Definition
The term self-insurance refers to a risk management approach whereby a company sets aside money to pay for certain losses. Large companies will oftentimes adopt a self-insurance approach when the risk of loss over time is thought to be less than the premiums paid to traditional insurance carriers plus the deductibles paid on claims.
Explanation
Companies oftentimes insure themselves against casualty losses due to fire, flood, and accidents. As companies grow in size, management may decide to adopt a policy of self-insurance against certain losses. From a practicable standpoint, self-insurance is really no insurance. Companies will do this if they believe the premiums paid to insurance companies and the deductibles that apply to claims are greater than the cost of the losses over an extended period of time. This is sometimes referred to as the law of large numbers.
Companies will oftentimes appropriate retained earnings to pay for losses. For example, the risk management team in a company may decide to take a self-insurance approach to employee medical claims. The board of directors of the company would then set aside (appropriate) retained earnings of the company to pay for medical claims. Such contingencies would be disclosed in the notes to the company's financial statements.
Generally Accepted Accounting Principles require companies to record these self-insurance losses as they are incurred. According to FASB's Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, companies are not permitted to accrue an expense for self-insurance claims.
Related Terms
appropriated retained earnings, accrued expenses
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