What Type of Expense Is Insurance in Accounting?

An expense in financial accounting represents the cost incurred by a business in its operations to generate revenue. Expenses differ fundamentally from assets and liabilities. While assets are resources a company owns that provide future economic benefit, and liabilities are obligations owed to others, expenses are costs consumed within a specific accounting period. These costs directly reduce revenue to determine net profit or loss and are recorded on a company’s income statement.

Insurance, a common financial product, involves regular payments, known as premiums, to an insurer in exchange for protection against potential future losses. The classification and treatment of these premiums in financial records are important for accurate reporting.

Insurance as an Expense

Insurance premiums are considered an expense because they represent a cost incurred for a benefit consumed within a defined period. This coverage protects against unforeseen events, and its cost is used up as time passes.

Unlike an asset, which provides economic benefits over multiple future periods, the value of insurance is realized during the period it covers. For instance, a one-year insurance policy provides protection only for that year. The premium paid is an operating cost, essential for a business to mitigate risks and ensure continuity. As the policy term progresses, the portion of the premium related to the expired coverage becomes an expense.

Categorizing Insurance Expenses

The categorization of insurance expenses depends on the context, specifically whether it pertains to a business or an individual, and the purpose of the coverage. For businesses, insurance premiums are generally classified as operating expenses, which are costs associated with running daily operations but not directly tied to the production of goods or services. These are typically listed on the income statement as selling, general, and administrative (SG&A) expenses.

Examples of business insurance categorized as operating expenses include general liability insurance, commercial property insurance, and professional liability (E&O) insurance. Additionally, workers’ compensation and commercial auto insurance are operating expenses.

In some cases, insurance costs can be part of the cost of goods sold (COGS), especially if directly related to production. For instance, product liability insurance for a manufacturing company might be considered part of COGS, as it is a direct cost associated with producing and selling the goods. However, this is less common, as most insurance relates to general business operations rather than direct production. Personal insurance, such as homeowner’s, auto, or personal health insurance, is generally considered a personal living expense and is not categorized as a business expense.

Accounting for Insurance Payments

When a business pays for insurance coverage that extends beyond the current accounting period, the payment is initially recorded as a prepaid expense, which is an asset. This treatment reflects that the business has paid for a service it will receive in the future. For example, if a company pays $12,000 for a one-year policy, the entire amount is initially debited to a “Prepaid Insurance” asset account.

As each month or accounting period passes, a portion of this prepaid asset is then recognized as an expense. This is done through an adjusting journal entry, where the “Insurance Expense” account is debited and the “Prepaid Insurance” asset account is credited. For a $12,000 annual policy, $1,000 would be expensed each month, accurately matching the cost to the period in which the coverage is consumed. This process ensures financial statements accurately reflect expenses incurred, adhering to the accrual basis of accounting. If the coverage period is very short, or the payment aligns perfectly with the current accounting period, the insurance might be expensed immediately rather than going through the prepaid asset stage.

Tax Treatment of Insurance Expenses

The tax deductibility of insurance expenses varies for businesses and individuals. For businesses, most ordinary and necessary insurance premiums are tax-deductible. The IRS defines “ordinary” as common and accepted, and “necessary” as helpful and appropriate for the business. This includes premiums for general liability, commercial property, professional liability, workers’ compensation, and commercial auto insurance. These deductions reduce the business’s taxable income.

However, certain business-related insurance premiums are typically not deductible, such as life insurance policies where the business is the beneficiary, or disability insurance that replaces lost earnings. For individuals, most personal insurance premiums, including auto, homeowner’s, and personal life insurance, are generally not tax-deductible. An important exception exists for self-employed individuals, who may deduct premiums paid for medical, dental, and qualifying long-term care insurance. This self-employed health insurance deduction is an adjustment to income on Form 1040, Schedule 1, and can be claimed even if the individual does not itemize.