Deferred Acquisition Cost Tax | Looking Under The Insurance Company Hood

by John Darer CLU ChFC MSSC CeFT RSP CLTC

Could insurance companies, including those that issue structured settlement annuities, offer more to their customers if a 27-year-old revenue sapping regressive Federal tax were abolished? 

The Deferred Acquisition Cost Tax (DAC Tax), introduced with the Revenue Reconciliation Act of 1990 which established IRC 848, is a federal tax on insurers [ including insurers that issue structured settlement annuities} that does not allow insurers to immediately deduct expenses incurred in putting business on the books,

What's the FAQ DAC?

even though the expenses are actual. These expenses often exceed the premiums paid in the early years of different types of insurance. Therefore, insurers are taxed on the premiums paid before any profits are made. This is a phantom tax on nonexistent money. The formula artificially inflates the taxable income of insurers for the current year by deferring expenses to future years. In theory, after an insurer starts to recoup the deferred expenses, a credit is issued toward the current year’s tax bill, which is inflated as a result of the current year’s DAC. However, the only way for the insurer to even approach break even is to stop growing. Otherwise, the dissipation of surplus restricts an insurer’s ability to write new business and it reduces funds needed for product development.

 Contrast this with modified cash basis accounting required by state regulators. Statutory accounting is a modified cash basis of accounting. Expenses are written off when paid, whether the asset is admitted or not.

The impact of this growth-inhibiting, regressive tax on smaller companies is dramatic, according to the National Alliance of Insurance Companies. This tax policy has disproportionately retarded the growth of the smaller insurers. These companies have the ability and need for greater growth than the larger companies. While larger companies, which have mature surpluses, may opt for a slow growth or no-growth strategy in order to counter the effects of the DAC Tax, this option is not available to smaller companies. In fact, some small companies are paying Federal Income Tax well in excess of 100% of statutory income says NALC.

A comment appearing on the Actuarial Outpost boils it down nicely:  "Taxes impact earnings which impacts the amount of money you have to invest. By paying more taxes earlier there is less money to earn interest on, and the effect is cumulative". 

In an environment where government seems to want to cut taxes and create jobs and growth, it seems that this is a worthy button to push.

If have the urge to explore your inner geek, you may find the Society of Actuaries Federal DAC Tax  to be a helpful read, with a little espresso.