Deferred Acquisition Costs (DAC) is a term commonly used in the insurance

General insurance

General insurance or non-life insurance policies, including automobile and homeowners policies, provide payments depending on the loss from a particular financial event. General insurance typically comprises any insurance that is not determined to be life insurance. It is called property and...

 business. It describes the practice of deferring

Deferral

Deferred, in accrual accounting, is any account where the asset or liability is not realized until a future date , e.g. annuities, charges, taxes, income, etc. The deferred item may be carried, dependent on type of deferral, as either an asset or liability...

 the cost of acquiring a new customer over the duration of the insurance contract. Insurance companies face large upfront costs incurred in issuing new business, such as commissions

Commission (remuneration)

The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...

 to sales agents, underwriting

Underwriting

Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...

, bonus interest and other acquisition expenses.

DAC under U.S. GAAP, MSSB (Modified Statutory Solvency Basis) and IAS 39

IAS 39

IAS 39: Financial Instruments: Recognition and Measurement is a measure of instrument of the International Accounting Standards Board ....

 are all very similar, except that
IAS 39 only allows direct, incremental costs to be deferred rather than all acquisition costs.

Background

Insurance companies incur large expense

Expense

In common usage, an expense or expenditure is an outflow of money to another person or group to pay for an item or service, or for a category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture or an automobile is often...

s when acquiring new business, but to ensure that they comply with GAAP's matching principle

Matching principle

The matching principle is a culmination of accrual accounting and the revenue recognition principle. They both determine the accounting period, in which revenues and expenses are recognized. According to the principle, expenses are recognized when obligations are incurred The matching principle...

 they need to spread out these costs over the period in which revenues are earned.

The DAC is treated as an asset

Asset

In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...

 on the Balance Sheet

Balance sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

 and amortized

Amortization

Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...

 over the life of the insurance contract.

Accrual accounting of DAC

Accrual accounting and deferring implies timewise matching(synchronization) of income and expenses: an incurred cost is capitalized and does not become an expense until it is recognized in the financial statements of the company. In an accounting sense, it is the amortization of that cost, and not the original cost itself, that becomes the expense. Hence, certain costs which are incurred to acquire insurance contracts should not be recognized as an expense in the accounting period in which they are incurred but should be capitalized as an asset on the balance sheet and gradually amortized over the lifetime of the insurance contracts. Such costs are called Deferred Acquisition Expenses (DAE) and capitalization of DAE results in setting up of an asset called Deferred Acquisition Costs (DAC).

Establishment of the DAC asset tends to reduce the policy’s first year strain and generally produces a smoother pattern of earnings.

To meet the capitalization criteria, these expenses must vary with and be primarily related to the acquisition of new business.

Examples of Deferrable Acquisition Expenses:

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

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.

DAC Amortization

Deferred Acquisition Costs (DAC) represents the “un-recovered investment” in the business and are therefore capitalized as an intangible asset to systematically match costs with related revenues. Over a period of time the acquisition costs are recognized as an expense, this is done by reducing 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 written-off.

The amortization requires an amortization basis that determines how much DAC should be written-off as an expense in each accounting period. The amortization basis varies by 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 and require adjusting DAC as needed. In addition, DAC amortization

Amortization

Amortization is the process of decreasing, or accounting for, an amount over a period. The word comes from Middle English amortisen to kill, alienate in mortmain, from Anglo-French amorteser, alteration of amortir, from Vulgar Latin admortire to kill, from Latin ad- + mort-, mors death.When used...

 uses estimated gross margin

Gross margin

Gross margin is the difference between revenue and cost before accounting for certain other costs...

s as a basis and an interest rate

Interest rate

An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

is applied to the DAC based on investment returns. The rate at which one amortized the DAC is referred to the k-factor.

A write off of DAC or amortization of DAC may be caused by dynamical unlocking or true up. The replacement of assumptions by experience for the projections of future years is called “dynamical unlocking”. The replacement of assumed values by realized values of the past year is called “true up process”.

• Shadow DAC includes unrealized gains as required for balance sheet reporting. In other words Shadow DAC is applied to reduce/increase the amortization of the DAC taking into consideration the unrealized gains and losses.
• Regular DAC amortization affects the income statement and does not take unrealized gains into account. In other words, regular DAC amortization takes into account any realized gains and losses in order to smooth out earnings. In case of a large loss regular DAC amortization can be applied to "defer" the acquisition costs to future periods thereby reducing the expenses and increasing yield for the specific period. The DAC amortization will thus increase in future reporting periods.

The K-Factor

Also referred to as KDAC, the K-Factor is basically the percentage of gross profits required to provide for deferred policy acquisition costs. KDAC is:
DAC amortization rate = Present value of Deferrable Acquisition Expenses + Accumulated Value of DAC/Present value of Estimated Gross Profits(EGPs) + Accumulated value of Actual Gross Profits(AGPs)

The K-factor can change from year to year due to:

1) The true-up process (replacement of expected values by realized values, i.e. actual historical gross profits (AGP) replace prior estimates of Gross profits (EGP))

2) The dynamical unlocking (replacement of assumptions by experience for the projections of future years)

The DAC is recoverable if the k-factor is less than 100%.

If there is an Unearned Revenue Liability, it may even be recoverable if the K-factor is higher than 100%.
If the K-factor is greater than 100% and there is no URL, a portion of the DAC or the total DAC has to be written off immediately, so that the new K-factor is equal 100%.

External links

• Example of Audit Program
• General Information
• Calculating DAC under FAS 97