What Are Deferred Acquisition Costs (DAC)?
Deferred acquisition costs (DAC) is an accounting method that is applicable in the insurance industry. Using the DAC method allows a company to defer the sales costs that are associated with acquiring a new customer over the term of the insurance contract.
- Deferred acquisition costs (DAC) is an accounting method that is applicable in the insurance industry.
- Using the DAC method allows a company to defer the sales costs that are associated with acquiring a new customer over the term of the insurance contract.
- Using this accounting method tends to reduce the first-year strain of policy and produces a smoother pattern of earnings.
- Companies may only defer costs associated with the successful placement of new business and cannot amortize all back-office expenses.
Understanding Deferred Acquisition Costs (DAC)
Insurance companies face large upfront costs when issuing new business, including referral commissions to external distributors and brokers, underwriting, and medical expenses. Often these costs can exceed the premiums paid in the early years of different types of insurance plans.
The implementation of DAC enables insurance companies to spread out these large costs (that otherwise would be paid upfront) gradually—as they earn revenues. Using this accounting method tends to produce a smoother pattern of earnings.
As of 2012, insurers are required to comply with a new Federal Accounting Standards Board (FASB) rule, “Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts,” or ASU 2010-26.
FASB allows insurance companies to capitalize on the costs of acquiring new customers by amortizing them over time. With this process, DACs are recorded as assets—rather than expenses—and they can be paid off gradually.
Deferred acquisition costs (DAC) are treated as an asset on the balance sheet and amortized over the life of the insurance contract.
The FASB also requires that companies amortize balances on a constant level basis over the expected term of contracts. In the case of unexpected contract terminations, FASB rules that DAC must be written off, but it is not subject to an impairment test. This means that the asset is not measured to see if it is still worth the amount stated on the balance sheet.
Deferred Acquisition Costs (DAC) Amortization
DAC represents the “un-recovered investment” in the policies issued and is therefore capitalized as an intangible asset to match costs with related revenues. Over time, the acquisition costs are recognized as an expense that reduces the DAC asset. The process of recognizing the costs in the income statement is known as amortization and refers to the DAC asset being amortized, or reduced over a number of years.
Amortization requires a basis that determines how much DAC should be turned into an expense for each accounting period. The amortization basis varies by the Federal Accounting Standards (FAS) classification:
- FAS 60/97LP – Premiums
- FAS 97 – Estimated Gross Profits (EGP)
- FAS 120 – Estimated Gross Margins (EGM)
Under FAS 60, assumptions are "locked-in" at policy issue and cannot be changed. However, under FAS 97 and 120, assumptions are based on estimates that can be readjusted as needed. DAC amortization uses estimated gross margins as a basis and an interest rate is applied to the DAC based on investment returns.
Requirements for Deferred Acquisition Costs (DAC)
Prior to the introduction of ASU 2010-26, DAC was described vaguely as costs that “vary with— and are primarily related to—the acquisition of insurance contracts.” That led companies with the difficult task of interpreting which expenses qualified for deferral and often prompted a broad range of insurance firms to categorize most of their costs as DAC.
FASB later concluded that DAC accounting was being abused. The board responded by providing clearer guidelines. ASU 2010-26 was accompanied by two important changes to meet the capitalization criteria:
- Companies may only defer costs associated with the successful placement of new business, rather than all sales-related expenses.
- Only a portion of back-office expenses directly linked to revenues can be considered a DAC asset.
Examples of deferrable costs include:
- Commissions in excess of ultimate commissions
- Underwriting costs
- Policy issuance costs