Deferred Acquisition Costs (DAC) represents the un-recovered investment in the policies issued and are therefore capitalized as an intangible asset to match costs with related revenues. Over the period of time, the acquisition costs are recognized as an expense that reduces 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 reduced over a number of years.
The amortization requires an amortization basis that determines how much DAC should be turned into an expense in each accounting period.
In addition, DAC amortization uses estimated gross margins as a basis and an interest rate is applied to the DAC based on investment returns. The rate at which one amortizes the DAC is referred to the k-factor.
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”.
Shadow DAC includes unrealized gains as required for balance sheet reporting. In other words Shadow DAC is applied to reduce/increase the amortization of the DAC taking into consideration the unrealized gains and losses.
Regular DAC amortization affects the income statement and does not take unrealized gains into account. In other words, regular DAC amortization takes into account any realized gains and losses in order to smooth out earnings. In case of a large loss regular DAC amortization can be applied to "defer" the acquisition costs to future periods thereby reducing the expenses and increasing yield for the specific period. The DAC amortization will thus increase in future reporting periods.