SELF-INSURANCE: ECONOMCIS AND TAX TREATMENT 

Seymour Fiekowsky 

U.S. Treasury Department 

OTA Paper 31 March 1978 

OTA Papers are circulated so that the preliminary findings of tax research conducted by Staff 

members and others associated with the Office of Tax Analysis may reach a wider audience. The 

views expressed are those of the author, and do not reflect Treasury Policy. Comments are invited, 

but OTA Papers should not be quoted without permission from the author.
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1/ 1\ ,( yJ, 

Seymour Fiekowsky 

BSM-78-53 March 28, 1978 

Self-Insurance: Economics and Tax Treatment 

I. Introduction 

Investment in, and the conduct of, an enterprise in an 

economic system predicated on private rights in property are 

fraught with uncertainty. Revenue and outlay flows are subject 

to unpredictable variances. Weather extremes and shifts in 

markets cause unexpected changes in sales and in costs. Additionally, unpredictable events such as fire, flood, accidents 

or theft may occur which wipe out some part of the enterprise 

capital. Because the brunt of these variances falls on the 

return to equity--the residual share of enterprise output--

this return expressed as a rate, is higher than returns to 

other rights to enterprise income (or assets) that are assigned 

priority of claim. 

Suppliers of capital are therefore aware that their returns 

may range from -100 percent, a total loss, to some high positive 

return. Given a set of environmental conditions that determine 

the distribution of potential results, enterprises attempt to 

minimize the variance in expected returns, particularly the 

probability of occurrence of total, or near total, loss of 

enterprise equity capital. One common way to do this is to 

increase the size of enterprise capital and diversify the 

markets in which the enterprise operates. This reduces the 

chance that any single commitment of capital--to a particular 

location or to a new product line or technology--will seriously 
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damage the ability of the enterprise to continue. In effect, 

the enterprise thereby "self-insures" itself against the likelihood of catastrophic losses by arranging to pool many uncertainties. In so doing, it uses some of the gains of part of the 

enterprise to cover the (individually)unpredictable losses it 

incurs with respect to particular commitments in other parts of 

the enterprise. 

Another conunon way to minimize the likelihood an enterprise 

will suffer catastrophic loss from the occurrence of a nonmagerial related loss is to form associations for the specific 

purpose of pooling such risks. Each member of the association 

contributes to a common pool of funds that is then available 

to reimburse a participating member who suffers the insuredagainst eventuality, such as a fire, flood or accident. This 

institutional arrangement, which we will call "cooperative 

insurance", to contrast it with self-insurance, operates 

financially the same way as does self-insurance: each participant allocates some part of his enterprise gross income 

to the insurance pool, and this covers the losses of specific 

participants, when they occur. 

It is noteworthy that, whether the particular uncertainty 

"insured" against is covered by "self-" or "cooperative" 

insurance, the coverage is accomplished by allocating a 

portion of enterprise capital, or what amounts to the same 
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thing, some of the income otherwise attributable to its 

capital, to the task. In an economic system with an income 

tax, the "fund" which supports this aspect of the economic 

process must be accumulated with after-tax funds. This condition in combination with the fact that cooperative insurance 

premia are costly for relatively small enterprises has attracted 

sympathetic interest in providing some relief mechanism for 

such enterprises.!/ 

Generally these proposals entail permitting enterprises 

to employ a tax accounting procedure under which an annual 

deduction, analogous to a cooperative insurance premium, may 

be taken to build-up a "reserve" to cover the loss, when and 

if it occurs. In this way, it is contended, small businesses 

may be aided in overcoming the tax burden on accumulating the 

capital buffer required to minimize the incidence of catastrophic loss. In particular, proposals have been made in 

Congress and by an Interagency Task Force which would permit 

such a self-insurance procedure to be adopted with respect to 

product liability claims that might confront a small business. 

