Under the deferral method, the incurred expenditures are not recorded immediately as an expense, but are instead spread out over the term of the policy. Expenses that can be amortized under this method include commissions paid to agents, marketing costs, and other acquisition costs incurred. Deferred acquisition costs can be carried on the balance sheet as an asset and are considered deferred income, even if the company has none of its own capital invested in the policy.

In essence, deferred acquisition costs (DAC) allows an insurance company to defer its expenses over the term of the policy, as opposed to expensing them immediately which is recognized as the normal accounting method. Generally Accepted Accounting Principle (GAAP) states that all costs of acquiring a new policyholder must be expensed in the period in which they are incurred. The DAC approach, however, allows the expenses to be spread out for financial reporting purposes.

Using DAC helps to improve the insurance's cash flow and increase the yield of the policy. It helps to reduce the “first-year strain” of the policy by taking acquisition costs associated with new business and spreading them out over the life of the policy. This allows the insurer to spread its expenses more evenly during the policy lifecycle.

Insurers typically choose to use the DAC method in order to smooth out its income statement over the life of the policy. By capitalizing the costs and spreading them over the life of the policy, insurers can reduce the volatility of their income statements and provide more accurate financial statements over time.

Deferred acquisition cost can be a great tool for insurance companies when used wisely. It improves the company’s financial reporting by smoothing the income statement and giving the company more time to use the deferred acquisition costs. However, the costs incurred must be evaluated carefully to make sure they are reasonable and necessary to acquire customers. When used properly, it can provide great financial results and increase the profitability of the company.