Deferred Acquisition Costs (DAC)

Deferred Acquisition Costs (DAC) — Definition and Overview

Deferred acquisition costs (DAC) are the costs an insurance company incurs to acquire new policies—commissions, underwriting, policy issuance, marketing and certain distribution expenses—that are capitalized as an asset and amortized over the life of the insurance contract. Capitalizing these acquisition costs smooths earnings by matching the expense recognition with the period over which revenue is earned.

Why DAC Matters

• Smooths volatility in earnings by spreading large upfront sales and distribution costs over the contract term.
• Reflects the “unrecovered investment” in in-force business on the balance sheet rather than recognizing a large expense immediately.
• Provides a clearer view of profitability by matching acquisition costs to the revenue those policies generate.

Accounting treatment

• DAC is recorded as an asset on the balance sheet and amortized into expense on the income statement over the applicable contract term.
• Amortization reduces the DAC asset over time as acquisition costs are recognized as expenses.
• If a contract terminates unexpectedly, remaining DAC related to that contract must be written off. DAC is generally not subject to a periodic impairment test.

Amortization methods and bases

The basis for amortizing DAC depends on the accounting framework and contract type:
* FAS 60 / 97LP: amortization based on premiums.
* FAS 97: amortization based on estimated gross profits (EGP).
* FAS 120: amortization based on estimated gross margins (EGM).

Under some frameworks (e.g., FAS 60) assumptions are “locked in” at policy issue and not changed; under others (FAS 97 and FAS 120) assumptions are estimate-driven and may be adjusted as experience emerges. DAC amortization often incorporates an interest or discount rate tied to expected investment returns.

Regulatory clarification and limits (ASU 2010-26)

Accounting guidance tightened the criteria for deferring acquisition costs to address overly broad practices:
* Only costs directly associated with successfully issued (in-force) contracts may be deferred.
* Only a reasonable portion of back-office and servicing costs that are directly related to acquiring new business may be capitalized.
* Items that qualify typically include sales commissions, underwriting and policy issuance costs, and certain distribution expenses that vary with and are primarily related to acquisition of contracts.

These changes aimed to reduce capitalization of general selling expenses that are not clearly incremental to successful new business.

Examples of deferrable and non-deferrable costs

Deferrable (when directly attributable to successful placements):
* Sales commissions and other direct distributor payments
* Underwriting and medical examination costs
* Policy issuance costs

Not generally deferrable:
* Broad marketing campaigns or general administrative overhead not directly attributable to successful contracts
* Costs that do not vary with or are not primarily related to acquiring contracts

Impact on financial statements

• Balance sheet: DAC increases intangible assets when capitalized.
• Income statement: Amortization of DAC is recognized as an expense over the contract life, smoothing early-year profitability.
• Earnings volatility is reduced because acquisition costs are matched with future revenues.

Bottom line

Deferred acquisition costs let insurers match acquisition expenses to the revenue-producing life of policies, improving comparability and smoothing reported earnings. Rigorous application of accounting guidance is required: only costs tied to successfully placed contracts and directly attributable acquisition activities should be capitalized, and remaining DAC must be written off if contracts terminate prematurely.