The foregoing introductory comments suggest that these mechanisms, if they are carefully designed to merely self-insure 

businesses would offer no palpable assistance to a small, 

prudently managed business. The following section sets out 

y A small firm will normally require a small amount of insurance for any particular class of uncertain event. But the 

costs of writing such a small policy, inspecting the applicant's mode of business operations, and administering the 

policy will be large, per dollar of insurance coverage. 
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in detail an analysis of self-insurance. The final section 

sets out the necessary characteristics of a "self-insurance" 

scheme that is both self-limiting and not subject to abuse. 

II. The economics and accounting for self-insurance. 

Suppose that a firm knows for certain that, if it sets 

aside $10,000 per year, over a long period of time this will 

cover claims against it although the precise dating of the 

claims is unpredictable. In terms of the capital of the 

enterprise, this says that a fund of assets augmented at the 

rate of $10,000 per year, will be sufficient to meet losses, 

or outflows from the fund, when they occur. The average 

size of this fund, of course, will depend on the pattern of 

occurrence of the events triggering the loss. If for example, 

each year, at indeterminate times during the year, $10,000 

of losses are experienced, then the average balance of the 

"fund" of assets in support of this "insurance reserve" will 

be close to zero: as much flows out of the fund as flows in. 

On the other hand, if the loss might be $100,000 but occurs, 

on the average only once in 10 years, the average balance in 

the self-insurance fund will approximate $50,000. 

The accounting for these two extremes consists of these 

elements: Each year, the enterprise records as an expense 

$10,000, and credits an account we shall call •reserve for 
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product liability claims" $10,000. In the first instance, 

when $10,000 of claims are satisfied each year, as each claim 

is satisfied, cash is paid (credited), and the reserve for 

product liability claims is correspondingly reduced (debited). 

At the end of the year, the net effect of this accounting procedure will have been to leave the balance in the reserve 

unchanged and to record as an expense the amount paid out as 

claims, $10,000. In the second instance, when claims arrive 

every 10 years, each year the expense is $10,000 (a debit to 

the current year's income account, or net worth), as is the 

addition to the reserve which then builds-up to $100,000 by 

the lOth year. In the lOth year, when the claim of $100,000 

is paid, this reduces assets and the reserve by $100,000, but 

has no effect on the expense charged for that year. 

The first case, that of equal annual claims results in a 

balance sheet showing zero in the reserve account. The second 

case, however, produces a balance sheet in the lOth year, 

before the claim is paid, which would show the following in 

the net worth section: Reserve for product liability claims, 

$100,000; and commingled with all its assets, an equivalent 

amount. After the $100,000 has been paid, the reserve balance 

would be zero, and the corresponding assets also zero. But, 

because the 10 years' of cash-flow had been earmarked, not 

included in annual income and, thereby, not included in retained 
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earnings, or earned surplus, the payment will not have impaired 

the ability of the enterprise to continue. This last statement 

follows from the fact that we have postulated that this is a 

prudently managed firm; that it will regard its reserve for 

product liability as a severable part of its assets and not 

a permanent portion of equity, or net worth. 

To this point, the discussion has proceeded on the assumption that a reliable estimate of the probability of occurrence, 

and the magnitude, of possible product liability losses is 

ascertainable. If the losses are statistically predictable, 

the question arises: Why would any firm with the expectations 

described by the second case incur the cost of maintaining a 

(real) reserve, $50,000 per year, on the average in the above 

example, rather than cooperatively insure? One answer is that, 

if the firm holds its own reserve, it can employ the assets 

thus financed and, thereby, possibly earn a high return while 

avoiding the administrative and related costs of cooperatively 

insuring. THis explains why even substantial enterprises will 

find it advantageous to self-insure against only moderate losses 

and to cooperatively insure only against extremely large 

potential losses. Self-insurance reserves against only moderate losses implies small capital funds for the purpose, and 

this is more economical than cooperative insurance for the 

same coverage. They will buy cooperative insurance only with 

a high "deductible" which is to say, insure only against losses 
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in excess of some specified amount, in order to avoid tying 

up capital. If there is no basis for statistically estimating 

the probability of occurrence, or the size, of some potential 

claim, the risk is simply uninsurable, by the enterprise itself 

or through cooperative insurance. 

