FASB Embedded Derivatives Dual-Trigger Financial Guarantee Contracts

FASB: Embedded Derivatives: Dual-Trigger Financial Guarantee Contracts

Derivatives Implementation Group

Statement 133 Implementation Issue No. B27

Title: Embedded Derivatives: Dual-Trigger Financial Guarantee Contracts
Paragraph references: 10, 12, 16, 17, 18
Date cleared by Board: March 14, 2001
Date posted to website: April 10, 2001
Date revision posted to website: May 1, 2003
Affected by: FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003)

QUESTION

If the payment of a claim under a financial guarantee insurance contract is triggered only by the occurrence of both the insured's credit losses exceeding a specified level and the credit losses in a customized pool of loans by third parties exceeding a specified level, does that financial guarantee insurance contract contain an embedded derivative that requires separate accounting under Statement 133?

BACKGROUND

ABC Company (ABC) extends credit to consumers through credit cards and personal loans of various sorts. The company is exposed to credit losses from its managed asset portfolio, including owned and securitized receivables. ABC would like to purchase an insurance policy to protect itself against high levels of consumer default.

The proposed insurance policy will entitle ABC Company to collect claims to the extent that its credit losses exceed a specified minimum level but limited to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level. Thus, ABC Company will collect claims based on the lesser of either (1) its actual credit losses or (2) the credit losses on a customized pool or index of consumer loans. Although the insurer's payment to ABC Company may be affected by credit losses on a customized pool, the payment nevertheless represents compensation for actual credit losses ABC Company incurred. ABC Company purchases this insurance to obtain a lower premium because claims are limited by external charge-off rates and the insurer is not exposed to ABC's underwriting performance. This type of control may also exist in property and casualty reinsurance policies. For example, an insurance company may purchase reinsurance that covers actual hurricane losses in excess of a specified level in their block of business, but the coverage does not apply to losses in excess of a geographically diversified index of hurricane losses.

Paragraph 10(d) of Statement 133, as amended by Statement 149, indicates that financial guarantee contracts are not subject to the Statement only if all of the following conditions are met:

  1. They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either at pre-specified payment dates or accelerated payment dates as a result of the incurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor.

  2. Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (1) above is past due.

  3. The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation.

Thus, financial guarantee contracts are subject to Statement 133 if they do not meet all of the above three criteria, for example, if they provide for payments to be made in response to changes in another underlying such as a decrease in a specified debtor’s creditworthiness.

RESPONSE

Financial guarantee insurance contracts are not subject to Statement 133 only if all of the conditions in paragraph 10(d) of Statement 133, as amended by Statement 149, are met. The description of the financial guarantee insurance contract in this Issue is insufficient for determining whether those conditions are met. The provisions of that contract that (a) limit any claims to the extent that ABC’s actual credit losses exceed a specified minimum level and (b) limit any payments for those claims to the amount by which the credit losses on a customized pool or index of consumer loans exceed that same specified minimum level represent a type of deductible and do not affect the application of the conditions in paragraph 10(d).

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.