Deferred Acquisition Cost (DAC) — the amount of an insurer’s acquisition costs incurred as premium is written but earned and expensed over the term of the policy. The unearned portion is capitalized and recognized as an asset on the insurer’s balance sheet.
Acquisition costs are the direct and indirect variable outlays incurred by an insurer at the time of selling or underwriting an insurance contract (both new and renewal). The costs may be in the form of brokerage, underwriting costs or medical expenses, etc.
The accounting norms stipulate that the acquisition costs can be capitalized and deferred if they can be offset by the revenues or future investment margins earned during the duration of the insurance contract. Investment margin refers to the difference between the investment earnings and interest payments.
Deferred Acquisition Costs (‘‘DAC’’)
DAC represents the costs of acquiring new business, principally direct sales commissions and other distribution and underwriting costs that have been deferred on the sale of annuity and insurance products and, to a lesser extent, certain mutual fund products.
These costs are deferred to the extent they are recoverable from future profits or premiums. The DAC
associated with insurance or annuity contracts that are significantly modified or internally replaced with another contract are accounted for as contract terminations. These transactions are anticipated in establishing amortization periods and other valuation assumptions.
Direct sales commissions and other costs deferred as DAC are amortized over time. For annuity and universal life contracts, DAC is amortized based on projections of estimated gross profits over amortization periods equal to the approximate life of the business. For other insurance products, DAC is generally amortized as a percentage of premiums over amortization periods equal to the premium-paying period.
For certain mutual fund products, DAC is generally amortized over fixed periods on a straight-line basis adjusted for redemptions. For annuity and universal life insurance products, the assumptions made in projecting future results and calculating the DAC balance and DAC amortization expense are management’s best estimates. Management is required to update these assumptions whenever it appears that, based on actual experience or other evidence, earlier estimates should be revised.
When assumptions are changed, the percentage of estimated gross profits used to amortize DAC might also change. A change in the required amortization percentage is applied retrospectively; an increase in amortization percentage will result in a decrease in the DAC balance and an increase in DAC amortization expense, while a decrease in amortization percentage will result in an increase in the DAC balance and a decrease in DAC amortization expense.
The impact on the results of operations of changing assumptions can be either positive or negative in any particular period and is reflected in the period in which such changes are made.
Accounting for Deferred Acquisition Costs(DACs)
The organization setting a country’s accounting standards establishes certain principles on the accounting of economic transactions. The principles are known as Financial Accounting Standards (FAS). The FAS classifies financial and insurance products based on their tenure and terms. The accounting treatment of DACs associated with each of the classes of products is different.
The FAS classifies insurance products in the following categories:
The FAS 120 category extends the accounting practices associated with FAS 60 and FAS 97 contracts to mutual life insurance enterprises. Policyholders own the enterprises; that is, the latter nominate and elect the board of directors. All profits are shared among the policyholders in a predetermined ratio.
The FAS-60 category includes short-duration and long-duration contracts. The FAS 60 short-duration contract includes insurance covers for a specific short duration, the provisions of which can be adjusted by the user. An example is property insurance.
The FAS 60 long-duration contract extends over a longer period of time, and the user cannot adjust its provisions. Some examples are endowment contracts, title insurance contracts, and annuity contracts.
The FAS 97 category includes long-term insurance policies that were not covered under FAS 60. The contracts are termed as universal life-type insurance contracts. They are similar to term-life policies but are more flexible since they allow adjustment of their provisions. Most of the contracts developed and gained popularity after the FAS 60 standards were established.
Deferred acquisition cost is important to the insurance industry since it helps achieve a stable pattern of earnings. As highlighted above, different accounting standards have different rules regarding the DAC asset (which is an intangible asset on the balance sheet), particularly around what expenses can be included in the DAC calculation.
In addition, it is important to note that these rules also differ across different types of insurance contracts – that is, the DAC rules for longer-duration insurance contracts (these are generally life insurance contracts, which by their very definition are long-dated) are not the same as those for shorter-duration insurance contracts. Finally, note that the accounting rules for insurers – particularly after the global financial crisis of 2008, have been tightened significantly, with increasingly conservative measures being introduced over time.