A. The effect of income taxes. 

We have also ignored the possible impact of taxation 

on the ability of a firm to self-insure, in the sense used 

above. To examine the effect of taxation, we postulate two 

tax regimes. One, which we may call present law, requires 

that the enterprise accumulate its (real) reserve with aftertax funds and permits a deduction for losses only when incurred; 

the other, which we will call hypothetical law, permits the 

enterprise to take deductions annually in the computation of 

taxable income equal to the estimated average annual loss. 

In both regimes, the marginal tax rate faced by the enterprise 

is 40 percent, and the after-tax return on assets is 10 percent 

(16 2/3 percent, before tax). Additionally, we assume that 

additions to the reserve are made at the beginning of each 

year and that claims, when due, are paid exactly at the end 

of the year; the annual additions to reserves, on a before 

tax basis, are $10,000, and the claims, when they occur, are 

$30,000. Finally, for reasons that will become clear later, 

we "compound" the earnings on the self-insurance reserve and 

add them to the reserve as they accrue. 
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The attached table records the results of 5 years' 

experience. In year il, the deposit, or addition, of $10,000 

of pre-tax income in a reserve yields $6,000 of assets, which 

"grow" to $6,660; while, under the hypothetical law, the $10,000 

is not taxed (is taken as a deduction from gross income) and 

thus provides $10,000 of assets which grow to $11,000. Note 

that, in both cases the "growth" is after tax; under the 

hypothetical law, notwithstanding the "tax-free" character of 

the funds used to acquire assets, the earnings thereon are 

taxed, for the assets corresponding to the reserve are commingled 

with other earning assets. In both cases $10,000 of pre-tax 

earnings are added to the reserve the second year, so that, 

at the end of the second year the balances in the asset 

reserves are $13,860 (present law) and $23,100 (hypothetical 

law). At the beginning of the third year, the customary 

additions to reserves are made, producing end of year balances 

of $21,846 (present law) and $36,410 (hypothetical law). At 

the end of the third year, a $30,000 claim, in pre-tax dollars, 

is paid. Under present law, this $30,000 is deducted from 

taxable income, which means the after-tax cost is reduced to 

$18,000 (60% of $30,000); in contrast, under hypothetical law, 

the $30,000 is not a reduction of taxable income, but only 

an allocation (deduction from) the reserve. Years 4 and 5 

follow the same pattern, and after paying the $30,000 claim 
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at the end of the fifth year, a slight balance remains in 

the reserve account under both tax regimes, $513.66 (present 

law) and $856.10 (hypothetical law). Over the 5 years, the 

average end-of-year reserve balances are $7,142.05 (present 

law) and $11,883.42 (hypothetical law). 

It should be apparent that, in terms of the net 

position of the enterprise, there is no real difference whatever between the two tax regimes: the apparent difference 

arises from the fact that the entries in the columns headed 

"present law" are always in "after-tax" magnitudes, the entries 

under "hypothetical law" are always in "before-tax• magnitudes; 

present law magnitudes are, therefore, always 60 percent of 

hypothetical law. The enterprise is not "better-off" under 

the one regime or the other as it takes steps to self-insure, 

if the two critical assumptions on which the example has been 

constructed hold. First, the statistical estimate of annual 

average liability to be covered by the reserve must be accurate; 

second, partially related to the first, the fund must never 

be usable for purposes other than coverage of the losses 

self-insured against. Suppose, for example, that the actual 

probability of loss is zero. Under present law treatment 

the enterprise setting aside $10,000 of annual before-tax 

income would have accumulated a capital stock of $40,293.66, 

all of which is "tax-paid" and hence indistinguishable from 

other capital of the enterprise, also accumulated with "tax-
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paid" funds. Under hypothetical law, the setting aside of 

$10,000 of pre-tax funds would have accumulated to $67,156. 

