FASB Embedded Derivatives Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments

FASB: Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments

Derivatives Implementation Group

Statement 133 Implementation Issue No. B36

Title: Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments
Paragraph references:

12, 14, 61(c)

Date cleared by Board: April 2, 2003
Date latest revision posted to website: June 16, 2006
Affected by: FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments, and FASB Statement No. 156, Accounting for Servicing of Financial Assets
(Revised June 16, 2006)

QUESTIONS

Are the embedded features of a debt instrument that incorporates credit risk exposures that are unrelated or only partially related to the creditworthiness of the obligor under that instrument clearly and closely related to the debt host contract? Does a modified coinsurance arrangement, in which funds are withheld by the ceding insurer and a return on those withheld funds is paid based on the ceding company’s return on certain of its investments, contain an embedded derivative feature that is not clearly and closely related to the host contract?

BACKGROUND

Questions have been raised regarding the following examples that illustrate instruments that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the obligor under that instrument.

Example 1—Credit-Linked Note Issued by a Corporation
Company A issues a fixed-rate, 10-year, $10 million credit-linked note to an investor that provides for periodic interest payments and the repayment of principal at maturity. However, upon default of a specified reference security (a Company X subordinated debt obligation)1 the redemption value of the note may be zero or there may be some claim to the recovery value of the reference security (depending on the terms of the specific arrangement). In an event of default of the specified reference security, there is no recourse to the general credit of the obligor (Company A). In exchange for accepting the default risk of the reference security, the note entitles the investor to an enhanced yield. The transaction results in the investor “selling credit protection” and Company A “buying credit protection.”

___________________
1Generally, the term reference security refers to the security whose credit rating or default determines the cash flows under a credit derivative. Usually, the terms of credit-linked notes explicitly reference CUSIP numbers of securities in the marketplace.

Example 2—Reinsurer’s Receivable Arising from a Modified Coinsurance Arrangement
Reinsurance Company B enters into a modified coinsurance arrangement (also referred to as a modco arrangement), which is a reinsurance arrangement in which funds are withheld by the ceding insurer, thereby creating an obligation for the ceding company to pay the reinsurer at a later date. Concurrently, the reinsurer (Company B) recognizes a funds-withheld receivable from the ceding insurer as well as a liability representing reserves for the insurance coverage assumed under the modco arrangement. (The amount of Company B’s receivable is the ceding company’s statutory reserve, whereas the amount of Company B’s liability is the reserve under generally accepted accounting principles.) The terms of the ceding company’s payable (and Company B’s funds-withheld receivable) provide for the future payment of a “principal” amount plus a return (that may be negative) that is based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets (such as a specific portfolio of its investment securities). That portfolio is typically composed primarily of fixed-rate debt securities.

Paragraph 61(c) of Statement 133 discusses whether certain embedded credit-sensitive features are clearly and closely related to the host contract. It states:

    Credit-sensitive payments. The creditworthiness of the debtor and the interest rate on a debt instrument are considered to be clearly and closely related. Thus, for debt instruments that have the interest rate reset in the event of (1) default (such as violation of a credit-risk-related covenant), (2) a change in the debtor’s published credit rating, or (3) a change in the debtor’s creditworthiness indicated by a change in its spread over Treasury bonds, the related embedded derivative would not be separated from the host contract.

RESPONSE

No. Paragraph 61(c) of Statement 133 indicates that the creditworthiness of an obligor (debtor) of a debt instrument and the interest rate on that instrument are clearly and closely related. Paragraph 190 illustrates a credit-sensitive bond in which the interest rate resets based on changes in the obligor’s credit rating. The analysis of that example indicates that the economic characteristics and risks of the embedded credit derivative are clearly and closely related to the economic characteristics and risks of the debt host contract. Conversely, if an instrument incorporates a credit risk exposure that is different from the risk exposure arising from the creditworthiness of the obligor under that instrument, such that the value of the instrument is affected by an event of default or a change in creditworthiness of a third party (that is, an entity that is not the obligor), then the economic characteristics and risks of the embedded credit derivative are not clearly and closely related to the economic characteristics and risks of the host contract, even though the obligor may own securities issued by that third party.

