What are Deferred Acquisition Costs?
Deferred acquisition cost (DAC) is an accounting measure that is specific to the insurance industry. As the term suggests, this accounting method represents the deferral of acquisition costs or the sales costs that an insurance company incurs in acquiring insurance contracts. DAC is an asset that sits on an insurance company’s balance sheet and represents the total of all costs incurred in acquiring new customer insurance contracts. Recognition of the acquisition costs is deferred and amortized over the lifetime of the insurance contracts. By recognizing expenses periodically over time rather than in full when they are incurred, the insurer can produce a smoother pattern of earnings over time. Before delving into more detail with DAC, let’s have a quick recap of how insurance companies make money and why DAC is necessary.
Key Learning Points
- Insurance companies incur significant one-time costs when acquiring a new customer, and these upfront costs may exceed premiums early in the life of the policy.
- Deferring acquisition costs and amortizing them over time creates a smoother pattern of earnings.
- Various accounting standards (IFRS, US GAAP) treat DAC differently.
How Do Insurers Make Money?
Insurers are in the business of managing risk. Individuals and companies that are concerned about potential hazards (e.g., accidents, theft, business risks, etc.) pay premiums to an insurance company, which in turn compensates them in the event of a loss. Economically speaking, insurance works by transferring risk from individuals to a larger group, which is better able to bear losses as they arise.
Insurance companies generate revenue by charging premiums and price risk by using sophisticated statistical tools and algorithms. Their actuaries determine the probability of an event occurring and the probability that the insured party will make a claim over the coverage period. The insurer collects premiums (revenue) from their customers in an amount based on the customer risk profile. While a one-time premium payment is possible, this is rare, as a significant proportion of customers prefer to pay their premiums at regular intervals – either monthly or annually. The insurance company invests the premiums in financial assets (there are significant restrictions on the type of financial assets acceptable), typically bonds, and generates investment income.
The Uneven Nature of Earnings in the Insurance Industry
In acquiring customers, the insurance company incurs significant sales costs. Some of these include
- Commissions paid to insurance agents and brokers
- Salaries, marketing, and advertising costs, and other administrative expenses
- Survey expenses (particularly in the case of property insurance)
These costs are incurred at the time the policy is sold (known in the insurance industry as “writing new business”). Under traditional accounting rules, these expenses would be reflected on the company’s income statement as they arise. However, an insurance company’s revenue is spread over the life of the insurance contract since premium income is received monthly/annually for the duration of the contract.
The result is an uneven earnings profile, with all the costs incurred upfront while the revenue is received over time, as illustrated in the diagram below.
This revenue and expense structure doesn’t accurately reflect the profitability of the insurance contract – and, as an extension, the business. This is where the DAC methodology comes into play, as it enables insurance companies to spread out the large upfront costs gradually – as they earn premiums – over the life-cycle of the insurance product, resulting in a “smoother” and more accurate picture of the insurance company’s earnings.
Present Value of Premiums
As observed above, the DAC method allows insurance companies to smooth earnings over the life of the insurance contract. This requires the insurance company to focus on both costs and revenue (premiums). Assume the insurance company sells a ten-year insurance contract with a monthly premium. The insurer knows with 100% certainty the total amount of premium revenue it will receive over the course of the next 120 months – and calculates the net present value of this revenue stream.
Different accounting standards have slightly different rules regarding how this is done (as well as around what discount rate is used), but fundamentally, the principle is the same. Once the insurer has the present value of the premium, it can deduct the costs incurred from selling this premium – and get an estimate of the gross profit earned. It is important to note that the DAC cannot exceed the estimated future gross profit arising from a particular insurance contract.
Putting it all together: DAC Accounting
As discussed above, the aim of DAC is to smooth the earnings profile for each of the insurance company’s contracts. DAC, therefore, represents the accumulated cost of acquiring new insurance contracts, which is then amortized over the duration of the contracts. DAC is an intangible asset that appears on the balance sheet.
Different accounting standards prescribe different principles when it comes to the accounting treatment of DAC – and differ most significantly in stating which acquisition costs can be deferred. Broadly speaking, US GAAP (the US accounting standard) allows for more types of acquisition costs to be deferred than other accounting standards. IFRS (International Financial Reporting Standard), which is the accounting standard used by the UK and European insurers, is slightly more conservative, resulting in a proportionately smaller number of acquisition costs to be deferred.
Regardless of the accounting standard, the DAC sits on the balance sheet as an intangible asset – to match costs with related revenues (premiums) as they are earned. And just like other intangible assets, the value of the DAC is amortized over the term of the insurance contract. In other words, over time, the acquisition costs (of acquiring a particular insurance contract) are recognized as an expense that reduces the DAC asset on the balance sheet. These costs are recognized in the income statement over the term of the insurance contract. Thus we see the “smoother” earnings profile for the insurance contract, as illustrated below.
Deferred acquisition cost is important to the insurance industry since it helps achieve a stable pattern of earnings. As highlighted above, different accounting standards have different rules regarding the DAC asset (which is an intangible asset on the balance sheet), particularly around what expenses can be included in the DAC calculation. In addition, it is important to note that these rules also differ across different types of insurance contracts – that is, the DAC rules for longer-duration insurance contracts (these are generally life insurance contracts, which by their very definition are long-dated) are not the same as those for shorter-duration insurance contracts. Finally, note that the accounting rules for insurers – particularly after the global financial crisis of 2008, have been tightened significantly, with increasingly conservative measures being introduced over time.