What are Deferred Acquisition Costs (DAC)?
The accounting method of deferred acquisition costs (DAC) is the process of writing off acquisition costs over the tenure of the contract. The part of the cost not covered through premium receipts in the first year is capitalized. It means that the unrecovered cost is recorded as a fixed, intangible asset on the balance sheet, and its value is written off or amortized over a number of years.
An insurance company incurs some expenditure in order to get a new client or renew a particular contract. The costs include commissions paid to brokers and underwriters, expenses incurred on account of risk assessment, and the cost 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 revenues that the insurance company generates 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.
- The process of writing off acquisition costs over the tenure of the contract is the accounting method of deferred acquisition costs (DAC).
- It means that the unrecovered cost is recorded as a fixed, intangible asset on the balance sheet, and its value is written off or amortized over a number of years.
- An insurance company incurs some acquisition costs in order 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 on the basis of 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 its provisions cannot be adjusted by the user. 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. The enterprises are owned by policyholders; that is, the latter nominate and elect the board of directors. All profits are shared among the policyholders in a pre-determined 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, the estimation of future cash flows, among others. 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 term of the policy, that is, five years. The part of the cost not written off will be recorded as an asset in the balance sheet.
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