The credit-linked note described in Example 1 includes an embedded credit derivative feature. In that example, the credit risk exposure of the reference security (Company X) and the risk exposure arising from the creditworthiness of the obligor (Company A) are not clearly and closely related. Thus, the economic characteristics and risks of the embedded derivative feature are not clearly and closely related to the economic characteristics and risks of the debt host contract and, accordingly, the criterion in paragraph 12(a) is met. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Statement 155 does not apply to hybrid financial instruments that are described in paragraph 8 of FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, which include insurance contracts as discussed in FASB Statements No. 60, Accounting and Reporting by Insurance Enterprises, and No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, other than financial guarantees and investment contracts. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.)

With respect to the modco arrangement in Example 2, the ceding company’s funds-withheld payable and Company B’s funds-withheld receivable includes an embedded derivative feature that is not clearly and closely related to the host contract. The yield on the payable and receivable in the host contract in this example is based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets (such as a specific portfolio of the ceding company’s investment securities). The risk exposure of the ceding company’s return on its general account assets or its securities portfolio is not clearly and closely related to the risk exposure arising from the overall creditworthiness of the ceding company, which is also affected by other factors. Consequently, the economic characteristics and risks of the embedded derivative feature are not clearly and closely related to the economic characteristics and risks of the host contract and, accordingly, the criterion in paragraph 12(a) is met. This analysis applies whether the host contract is determined to be a debt host or an insurance contract. For example, if the host contract is determined to be the modco arrangement (including the funds-withheld receivable-payable but excluding the embedded derivative), the economic characteristics and risks of the embedded derivative feature are not clearly and closely related to the economic characteristics and risks of the host contract and, accordingly, the criterion in paragraph 12(a) is met.

In both of these examples, the embedded derivative feature generally will require bifurcation. However, the criteria in paragraphs 12(b) and 12(c) of Statement 133 must be considered prior to concluding that the embedded derivative feature should be bifurcated and accounted for separately. In Example 1, consideration should be given to whether the embedded derivative feature could possibly not be subject to Statement 133 as a financial guarantee under paragraph 10(d) and, in that case, the embedded derivative feature would not warrant bifurcation. In Example 2, the other criteria in paragraph 12 generally would be met, thereby requiring that the embedded derivative feature be bifurcated and accounted for separately. The nature of the embedded derivative feature and the host contract in both examples should be determined based on the facts and circumstances of the individual contract.

Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets,” addresses implementation issues related to the scope exception in paragraph 14 of Statement 133 for interest-only strips and principal-only strips but only for instruments recognized prior to the effective date of Statement 155. Implementation Issue D1 indicates that certain assets or liabilities that are beneficial interests or interests that continue to be held by a transferor in securitized financial assets are not subject to Statement 133. Implementation Issue D1 does not apply to interests in nonsecuritized financial assets. Accordingly, the implementation guidance in Implementation Issue B36 does not apply to hybrid instruments that are beneficial interests or interests that continue to be held by a transferor in securitized financial assets if they are not subject to Statement 133 pursuant to Implementation Issue D1.

This Implementation Issue should be applied to all other arrangements that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. The guidance in this Implementation Issue does not affect the accounting for a nonrecourse debt arrangement (that is, a debt arrangement in which, in the event that the debtor does not make the payments due under the loan, the creditor has recourse solely to the specified property pledged as collateral).

At any time during the fiscal quarter that the guidance in this Implementation Issue is initially applied, companies that have ceded insurance under existing modco arrangements may reclassify securities from the held-to-maturity and available-for-sale categories into the trading category without calling into question the intent of those companies to hold other debt securities to maturity in the future; however, those “taint-free” reclassifications are limited to the amount and type of securities related to the embedded derivatives that are being newly accounted for as derivatives in conjunction with the initial application of that guidance to modco arrangements. The ceding companies should account for those reclassifications as a transfer between categories of investments under paragraph 15 of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.

EFFECTIVE DATE AND TRANSITION

The effective date of the implementation guidance in this Issue is the first day of the first fiscal quarter beginning after September 15, 2003. Earlier application as of the beginning of a fiscal quarter is permitted. If an entity had not bifurcated an embedded derivative but is required to do so under the revised guidance, the entity should account for the effects of initially complying with the revised implementation guidance prospectively for all existing financial instruments, except for the existing contracts that qualify for the grandfathering provisions of paragraph 50, which exempts certain hybrid instruments from the embedded derivative provisions of Statement 133 on an all-or-none basis. The effects of initially complying with the revised implementation guidance as of the effective date should be reported as a cumulative-effect-type adjustment of net income.

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.