FASB Embedded Derivatives Dual-Trigger Property and Casualty Insurance Contracts

FASB: Embedded Derivatives: Dual-Trigger Property and Casualty Insurance Contracts

Derivatives Implementation Group

Statement 133 Implementation Issue No. B26

Title: Embedded Derivatives: Dual-Trigger Property and Casualty Insurance Contracts
Paragraph references: 10, 12
Date cleared by Board: March 14, 2001
Date posted to website: April 10, 2001

QUESTION

From both the insurer's and policyholder's standpoint, does a property and casualty insurance contract for which payment of a benefit/claim is triggered by the occurrence of both an insurable event and changes in a separate pre-identified variable contain an embedded derivative instrument that is required to be separately accounted for as a derivative instrument under Statement 133?

BACKGROUND

Paragraph 10(c)(2) of Statement 133 states:

    Traditional property and casualty contracts. The payment of benefits is the result of an identifiable insurable event (for example, theft or fire) instead of changes in a variable.

Paragraph 10(c) states:

    Certain insurance contracts. Generally, contracts of the type that are within the scope of FASB Statements No. 60, Accounting and Reporting by Insurance Enterprises, No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, and No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, are not subject to the requirements of this Statement whether or not they are written by insurance enterprises. That is, a contract is not subject to the requirements of this Statement if it entitles the holder to be compensated only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk.

Paragraph 281 states:

    Insurance contracts often have some of the same characteristics as derivative instruments that are within the scope of this Statement. Often, however, they lack one or more of those characteristics. As a result, most traditional insurance contracts will not be derivative instruments as defined in this Statement. They will be excluded from that definition because they entitle the holder to compensation only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of a specific asset or liability for which the holder is at risk.

Based on this guidance, it is unclear how to account for insurance contracts with terms that require that the insured incur an actual loss other than a change in price and that a specified change in a variable occur (or be referenced) in order for a benefit/claim to be paid. This has become an issue as insurance products evolve to provide tailored commercial risk coverage at lower premiums. A common characteristic of dual-trigger policies is that the payment of a claim is triggered by the occurrence of two events (that is, the occurrence of both an insurable event and changes in a separate pre-identified variable). Since the likelihood of both events occurring is less than the likelihood of only one of the events occurring, the dual-trigger policy premiums are lower than traditional policies that insure only one of the risks. The policyholder is often purchasing the policy to provide for coverage against a catastrophe since if both events occur, the combined impact may be disastrous to its business. The following examples illustrate the characteristics of dual-trigger policies offered to different types of policyholders that have different risk management needs.

Electric Utility Company

A dual-trigger policy pays for a level of actual losses caused by the following two events occurring simultaneously:

  1. A power outage resulting from equipment failure or storm-related damage causes more than 500 megawatts (MW) of lost power.

  2. The spot market price for power exceeds $65 per MW hour during the storm or equipment-failure period.

The contract pays the difference between the strike price and the actual market price for the lost power (that is, the cost of replacement power).

Trucking Delivery Company

A dual-trigger policy pays extra expenses associated with rerouting trucks over a certain time period if snowfall exceeds a specified level during that time period. The snowfall causes delays and creates the need to reroute trucks to meet delivery demands.

Hospital

A dual-trigger policy pays actual medical malpractice claims above a specified level only if the value of the hospital's equity portfolio falls below a specified level during the same period.

Iron Ore Mining Company

A dual-trigger policy pays a specified level of workers' compensation claims (not to exceed actual claims) if the claims exceed a specified level at the same time iron ore prices decrease below a specified level.

Golf Resort in Florida

A dual-trigger policy pays property damage from hurricanes incurred by a specific golf resort in Florida; however, the losses are covered only if other golf courses in the region incur hurricane-related losses and the claims cannot exceed the average property damages incurred by the other golf resorts in the county.

Cherry Orchard in Michigan

A dual-trigger policy pays crop losses incurred due to bad weather during growing season, and the claims are at risk of being reduced based on changes in the inflation rate in Brazil. The cherry producer has no operations in Brazil or any transactions in Brazilian currency. However, a Brazilian cherry producer exports cherries to the United States and is a competitor of the Michigan cherry producer.

Property-Casualty Reinsurance Contract

Reinsurance contracts, which indemnify the holder of the contract (the reinsured) against loss or liability relating to insurance risk, are accounted for under the provisions of FASB Statement No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. Reinsurance contract provisions often adjust the amount at risk or the price of the amount at risk for a number of events or circumstances, such as loss experience or premium volume, while continuing to provide indemnification related to insurance risk. One type of reinsurance contract, an "excess contract," provides the reinsured with indemnification against a finite amount of insured losses in excess of a defined level of insured losses retained by the reinsured.

