Gaap, Life Insurance, And Dac: What's Allowed?

Deferred acquisition costs (DAC) are an accounting method used in the insurance industry to defer the sales costs associated with acquiring a new customer over the term of the insurance contract. DAC is an asset on the balance sheet representing the deferral of the cost of acquiring new insurance contracts, amortising the costs over their duration. This is particularly relevant for life insurance companies, which face large upfront costs when issuing new business, such as commissions to sales agents, underwriting, and other acquisition expenses. Under US GAAP, insurance companies are allowed to capitalise on the costs of acquiring new customers by amortising them over time. This results in a smoother pattern of earnings.

How is DAC treated in GAAP?

Deferred acquisition costs (DAC) are an accounting method used in the insurance industry. DAC allows a company to defer the sales costs associated with acquiring a new customer over the term of the insurance contract. This method is applicable when the acquisition costs exceed the insurance company's revenues from the premium received in the first year.

DAC is treated as an asset on the balance sheet and amortized over the life of the insurance contract. This process is known as amortization and refers to the DAC asset being reduced over a number of years. The amortization requires a basis that determines how much DAC should be turned into an expense for each accounting period. The basis varies by the Federal Accounting Standards (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 the policy issue and cannot be changed. However, under FAS 97 and 120, assumptions are based on estimates that can be adjusted as needed. Additionally, DAC amortization uses estimated gross margins as a basis, and an interest rate is applied to the DAC based on investment returns.

The use of DAC in insurance accounting is allowed under GAAP, as it aligns with GAAP's matching principle. However, it is important to note that not all acquisition costs can be deferred. Only costs that are directly related to the successful placement of new business and vary with the acquisition of new policies can be classified as DAC. Other expenses, such as non-deferrable acquisition expenses, are recognized as expenses in the accounting period in which they are incurred.

What is the impact of DAC on earnings?

Deferred Acquisition Costs (DAC) have a notable impact on earnings. DAC is an asset on the balance sheet, representing the deferral of the cost of acquiring new insurance contracts. This method allows insurance companies to spread out the significant upfront costs of acquiring new business, such as referral commissions, underwriting, and medical expenses, over the duration of the contract. This approach ensures a more balanced and predictable earnings pattern by reducing the strain on the first year's financials.

The implementation of DAC by the Federal Accounting Standards Board (FASB) in 2012 introduced the "Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts" rule (ASU 2010-26). This rule allows insurance companies to treat DAC as an asset rather than an immediate expense, amortizing it over the life of the insurance contract. This gradual recognition of costs as expenses over time helps create a smoother earnings trajectory.

The impact of DAC on earnings is significant. By deferring acquisition costs, insurance companies can avoid upfront expenses outweighing premiums received in the initial years, especially in cases of substantial upfront costs. This ensures that earnings are spread out more evenly over the contract's lifespan, improving profitability and financial stability.

The specific impact on earnings can be seen through the calculation of the K-factor or KDAC, which is the amortization rate of DAC. The K-factor is calculated as the percentage of gross profits required to cover deferred policy acquisition costs. A K-factor of less than 100% indicates that the DAC is recoverable, while a K-factor greater than 100% may require a write-off of a portion or the entire DAC.

In summary, DAC plays a crucial role in shaping the earnings of insurance companies by providing a strategic method to manage acquisition expenses. By deferring and spreading out these costs over the duration of insurance contracts, DAC helps create a smoother and more balanced earnings pattern, ultimately enhancing the financial stability and transparency of insurance companies.

How does DAC affect tax reserves?

Deferred acquisition costs (DAC) are an asset on the balance sheet, representing the deferral of the cost of acquiring new insurance contracts. DAC is treated as an asset and amortized over the life of the insurance contract.

DAC is used to offset the timing mismatch between an insurer collecting taxes and paying the IRS. The 'DAC Tax' is a proxy for acquisition expenses, with a percentage of premiums being deferred into a tax asset. This reduces the tax reserves, which in turn increases tax liability.

The DAC tax is a benefit for the IRS, as it results in a 0% interest loan on a percentage of the insurer's premiums, paid back over a number of years. This means that the DAC tax does affect tax reserves, as it increases tax liability.

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 the policy issue and cannot be changed. However, under FAS 97 and 120, assumptions are based on estimates that require adjusting DAC as needed.

The DAC is recoverable if the K-factor is less than 100%. The K-factor is the percentage of gross profits required to provide for deferred policy acquisition costs. If the K-factor is greater than 100%, a portion of the DAC must be written off immediately.

How does DAC work for different types of insurance policies?

Deferred acquisition costs (DAC) is an accounting method that insurance companies use to defer the sales costs associated with acquiring a new customer over the term of the insurance contract. DAC is treated as an asset on the balance sheet and amortized over the life of the insurance contract.

The Federal Accounting Standards Board (FASB) allows insurance companies to capitalize on the costs of acquiring new customers by amortizing them over time. This process allows DACs to be recorded as assets and paid off gradually, rather than being recognized as expenses. The FASB also requires companies to amortize balances on a constant level basis over the expected term of the contracts. In the case of unexpected contract terminations, the FASB rules state that DAC must be written off, but it is not subject to an impairment test.

The specific treatment of DAC depends on the type of insurance policy in question. The FASB sets distinct rules for accounting for DACs for different categories of insurance products. These categories include:

• FAS-60: This category includes short-duration and long-duration contracts. Short-duration contracts cover insurance for a specific period, such as property insurance, while long-duration contracts extend over a longer period and cannot be adjusted, such as endowment or annuity contracts.
• FAS 97: This category includes long-term insurance policies that are not covered under FAS 60, such as universal life-type insurance contracts.
• FAS 120: This category extends the accounting practices associated with FAS 60 and FAS 97 contracts to mutual life insurance enterprises, where policyholders own the enterprise and share profits.

The basic accounting treatment of DACs is similar across all categories, but the differences lie in the proportion of commissions that can be capitalized and the estimation of future cash flows.

Overall, the use of DAC allows insurance companies to spread out the large upfront costs of acquiring new customers, resulting in a smoother pattern of earnings over the life of the insurance contract.

What are the requirements for DAC?

Requirements for DAC

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

Commissions in excess of ultimate commissions and policy issuance costs are examples of deferrable 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.

Prior to the introduction of ASU 2010-26, DAC was described vaguely as costs that “vary with—and are primarily related to—the acquisition of insurance contracts”. This left companies with the difficult task of interpreting which expenses qualified for deferral, and often prompted a broad range of insurance firms to categorize most of their costs as DAC.

FASB later concluded that DAC accounting was being abused. The board responded by providing clearer guidelines. ASU 2010-26 was accompanied by two important changes to meet the capitalization criteria:

• Companies may only defer costs associated with the successful placement of new business, rather than all sales-related expenses.
• Only a portion of back-office expenses directly linked to revenues can be considered a DAC asset.

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