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Deferred Acquisition Costs include all expenses that vary with and are directly related to the acquisition of new and renewal contracts.These expenses are capitalized and amortized over a period not exceeding the life of the policy,in proportion to Estimated Gross Profits (EGP).
The EGP is defined as:

EGP =
Cost of insurance charges(Mortality charges assessed) less death benefits paid in excess of account values released
+ Level expenses charges less administration expenses
+ Investment earnings on account balances less interest credited
+ Surrender charges collected

The EGPs are projected until the end of all contracts of the corresponding book of business using best estimate assumptions.The present values of the EGPs are calculated by using the credited rate as discount rate.
These assumptions are adjusted for future years according to actual experience.

A write off of DAC or amortization of DAC may be caused by dynamical unlocking or true up.
The replacement of assumptions by experience for the projections of future years is called “dynamical unlocking”.
The replacement of assumed values by realized values of the past year is called “true up process”.

The DAC balance as at the valuation data can be derived using the following two methods:

1)Retrospective Method:

Ending DAC Balance (EOY DAC) =
  Beginning DAC balance (BOY DAC)
  + New DAC (DE)
  + DAC Interest on BOY DAC and DE
  – DAC Amortization Charge (kDAC x EGP)

Mathematically,
DAC(t) = (DAC(t-1) + DAE(t))*(1+i(t))- K*AGP(t)
where,
•Beginning DAC balance will equal the closing DAC balance from the previous reporting period.

•New DAC is the amount of new DAC created in the reporting period. This reflects the DAC created for new business written in the reporting period as well as the additional DAC created on in-force business. New DAC includes:

Commission DAC
Expense(Non Commission) DAC

•Interest on DAC - As DAC is an asset on the balance sheet of the company, it earns interest.

•DAC Amortization - This reflects the amount of DAC that is charged as an expense in the income statement in the current reporting period.
Mathematically,Amortization for period t = KDAC * Actual Gross Profits(t)
KDAC is the DAC amortization rate and equals
Present value of Deferrable Acquisition Expenses + Accumulated Value of DAC/Present value of Estimated Gross Profits(EGPs) + Accumulated value of Actual Gross Profits(AGPs)

KDAC is basically percentage of gross profits required to provide for deferred policy acquisition costs.
The K-factor can change from year to year due to:
1)The true-up process (replacement of expected values by realized values, e.g. Actual historical gross profits(AGP) replace prior estimates of Gross profits(EGP)
2)The dynamical unlocking ( replacement of assumptions by experience for the projections of future years)
The DAC is recoverable if the k-factor is less than 100%.
If there is and Unearned Revenue Liabiliy, it may even be recoverable if the K-factor is higher than 100%.
If the K-factor is greater than 100% and there is no URL, a portion of the DAC or the total DAC has to be written off immediately, so that the new K-factor is equal 100%.

2)Prospective View of DAC

DAC Balance = kDAC x PV(Future Gross Profits) – PV(Future Deferred Expenses)
Mathematically,
DAC(t) = K*PV(EGP(t))- PV(DAE(t))

Formula(1) is preferred, because this DAC-roll forward provides more insight.

Deferred Acquisition Costs include all expenses that vary with and are directly related to the acquisition of new and renewal contracts.These expenses are capitalized and amortized in proportion to Estimated Gross Margins (EGM)

EGMs =
 Premiums
 plus  investment income on benefit reserve
 less  Non deferred expenses (This includes maintenance expense and ultimate renewal commission)
less  change in net level premium reserve

less  Death,surrender and endowment benefits
less  policyholder dividends

Assumptions for Estimated Gross Margins
1) Assumptions must be best estimate
2) Assumptions are continually unlocked as US GAAP book says on page 133 under section 5.5
“The assumptions underlying the policyholder benefit liability are established by reference to the contract for which the liability is being established. As a result, these assumptions are established at issue of the contract and do not change unless, in the rare circumstance,there is a post-issue contract modification. on the other hand, the assumptons used in estimating future gross margins need to be reviewed periodically and updated to reflect current estimates”
3) DAC discount rate equals earned rate

If EGMs do not show a good pattern, then an alternative amortization basis should be used as paragraph 20 of SOP 95-1 says:

“If significant negative gross margins are expected in any period, then the present value of gross margins before annual dividends, estimated gross premiums, or the balance of insurance in force should be substituted as the base for computing amortization”

However, the US GAAP book for life insurers says at the end of page 132:
“Once an alternative amortization base has been selected and put into use, it should continue to be used over the life of the contracts for which it has been made.”

