What are deferred acquisition costs – CAD?
Usually used in the insurance sector, deferred acquisition costs (DAC) correspond to a company that defers the selling costs associated with the acquisition of a new client during the term of the insurance contract.
Understanding deferred acquisition costs (CAD)
Insurance companies face significant up-front costs when initiating new business, including referral commissions to external distributors and brokers, sales charges and medical costs. Often these costs may exceed the premiums paid in the first years of the different types of insurance plans.
The implementation of the DAC allows insurance companies to gradually spread these costs as they generate revenue. The use of this accounting method tends to reduce the pressure on policy in the first year and produces a more harmonious compensation model.
In 2020, insurers were required to comply with a new rule of the Federal Accounting Standards Board (FASB), “Accounting for costs associated with the acquisition or renewal of insurance contracts” or ASU 2020-26. The FASB allows companies to capitalize on these costs and amortize them over time, which means that they are recognized as assets rather than expenses and can be reimbursed gradually.
The CED is treated as an asset on the balance sheet and amortized over the duration of the insurance contract, in accordance with generally accepted accounting principles (GAAP).
The FASB requires businesses to amortize balances “at a constant level” over the expected duration of the contracts. In the event of an unexpected contract termination, the FASB decides that the DAC should be written off but is not subjected to an impairment test, which means that the asset is not evaluated to see if it is still worth the amount indicated in the balance sheet.
Amortization of CAD
CAD represents “investment not recovered” in policies issued and is therefore capitalized as an intangible asset to match costs with related income. Over time, acquisition costs are expensed which reduce the CAD assets. The process of recognizing costs in the income statement is called depreciation and refers to the CAD assets that are depreciated or reduced over a number of years.
Amortization requires a basis that determines the amount of the CED that must be converted into an expense for each accounting period. The depreciation base varies according to the classification of federal accounting standards (FAS):
- FAS 60 / 97LP – Premiums
- FAS 97 – Estimated gross profit (EGP)
- FAS 120 – Estimated Gross Margins (EGM)
Under FAS 60, the assumptions are “locked” to the policy question and cannot be changed. However, under FAS 97 and 120, the assumptions are based on estimates which can be adjusted if necessary. CAD amortization uses the estimated gross margins as a basis and an interest rate is applied to CAD based on the returns on investments.
Deferred acquisition cost (CAD) requirements
Prior to the introduction of ASU 2020-26, CAD was vaguely described as costs that “vary with and are mainly related to the acquisition of insurance contracts”. This has led companies to the difficult task of interpreting expenses that can be deferred and often prompted a wide range of insurance companies to classify most of their costs in the CAD.
The FASB subsequently concluded that the CAD accounting was abused and responded by providing clearer instructions. ASU 2020-26 was accompanied by two major changes to meet the capitalization criteria:
- Businesses can only defer costs associated with successfully placing new business, rather than all expenses related to sales.
- Only part of the back office expenses directly linked to revenues can be considered as CAD assets.
The following are examples of deferred charges:
- Commissions higher than ultimate commissions
- Subscription fees
- Policy issue costs
Key points to remember
- Deferred acquisition costs (DAC) correspond to a company that defers the costs associated with the acquisition of a new client during the term of the insurance contract.
- The use of this accounting method tends to reduce the pressure on policy in the first year and produces a more harmonious compensation model.
- CAD is capitalized as an intangible asset to match costs with related revenues.
- Businesses can only carry forward the costs associated with successfully placing new business and cannot amortize all back office expenses.