Then, since there is no claim against this reserve (and stock 

of assets), the hypothetical law tax treatment would have 

provided the enterprise a 2/3 enrichment by permitting the 

accumulation of enterprise capital with untaxed funds. If, 

under hypothetical law, an enterprise is to be permitted to 

self-insure, and if there is no sound statistical basis for 

estimating the probability and magnitude of future losses, 

then some means must be provided to tax the accumulated 

reserve experience demonstrates is not required to cover the 

allegedly insured against losses. Such a means is readily 

at hand: if the hypothetical law reserve (including accumulated 

after-tax earnings) is subject to tax when the enterprise 

determines that the reserve is redundant, the "gain" from 

holding capital acquired with untaxed funds will be fully 

eliminated. For example, if after 5 years in the foregoing 

example, the hypothetical law cumulative reserve of $67,156, 

assumed to be found to be unnecessary, is taxed at 40 percent, 

the enterprise will have remaining $40,293.66, exactly the 

same amount the enterprise would have under present law. 

This helps explain why the device of cumulating the 

two reserves was adopted. If the (taxed) earnings of the 

capital acquired with untaxed funds are not associated with 
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the capital fund, an enterprise applying the hypothetical 

law "reserving" mechanism could profit, as compared with 

present law, by enjoying twice the net income flow from the 

fund, even though he later "repays" the Treasury its "share" 

of the previously untaxed capital when dissolving the fund. 

The combination of current taxation of income earned by the 

hypothetical law fund plus treatment of those earnings, if 

retained in the fund, as capital acquired with untaxed funds, 

ensures that the provisions of the hypothetical law cannot be 

used to circumvent the income tax. 

III. Necessary attributes of a proposal to permit self-insurance 

funds. 

The foregoing section has demonstrated that present law 

tax treatment does not discourage self-insurance, if an enterprise so desires. Nevertheless, from a purely financial 

accounting point of view there is some virtue in encouraging 

the use of explicit reserving for the occurrence of individually unpredictable losses. In the hypothetical law example 

previously used, assuming the accuracy of the estimated 

average annual loss of $10,000, a better-more consistent--

annual measure of enterprise income is produced by annually 

recognizing that loss rather than waiting until the losses 

occur, as happens under present law rules. From the discussion thus far completed, four cardinal rules for a tax 
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accounting system permitting the current deduction of a 

self-insurance premium emerge: 

A. Assets representing the reserve must be segregated, 

as by deposit in a trust established for the purpose. 

The essentiality of this rule derives from these 

considerations. First, there is no operational method of 

testing the "sincerity" of a taxpayer who would establish a 

self-insurance fund. The validity of estimates of the probability of occurrence and the size of future losses are not 

testable by information available to revenue agents; nor can 

any objective test be reasonably applied to determine whether 

the self-insurer really maintains the lower debt/equity ratio 

implied by his estimates of risk exposure, i.e., that the 

"reserve" is above the ordinary net worth required by his 

creditors and needed to carry on his business in the event 

the "reserve" must be liquidated to satisfy a claim. Lacking 

these means of determining "sincerity", statistical realiability, 

and prudence of a taxpayer who otherwise would pay no penalty 

for establishing a "reserve" solely for the purpose of circumventing the tax laws, the only available discipline to prevent 

abuse is to require the self-insurer to, in fact, sever the 

funds from his own control. As a corollary to this, the trust 

fund should be prohibited from owning securities or notes 

issued by any self-insurer availing himself of this option. 
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B. Income earned by the assets held in trust shall be 

taxable to the beneficiary enterprise as earned. 

The need for this rule is obvious. To allow exemption 

of this income from tax would not only constitute a subsidy to 

the beneficiary enterprise, but because it is in tax-exempt 

form, it degrades the progressivity of the tax system and induces 

an excess revenue loss. If there is some reason to subsidize 

small, or other worthy businesses engaging in this elective 

form of self-insurance, it should be provided in taxable form. 

For example, some schedule of credits per dollar deposited 

might be offered, if the enterprise would reduce its tax 

deductions for losses (or additions to reserves) that year by 

the amount of the credit. 