The DAC balance as at the valuation date can be derived by the following two methods:

1)Retrospective Method

Ending DAC balance (EOY DAC)
  = Opening DAC Balance (BOY DAC)
  + New DAC
  + DAC interest on BOY DAC and New DAC
  – DAC Amortization Charge (kDAC x AGM)

Mathematically,
DAC(t) =(DAC(t-1)+(DAE(t))*(1+i(t))-KDAC*AGM(t)

Where
•Opening DAC balance will equal the closing DAC balance from the previous reporting period.

•New DAC is the amount of new DAC created in the reporting period. This reflects the DAC created for new business written in the reporting period as well as the additional DAC created on in-force business. New DAC includes:

Commission DAC
Expense(Non Commission) DAC

•Interest on DAC - As DAC is an asset on the balance sheet of the company, it earns interest.

•DAC Amortization - This reflects the amount of DAC that is charged as an expense in the income statement in the current reporting period.
Mathematically,Amortization for period t = KDAC * Actual Gross Margins(t)
KDAC is the DAC amortization rate and equals
Present value of Deferrable Acquisition Expenses + Accumulated Value of DAC/Present value of Estimated Gross Margins(EGMs) + Accumulated value of Actual Gross Margins(AGMs)

KDAC is basically percentage of gross margins required to provide for deferred policy acquisition costs.The DAC is recoverable if the k-factor is less than 100%.If the K-factor is greater than 100%, a portion of the DAC or the total DAC has to be written off immediately, so that the new K-factor is equal 100%.

2)Prospective View of DAC

DAC balance
  = (DAC amortization rate
  x PV of future gross margins)
  -  PV of future deferred expenses

Formula(1) is preferred as this DAC-roll forward provides more insight.

For FAS 120 products the DAC-amortization is analog to FAS 97 products with the following two differences:
The EGPs are replaced by the Estimated Gross Margins(EGMs)
The earned rate is used as discount rate instead of the credited rate.

DAC for FAS 60 includes all expenses that vary with and are directly related to the acquistion of new and renewal contracts. These expenses are capitalized and amortized in proportion to Gross Premiums(GP).

The DAC balance as at the valuation data can be derived using the following two methods:

1)Retrospective Method:

Ending DAC Balance(EOY DAC)
= Beginning DAC Balance (BOY DAC)
+ New DAC
+DAC interest on BOY DAC and New DAC
- DAC Amortization

Mathematically,
The DAC-roll forward is as follows:
DAC(t) = (DAC(t-1)+DAE(t))*(1+i(t))- KDAC*GP(t)*(1+i(t))

Where
•Beginning DAC balance will equal the closing DAC balance from the previous reporting period.

•New DAC is the amount of new DAC created in the reporting period. This reflects the DAC created for new business written in the reporting period as well as the additional DAC created on in-force business. New DAC includes:

Commission DAC
Expense(Non Commission) DAC

•Interest on DAC - As DAC is an asset on the balance sheet of the company, it earns interest.

•DAC Amortization - This reflects the amount of DAC that is charged as an expense in the income statement in the current reporting period.
Mathematically,Amortization for period t = KDAC * Gross Premium(t)
KDAC = PV(Deferrable Acquisition Expenses)/PV(Gross premiums)
It is basically percentage of gross premiums required to provide for deferred policy acquisition costs

2)Prospective Method

DAC balance
= (DAC amortization rate
x PV of future gross premiums)
-  PV of future deferred expenses

Formula(1) is preferred as this DAC-roll forward provides more insight.

To determine if the DAC is recoverable or not, present value of the gross premiums is split as follows:
PV of gross premiums 100%
= PV of future policyholders benefits including related expenses x%
+ PV of policy maintenance expenses y%
+ PV of deferrable acquisition expenses K%
+ PV of future profits including administration expenses p%

In these projections, the locked-in best estimate assumptions including lapse rates and PADs are used.

