Insurance Proceeds: What it is, How it Works

What Are Insurance Proceeds?

Insurance proceeds are benefit proceeds paid out by any insurance policy as a result of a claim. Insurance proceeds are paid out once a claim has been verified, and they financially indemnify the insured for a loss that is covered under the policy. Insurance proceeds are sometimes paid directly to a care provider (as with health insurance), but usually, it is sent to the insured in the form of a check.

Understanding Insurance Proceeds

When an individual or business purchases insurance, they are protecting themselves against any adverse situation that could result in a financial loss. The insured pays premiums to an insurance company for this service and as part of the arrangement, the insurance company is liable to payout proceeds against verified claims that the insured files. Insurance proceeds are the monies an insurance company pays to cover any financial loss.

Insurance proceeds are not just handed out when an insured individual files a claim. An entire process of evaluating the claim, the contract, the extent of the damage, and sometimes police reports are needed before proceeds can be paid.

Proceeds can be paid as one lump sum by the insurance company or in multiple installments over a specific time frame, depending on the policy.

Accounting for Insurance Proceeds

Insurance proceeds require some specific accounting procedures. For example, if an insurance company pays for the loss, an accountant should record the full amount of the insurance proceeds and the full amount of the loss.

Here's how it works: consider a fire that destroys $15,000 of inventory that belongs to Company X. Since the insurance company covers the entire loss, the first entry is a $15,000 debit to fire damage, and a $15,000 credit to inventory to remove the inventory from your accounting books. The second entry is a $15,000 debit to cash-fire damage reimbursement, and a $15,000 credit to fire damage. This procedure zeroes out the amount of the fire damage loss on Company X's books.

Based on the amount of the insurance proceeds, a person may have a gain or loss. For example, if $10,000 of inventory is damaged in a fire and the proceeds are $7,000, the transaction should be recorded as a $7,000 debit to cash-fire damage reimbursement, a $3,000 debit to loss on insurance proceeds, and a $10,000 credit to inventory.

If the proceeds check is larger than the loss, the surplus is recorded as a gain. If $10,000 of inventory is damaged, and the insurance proceeds are $12,000, record the transaction as a $12,000 debit to cash-fire damage reimbursement, a $10,000 credit to inventory, and a $2,000 credit to gain on insurance proceeds.

Insurance Proceeds and Taxes

Insurance proceeds are tax-free in most cases, regardless of the type of insurance or policy. One exception is disability insurance, which is taxable to the insured as income if the insured used pretax income to pay premiums. Another is when a homeowner receives insurance proceeds for a damaged or destroyed home that exceeds the property's adjusted basis. In this case, the profit is taxed as a capital gain unless a replacement property is purchased within a specified period of time.

Usually, when a person receives insurance proceeds from a life insurance policy due to the death of the insured person, the payout isn't taxable, and you aren't required to report it as income. However, interest income is taxable and reportable as interest received. 

If a life insurance policy was transferred to you for cash or other valuable consideration, the insurance proceeds exclusion is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. Some exceptions apply to this rule, but generally, you report the taxable amount based on the type of income document you receive.