C. Withdrawals from the trust fund for any purpose other 

than coverage of claims for which the fund was established must be taxable to the beneficiary enterprise. 

As was shown in the previous section, to permit nontaxable withdrawals of reserve assets for purposes other than 

coverage of the claims insured against confers an unjustified 

benefit on the self-insuring enterprise which, again, is proportional to its income status. 

D. As a procedural rule, only additions to the insurance 

reserve, net of gains and losses experienced by the 

trust fund or trustees fees, may be permanently held 

in trust. 

Since the essence of the hypothetical tax law treatment of self-insurance reserves is to maintain strict segregation of pre- and post-tax funds, and given the fungibility 
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of money, it is necessary that the income (loss) earned by 

assets held in the trust fund (insurance reserve) be literally 

paid-out to the self-insuring enterprise. Positive income 

presents no problem; the trustee would be required to advise 

the self-insurer at the end of a period no longer than one 

year what income has been earned and which is to be included 

in the taxpayer's taxable income, and to pay out the funds to 

the self-insurer at the earliest practicable time. Losses, 

on the other hand, would be reported to the self-insurer who 

would then have to reduce the magnitude of the loss by his tax 

rate before reporting it as a loss, or deduction in his tax 

return for the year.!/ In both cases, the amounts taken from 

the fund are treated as nonqualified withdrawals. Trustees' 

fees, like any other ordinary business expense, are payable 

with untaxed funds and, hence, may be directly taken out of 

the trust fund balance; they would be treated as a qualified 

withdrawal, already deducted from gross income of the selfinsurer. 

If a self-insurer sets aside $1 of gross income as a selfinsurance reserve, under present law he pays tax of 40¢ (under 

our assumption of a 40 percent tax rate) and has left 60¢ 

of assets representing his·own disposable funds. If, then, 

the 60¢ asset is sold for 30¢, the self-insurer should be 

allowed a deduction of that amount, making his net after-tax 

loss 18¢, i.e., he ends up with 42¢. 

In contrast, under hypothetical law, $1 of gross income set 

aside in the trust fund. If this $1 asset is sold for 50¢, 

the trustee would report to the self-insurer a loss of 50¢; 

the self-insurer would reduce this loss by 40 percent--to 30¢ 

reportable that year as a loss in his tax return, deriving 

a "refund" of 12¢. If the self-insurer were to withdraw his 

50¢, pay 20¢ in tax, he would end up exactly in the position 

of the self-insurer under present law, namely with 42¢. 
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_.----...~ /"'"'"--

Balance Sheet Impact of Alternative Tax Treatments of Individually Unpredictable Losses 

Present law : Hypothet1cal~aw 

: (deduct loss when incurred) : (deduct $10,000/vr. J 

Increase : ''Fund "1/ • "Fund" 1/ : "Fund "1/ 

: in "fund" : balance- ; addition- : balanceYear, transaction : (beg. of yr.): (end of yr.):(beg.of yr.): (end of yr.L 

tl: Set aside $10,000 of gross income 

12: Set aside $10,000 of gross income 

13: Set aside $10,000, etc. 

Pay $30,000 claim 

14: Set aside $10,000, etc. 

15: Set aside $10,000, etc. 

Pay $30,000 claim 

$6,000 

6,000 

6,000 

6,000 

6,000 

$ 6,660 

13,860 

21,846 

-18,000 

3,846 

10,830.60 

18,513.66 

-18,000.00 

513.66 

$10,000 

10,000 

10,000 

10,000 

10,000 

$ 11,000 

23,100 

36,410 

-30,000 

6, 410 

18,051 

30,856.10 

-30,000.00 

856.10 

offrce o-f -the -Secretary or-tne-Treasury______ ~----- ~- --- March 2 9 , T978 

Office of Tax Analysis 

1/ The "Fund" balance is explicitly an earmarked portion of net worth, implicitly a corresponding 

., - amount of assets held by the enterprise.