Purpose of Insurance

• The insurance industry operates according to the principle of indemnification, which means restoring the insured person or business to the same financial position as before the loss occurred. A true indemnity settlement does not cause any financial gain; the insured person is not better off after the loss as he was before. Typically, damaged property gets repaired, replaced or cashed out for its value; medical and other bills are paid; the loss is restored without profit.
  
  

Property Insurance

• There are some exceptions to the principle of indemnity, though they are rare. With property insurance such as auto and home, the taxable portion of your benefit is determined by comparing the settlement amount to your cost basis, or size of your initial investment, in the property. If you buy a home for $150,000 and perform $50,000 of renovations to it, then receive a cash settlement of $225,000, you may be taxed on the $25,000 that exceeds your cost basis unless you reinvest the proceeds into repairing the home.
  
  

Life Insurance

• One of the biggest financial benefits to a life insurance settlement is that it is not normally considered taxable income. There are three notable exceptions. First, if you deducted the premiums from your taxes or had your employer pay the premiums for you, the benefit may be taxable. Second, if the company delays paying the benefit and must pay you interest, the interest amount is taxable. Third, if the proceeds become part of your estate, they may be subject to estate taxation.
  
  

Personal Injury Settlements

• "Personal injury" is a term used to describe non-tangible losses such as harassment, defamation and slander, among others. Insurance settlements of this type are usually subject to taxation unless accompanied by a physical injury and resulting from a tort, or wrongdoing. If you receive a personal injury settlement, or any insurance settlement where you need clarification about its taxation, consult an accountant or other tax professional. Mishandling your settlement can result in large, unwanted tax liabilities.