Understanding Deferred Acquisition Costs (DAC) in Insurance

What Are Deferred Acquisition Costs in Insurance?

Deferred acquisition costs (DAC) is an accounting method that is applicable in the insurance industry. The DAC method lets companies spread out the costs of getting a new customer over the insurance contract term.

Deferred acquisition costs (DAC) are the costs an insurance company spends to sell a policy, such as commissions or marketing. DAC is spread out over the life of a contract instead of being counted all at once. This helps insurers avoid large initial expenses so they can smooth out their earnings over time. DAC is important because it makes financial results more stable and predictable. Accounting rules, such as ASU 2010-26, offer guidance on how insurance companies should handle DAC.

The Benefits of DAC for Insurance Companies

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.

The FASB lets insurance companies spread out the costs of getting new customers over time.. With this process, DACs are recorded as assets—rather than expenses—and they can be paid off gradually.

The FASB requires companies to spread out balances evenly over the contract term. 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.

Important Factors for Utilizing DAC in Insurance

The Impact of DAC Amortization on Financial Statements

DAC shows the “unrecovered investment” in policies and is counted as an intangible asset to match costs with revenues. Over time, the acquisition costs turn into expenses that lower the DAC asset. This process, called amortization, refers to how DAC assets decrease over the years in the income statement.

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.

Essential Requirements for DAC Accounting Compliance

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

The Bottom Line

Deferred acquisition costs are an accounting method insurance companies use to spread the costs of acquiring new policies over the life of the contract. This helps smooth earnings by avoiding large upfront expenses. According to FASB’s ASU 2010-26, only costs tied to successfully placed new business can be deferred. DAC is recorded as an asset on the balance sheet and gradually amortized. If a contract ends unexpectedly, DAC must be taken off the books to keep sales costs organized.