The following is an example of a reinsurance contract with a provision that adjusts the retention amount downward based on the performance of a specified equity index:

Reinsurer enters into a reinsurance contract with Reinsured to indemnify Reinsured for certain insured losses in excess of a defined retention. The intent of the coverage is to protect Reinsured from significant or catastrophic property-casualty losses. The coverage would include a retention amount that would be adjusted downward according to a scale tied to the Dow Jones Industrial Average (DJIA). If a catastrophic loss occurs, Reinsured would likely have to liquidate some of its investment holdings (bonds or equities) to pay its losses, which exposes Reinsured to significant investment risk in a down market. The adjustment feature provides protection against investment risk by allowing Reinsured to recover more losses in a declining investment market. Reinsured has no ability to receive appreciation in the DJIA.

Parties: Reinsurer and Reinsured

Coverage: Property Losses

Period: 1/1/X1 through 12/31/X1

Retention: $20 million per occurrence, adjusted downward in the same percentage as period-to-date (from 1/1/X1 to measurement date) decreases in the DJIA, not to exceed 50%

Limit: $15 million per occurrence, $15 million per annum

Premium: $1.4 million per annum

Both of the following scenarios assume that the DJIA on 1/1/X1 was 10,000.

 

Scenario 1

Scenario 2

 

7/1/X1

9/1/X1

7/1/X1

9/1/X1

Property-casualty losses

$25,000,000

$25,000,000

$15,000,000

$15,000,000

DJIA

10,000

8,000

10,000

7,000

Retention

20,000,000

16,000,000

20,000,000

14,000,000

Recovery under contract

5,000,000

9,000,000

0

1,000,000

RESPONSE

Only those contracts for which payment of a claim is triggered only by a bona fide insurable exposure (that is, contracts comprising either solely insurance or both an insurance component and a derivative instrument) may qualify for the exception under paragraph 10(c). In order to qualify, the contract must provide for a legitimate transfer of risk, not simply constitute a deposit or form of self-insurance. A property and casualty contract that provides for the payment of benefits/claims as a result of both an identifiable insurable event and changes in a variable would in its entirety qualify for the insurance exclusion in paragraph 10(c)(2) of Statement 133 (and thus not contain an embedded derivative instrument that is required to be separately accounted for as a derivative instrument) provided all of the following conditions are met:

  1. Benefits/claims are paid only if an identifiable insurable event occurs (for example, theft or fire) pursuant to the requirements of paragraph 10(c)(2) of Statement 133.

  2. The amount of the payment is limited to the amount of the policyholder's incurred insured loss.

  3. The contract does not involve essentially assured amounts of cash flows (regardless of the timing of those cash flows) based on insurable events highly probable of occurrence because the insured would nearly always receive the benefits (or suffer the detriment) of changes in the variable. If there is an actuarially determined minimum amount of expected claim payments (and those cash flows are indexed to or altered by changes in a variable) that are the result of insurable events that are highly probable of occurring under the contract and those minimum payment amounts are expected to be paid each policy year (or on another predictable basis), that "portion" of the contract does not qualify for the insurance exception. (For example, if an insured has received at least $2 million in claim payments from its insurance company (or at least $2 million in claim payments were made by the insurance company on the insured's behalf) for each of the previous 5 years related to specific types of insured events that occur each year, that minimum level of coverage would not qualify for the insurance exclusion.) If an insurance contract has an actuarially determined minimum amount of expected claim payments that are highly probable of occurring, then effectively the amount of those claims is the contract's minimum notional amount (analogous to the guidance in Statement 133 Implementation Issue No. A6, "Notional Amount of Commodity Contracts") in determining the embedded derivative.

Based on this framework, all the contracts discussed in the Background section qualify for either the paragraph 10(c)(2) exception for traditional property and casualty contracts or the paragraph 10(e)(2) exception for non-exchange-traded contracts involving non-financial assets. Therefore, the dual-trigger variable in those contracts is not separated and accounted for separately as a derivative. In contrast, if a contract issued by an insurance company involves essentially assured amounts of cash flows based on insurable events that are highly probable of occurrence (as discussed in requirement 3 above), an embedded derivative instrument related to changes in the separate pre-identified variable for that portion of the contract would be required to be separately accounted for as a derivative instrument.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.