What is 'Deferred Acquisition Costs (DAC)'

Typically used in the insurance industry, deferred acquisition costs (DAC) is when a company defers the sales costs that are associated with acquiring a new customer over the term of the insurance contract.

BREAKING DOWN 'Deferred Acquisition Costs (DAC)'

Most of the sales costs arise from referral commissions to external distributors and brokers. These are the costs to which deferred acquisition costs action can apply 

Insurers incur up-front customer acquisition expenses that can amount to multiples of the policy’s first-year premium. As of 2012, insurers were 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 companies to capitalize these costs and amortize them over time. The resulting DAC can be a substantial asset on carriers’ balance sheets that must be in compliance with generally accepted accounting principles (GAAP).

Implementation of DAC tends to reduce the first-year strain of a policy and produces a smoother pattern of earnings.

Examples of Deferrable Acquisition Costs

To meet the capitalization criteria, expenses must vary with and be primarily related to the acquisition of new business. All other expenses associated with the new business that do not vary with and are not primarily related to new policies are classified as non-deferrable acquisition expenses. Examples of deferrable costs include:

  • Commissions in excess of ultimate commissions
  • Underwriting costs
  • Policy Issuance costs

DAC Amortization

DAC represents the “un-recovered investment” in the policies issued and are 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 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. Meanwhile, DAC amortization uses estimated gross margins as a basis and an interest rate is applied to the DAC based on investment returns.

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