The DAC is recoverable if the sum of the x,y and k factor is lower than 100% i.e.

if x+y+k<100%
If x+y+k>100%, a portion of the DAC or the total DAC has to be written off immediately, so that the new x+y+k factor is equal to 100%.

The essential principles of US GAAP financial reporting are-
Accrual accounting, matching and deferring

Accrual accounting and deferring implies time wise matching(synchronization) of proceeds(income) and expenditures(outgo).

The essence of the principle is - A cost does not become an expense until it is recognized in the financial statement of the company. In an accounting sense, it is the amortization of that cost, and not the original cost itself, that becomes the expense.

Hence, certain costs which are incurred to acquire insurance contracts should not be recognized as an expense in the accounting period in which they are incurred but should be capitalized as an asset on the balance sheet and gradually amortized over the life time of the insurance contracts. Such costs are called Deferred Acquisition expenses(DAE) and capitalization of DAE results in setting up of an asset called Deferred Acquisition Costs(DAC).
Establishment of the DAC asset tends to reduce the policy’s first year strain and generally produces a smoother pattern of earnings.

But not all the expenses are deferred.
To meet the capitalization criteria, these expenses must vary with and be primarily related to the acquisition of new business.
Examples of Deferrable Acquisition Expenses:
Commissions in excess of ultimate commissions
Underwriting costs
Policy Issuance costs

Non-Deferrable Acquisition Expenses

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.
Examples- Advertising costs, development of illustration system for new products, agent recruitment and training.
These expenses are not capitalized and are charged in the period incurred.

While doing expense classification, the fundamental question is:
To defer or not to defer?

The answer is:
To defer: If you have to incur these expenses only when you sell a product
Not to defer: If have to incur these expenses independent of the sales volume

Deferred Acquisition Costs(DAC) represents the “un-recovered investment” in the business and are therefore capitalized as an intangible asset to systematically match costs with related revenues. Over a period of time the acquisition costs are recognised as an expense, this is done by reducing the DAC asset. The process of recognizing the costs in the income statement is known as amortization and refers to the DAC asset being amortized, or written-off.
The amortization requires an amortization basis that determines how much DAC should be written-off as an expense in each accounting period. The amortization basis varies by FAS classification of the product and is given below:

FAS 60/97LP - Premiums
FAS 97  - Estimated Gross Profits (EGP)
FAS 120  - Estimated Gross Margins (EGM)

Here is the list of Key GAAP Phrases:

•FASB - Financial Accounting Standards Board
•FASB 60 - Accounting for non-par contracts - 1982
•FASB 120 - Accounting and Reporting by Mutual Life Insurance Enterprises – 1995
•FASB 97 - Accounting for investment and universal life contracts 1987
•FASB 109 - Accounting for income taxes
•FASB 113 - Accounting for reinsurers - 1992
•FASB 133 - Accounting for derivatives - 2001
•FASB 115, Accounting and Reporting for Certain Investments in Debt and Equity Securities - 1993
•DAE – Deferred Acquisition Expenses
•DAC – Deferred Acquisition Costs
•EGM – Estimated Gross Margins - Amortization base for participating products
•EGP – Estimated Gross Profits - Amortization base for participating products
•K Factor - Amortization rate (applied to gross premiums, EGPs, or EGMs)
•PAD - Provision for Adverse Deviation
•SOP - Statement of Position
•SOP 03-1 - Accounting for GMDB, GMIB, persistency bonus, bonus interest - 2003
•SOP 00-3 - Accounting by Insurance Enterprises for Demutualizations and Formations of Mutual Insurance Holding Companies and for Certain Long-Duration Participating Contracts - 2000
•SOP 05-1 - Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts - 2005
•SOP 95-1 - Accounting for participating products
•SOP 99-20 - Accounting for certain securitized assets
•URL - Unearned Revenue Liability
•ABS - Asset Backed Security
•AcSEC - Accounting Standards Executive Committee
•DIG - Derivatives Implementation Group
•IRR - Internal Rate of Return