UK Accounting Glossary
Self-insurance is a risk management method whereby an eligible risk is retained, but a calculated amount of money is set aside to compensate for the loss. The amount is calculated using actuarial and insurance information and the law of large numbers so that the amount set aside (similar to an insurance premium) is enough to cover the future uncertain loss. Self-insurance is similar to insurance in concept, but it does not involve paying a premium to an insurer.
Self-insurance is only possible for a truly insurable risk, meaning a risk that is measurable enough in the aggregate to be able to accurately estimate the amount that needs to be set aside. For a risk to be insurable, it must have a few characteristics, one essentially needs to involve a large number of similar risks, so that the aggregate risk can be measured according to the law of large numbers. The other quality of an insurable risk is that it must not be catastrophic. Any risk where the potential loss is so large that no one could afford to pay the appropriate premium is not insurable. An example is that earthquakes cannot be fully insured against because an earthquake can cause more damage than any insurer has in total assets, and the proper premium would be so high, very, very few consumers could afford it.
Full self-insurance is rarely done. Usually, a portion of the risk is retained and self-insured, and a stop loss or stop-gap policy is purchased with very high limits and very high deductibles. This stop-loss policy does not pay until the high deductible is satisfied which is relatively rare, so the stop-loss coverage is relatively inexpensive.
Examples of full self-insurance occur for various types of employee benefits insurance for corporations with many thousands of employees. Hundreds of thousands of employees is a large enough pool to be able to calculate the risk accurately and fully self insure in some cases.
The idea of self-insurance is that by retaining, calculating risks, and paying the resulting claims or losses, the overall process is cheaper than could be done by paying an insurance company to do it because the company self-insuring does not have to pay the profit component to the insurer.
Self-insurance does not work for individuals because individuals rarely have enough money to set aside to cover a potential future loss, and even if they did, they do not have a large enough number of similar potential risk exposures to spread the risk across and quantify it. For individuals, the answer is either purchasing insurance or retaining the risk.
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This glossary post was last updated: 20th February 2020.