An insurance policy is purchased to cover the risk on the assets and operations of the business. In case of a loss, an insurance claim is filed.
In other words, insurance claims are received when a policyholder faces an unfortunate circumstance and requests the insurance company to compensate for his loss provided that the loss is covered under the policy of the Insurance Company.
The insurance company confirms the claim after validating the loss. If the loss is valid and comes under the insurance terms, then a payment is made to the aggrieved party for the loss.
Different insurance claims range from insurance against business assets to health and life insurance programs.
Even insurance companies offer the facility to obtain special cover on the operations and special orders to be filled by the business.
How To Account For Insurance Proceeds?
When a business experiences actual loss due to damage or theft etc, it files an insurance claim. Insurance providers analyze the amount of loss and then compensate companies according to their policies.
When a business receives an insurance claim, it has to record it in a proper account. It is common for entities not to record an insurance claim until it is received, but such claims can be recognized in books if the amount is probable and there is a high degree of certainty related to payment.
Insurance claims received are disclosed properly in the financial statement. A journal entry is posted for the amounts received from insurance companies by crediting the actual figures of lost assets against which we claimed insurance.
If the insurance company accepts our claims after a thorough investigation of the loss, we can record them as debtors. The destroyed asset or Inventory is credited. Any difference between actual loss and the amount received from insurance companies is charged to the profit and loss account.
Journal entries for insurance claim
The journal entry for insurance claims involves three account heads. Let’s discuss this concept in detail with the help of examples. Suppose The flood destroyed Inventory costing $50,000.
The insurance claim was filed, and the insurer has agreed to pay $45,000.
| Particulars | Debit $ | Credit $ |
| Insurance claim account (the debtor) | 45,000 | |
| Profit and loss account(loss) | 5,000 | |
| Inventory | 50,000 |
The first debit of the transaction records the right to receive the claim; it’s only recorded once the insurance company has agreed to pay some specific amount under a valid claim.
Once insurance proceeds are received, it’s removed from the books, and cash is shown in its place (that’s like a normal accounting operation).
The second debit of the transaction records loss in the profit and loss statement. The loss is recorded because the book value of the asset written off is more than the insurance proceeds.
Sometimes, the business may receive more insurance claims than book value; in such a scenario, it’s considered profit on disposal and credited in the income statement.
However, that’s a rare situation and seen when book value is substantially low.
The credit in the journal entry removes Inventory in the business accounts; it’s because Inventory has been destroyed and needs to be removed from the business books.
The first debit recorded is receivable, which will be removed from the business books once cash is received from the insurance company.
The journal entry will be recorded as follows:
| Particulars | Debit $ | Credit $ |
| Bank | 45,000 | |
| Insurance claim account(the debtor) | 45,000 |
The debit impact of the transaction is the receipt of the cash in a bank account; it’s the receipt of cash from insurance companies. On the other hand, the credit impact of the transaction is the removal of the right to receive cash as it has been realized.
Example of journal entry for the insurance proceeds and accumulated depreciation
Companies get insurance cover on the property, plant, and equipment, It’s because these assets carry higher worth, and businesses cannot survive if something goes wrong with these assets.
Suppose that there is an asset subjected to accumulated depreciation is destroyed by the flood. The cost of the machinery destroyed by the flood was $12,000, and it has accumulated depreciation of $6,000.
An insurance claim amounted to $6,000 was filed. However, the insurance company only agreed to pay $5,000. The journal entry for this transaction will be as follows.
The journal entry will be recorded as follows:
| Particulars | Debit $ | Credit $ |
| Insurance claim account(the debtor) | 5,000 | |
| Accumulated depreciation | 6,000 | |
| Profit and loss account | 1,000 | |
| Machinery Account | 12,000 |
The first debit records proceed receivable from the insurance company, and the second debit removes the contra account created against the charge of depreciation in the accounting record.
Similarly, third debit records loss as net book value is more than insurance proceeds to be received. On the other hand, credit transaction removes machinery from the books.
Later on, when the insurance company pays the amount, the following journal entry will be passed.
| Particulars | Debit $ | Credit $ |
| Bank | 5,000 | |
| Insurance claim account(the debtor) | 5,000 |
Prepaid insurance expense
Prepaid insurance is recorded as an asset on the balance sheet, and it’s adjusted as expenses at the end of the months covered in the insurance policy.
Suppose company ABS Limited bought an insurance policy for its PPE on August 30th, 2021; the cost of the insurance policy amounts to $10,000.
At the year-end of December 2021, six months of coverage have been utilized.
So, $5,000 has been charged as an expense in the profit and loss statement. Likewise, $5,000 remains on the books as prepaid insurance. This amount of $5,000 will be adjusted as expenses by utilizing the prepaid insurance.
Conclusion
The business needs to obtain insurance cover on their assets to avoid the risk of theft and discrepancies etc. To obtain an insurance policy, they reach out to insurance companies and pay a certain fee for the policy issuance.
The details of the assets covered in the insurance policy are mentioned along with the cover. The insurance companies get a fee for the issuing cover, and the policyholder gets cover on the assets.
If there is some discrepancy with an asset in the time covered in the insurance policy, the claim is made. Once the claim is validated, the insurance company commits to pay the policyholder.
Once the claim is validated policyholder removes an asset from the books and records the right to receive the cash.
Further, if there is some difference between the net book value and the insurance proceeds, the difference is charged in the income statement.
Frequently asked questions
How to account for a premium paid on the purchase of an insurance policy?
The premium paid on the insurance policy is charged in the income statement, and it’s an expense for the business and is charged straight in the income statement.
What are the write-off charges in the insurance?
The write-off term is used in the insurance to issue an insurance policy, and subscribers bear the charges for the write-off.
What is the claim, and how do insurance companies validate the claim?
If the insurance policyholder faces some discrepancies/problems in the assets, they file a claim to be compensated as they had covered the assets in the insurance.
Once the claim is validated, the insurance policyholder recognizes receivables in the balance sheet.
How do insurance companies earn?
The insurance companies earn via policy write-off and payment of the premium. The writing-off fee is earned when the policy is written off, and the premium is collected from period to period continuously.
What is Takaful?
Takaful is an Islamic mode of finance for insurance. The members of the Takaful contribute to the funds and protect each other from loss or damage. It’s based on the rules of Islamic sharia and religious laws.
The idea of Takaful is based on social cooperation and protection for each other. Further, it also covers life, health, life insurance, etc.
