the asset. A tax adviser should review large claims.
Insurers may also recover money themselves, a process known as subrogation, by pursuing the party that caused the loss. Policyholders should keep evidence and avoid releasing a third party from liability, because that could damage the insurer's rights and affect the claim.
In practice
Real-world examples
Example 1
A logistics company's truck is stolen and written off at a loss of $90,000. The insurer pays $80,000 after a $10,000 deductible, and the accountant records the recovery against the loss in the same period.
Example 2
A retailer suffers storm damage to its stores and records repair costs of $250,000. It records an insurance receivable only once the insurer confirms the claim is accepted, not at the time of the storm.
Example 3
A manufacturer's building with a book value of $300,000 is destroyed, and the insurer pays $450,000 on a replacement cost policy. The $150,000 above book value is treated as a gain and is recognised when the payment is agreed and certain.
Think of it
Imagine your car gets a flat tyre. You pay a mechanic to fix it, but because you have roadside assistance, the company reimburses you for the repair bill. That reimbursement is your insurance recovery.
Formula
Calculation
Net loss after recovery = Loss - Insurance recovery
Insurance recovery = Loss covered - Deductible, subject to the policy limit
A warehouse fire destroys inventory with a carrying value of $400,000. The policy has a deductible of $25,000 and a limit well above the loss, so the insurance recovery is 400,000 - 25,000 = $375,000. The net loss borne by the company is 400,000 - 375,000 = $25,000, which equals the deductible. If the insurer's payment arrives in the next quarter, the company records a receivable of $375,000 once the recovery is probable.Case study
Seen in the real world
Ashford Textiles is an illustrative, fictional company that suffered a fire in December, three weeks before its year end. Stock worth $800,000 was destroyed, and the finance manager recorded the loss immediately.
The insurer had acknowledged the claim but not yet confirmed the amount, and the policy carried a $50,000 deductible. The auditors agreed that the company could record a recovery of $750,000 only after the insurer wrote to confirm that the claim would be paid in that amount, which happened in January before the accounts were signed.
Because the confirmation gave evidence of conditions at the year end, the fictional accounts showed the receivable, and the net loss was the $50,000 deductible. The illustrative lesson is that recoveries need support, and a verbal assurance from an insurer is not enough.
Watch out
Common mistakes
- Recording the recovery before it is probable or virtually certain, which can overstate profit if the insurer later disputes the claim.
- Forgetting the deductible and policy limits, so the expected recovery is larger than the cash that arrives.
- Ignoring the tax effect of proceeds above the book value of a destroyed asset, which can create an unexpected gain.
Questions
People also ask
Is an insurance recovery treated as revenue?
No, it is normally shown as an offset to the related loss or as a separate gain, and not as sales revenue from customers.
When should a business recognise an insurance receivable?
Once the recovery is probable under US rules, or virtually certain under international rules, and usually when the insurer has accepted the claim.
What is subrogation?
It is the insurer's right, after paying a claim, to pursue the party that caused the loss in order to recover what it paid.