The process of writing off acquisition costs over the tenure of the contract
Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets
In the insurance industry, deferred acquisition costs are the accumulated costs of acquiring new insurance contracts and amortizing them over the duration of the contracts. The portion of unrecoverable costs from premium receipts is capitalized as intangible assets on the balance sheet. Amortizing over the contract term aligns with GAAP’s matching principle.
Insurance companies incur expenditures to acquire new clients or to renew a particular contract. These costs include commissions paid to brokers and underwriters, underwriting costs, and costs of issuing the policy. They are known as acquisition costs since they are incurred by the company while acquiring new business.
Often, acquisition costs exceed the insurance company’s revenues through the premium received in the first year. The Federal Accounting Standards Board (FASB) allows insurance companies to write off acquisition costs over the duration of the contract, instead of all at once. The FASB is the organization that establishes rules for accounting and financial reporting for companies and non-profit entities in the U.S.
Insurance contract acquisition costs that exceed the premium receipts earned are capitalized and are called deferred acquisition costs (DAC).
These unrecovered costs are capitalized as fixed, intangible assets on the balance sheet, and their value is written off or amortized over several years.
An insurance company typically incurs some acquisition costs to get a new client or renew a particular contract.
Accounting for 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:
1. FAS 60
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.
2. FAS 97
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.
3. FAS 120
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 FASB sets distinct rules on accounting for DACs for each of the above categories. The differences depend on the proportion of commissions that can be capitalized and the estimation of future cash flows. However, the basic accounting treatment of DACs is similar across all categories.
The working principle of the contract requires insurance companies to ensure that the present value of all future premium payments must be equal to the present value of all acquisition costs. It can be understood through the following simplified example.
Consider an insurance policy where the policyholder pays a yearly premium of $2,000 for the next five years. The annual market interest rate is 10%. The present value of all premium payments is computed in the following manner:
For the acquisition cost to be recoverable, its value must be less than $6,481.57. Assume the acquisition cost for the insurance company is $5,000. Then, the amount can be written off throughout the policy, that is, five years. The part of the cost not written off will be recorded as an asset in the balance sheet.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!
Take your learning and productivity to the next level with our Premium Templates.
Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.
Already have a Self-Study or Full-Immersion membership? Log in
Access Exclusive Templates
Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.