FASB Embedded Derivatives Clearly and Closely Related Criteria for Market Adjusted Value Prepayment Options

FASB: Embedded Derivatives: Clearly and Closely Related Criteria for Market Adjusted Value Prepayment Options

Derivatives Implementation Group

Statement 133 Implementation Issue No. B9

Title: Embedded Derivatives: Clearly and Closely Related Criteria for Market Adjusted Value Prepayment Options
Paragraph references: 13, 61(a), 61(d)
Date cleared by Board: December 6, 2000

QUESTION

Are the economic characteristics and risks of the embedded derivative (market adjusted value prepayment option) in a market value annuity contract (MVA or the hybrid instrument) clearly and closely related to the economic characteristics and risks of the host contract?

BACKGROUND

An MVA accounted for as an investment contract under FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, given its lack of significant mortality risk, provides for a return of principal plus a fixed rate of return if held to maturity, or alternatively, a "market adjusted value" if the surrender option is exercised by the contract holder prior to maturity. The market adjusted value is typically based on current interest crediting rates being offered for new MVA purchases. As an example of how the market adjusted value is calculated at any period end, the formula typically takes the contractual guaranteed amount payable at the end of the specified term, including the applicable guaranteed interest, and discounts that future cash flow to its present value using rates currently being offered for new MVA purchases with terms equal to the remaining term to maturity of the existing MVA. As a result, the market value adjustment may be positive or negative, depending upon market interest rates at each period end. In a rising interest rate environment, the market adjustment may be such that less than substantially all principal is recovered upon surrender.

The following is an example of an annuity with a fixed return if held for a specified period or market adjusted value if surrendered early.

  • Single premium deposit: $100,000 on 12/31/98
  • Maturity Date: 12/31/07 (9 yr. term)
  • Guaranteed Fixed Rate: 7%
  • Fixed Maturity Value: $183,846 ($100,000 @ 7% compounded for 9 yrs.)
  • Market Value Adjustment Formula: Discount future fixed maturity value to present value at surrender date using currently offered market value annuity rate for the period of time left until maturity.
12/31/99 Valuation Date
5%
9%
(1) Fixed rate account value @7% $107,000 $107,000
(2) Market Adjusted Value   124,434     92,266
(3) Market Value Adjustment $  17,434 $(14,734)
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RESPONSE

Yes, the embedded derivative (prepayment option) is clearly and closely related to the host debt contract.

Paragraph 61(d) provides interpretation of the clearly and closely related criteria as it applies to debt with put options, noting that:

   Call options (or put options) that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both (1) the debt involves a substantial premium or discount (which is common with zero-coupon bonds) and (2) the put or call option is only contingently exercisable. Thus, if a substantial premium or discount is not involved, embedded calls and puts (including contingent call or put options that are not exercisable unless an event of default occurs) would not be separated from the host contract.

The terms of MVAs do not include either feature. There is no substantial premium or discount present in these contracts at inception, and the put option is exercisable at any time by the contract holder (that is, it is not "contingently exercisable").

Since the embedded derivative has an underlying that is an interest rate index and the host contract is a debt instrument, the MVA contract must be analyzed under the criteria in paragraphs 13 and 61(a) as well. Pursuant to the FASB staff guidance presented in Statement 133 Implementation Issue No. B5, Investor Permitted, but Not Forced, to Settle Without Recovering Substantially All of the Initial Investment, the condition in paragraph 13(a) was intended to apply only to those situations in which the investor (creditor) could be forced by the terms of a hybrid instrument to accept settlement at an amount that causes the investor not to recover substantially all of its initial recorded investment. That is, because the investor always has the option to hold the MVA contract to maturity and receive the fixed rate and the insurance company cannot force the investor to surrender, the condition in paragraph 13(a) would not be met (that is, the insurance company does not have the contractual right to demand surrender and put the investor in a situation of not recovering substantially all of its initial recorded investment). The condition in paragraph 13(b) also would not be met in a typical MVA contract, since there is no leverage feature that would result in twice the initial and current market rate of return.

Because the criteria in paragraphs 13, 61(a), and 61(d) are not met, the prepayment option is considered clearly and closely related to the host debt instrument.

As the above examples demonstrate, the prepayment option enables the holder simply to cash out of the instrument at fair value at the surrender date. The prepayment option provides only liquidity to the holder. The holder receives only the market adjusted value, which is equal to the fair value of the investment contract at the surrender date. As such, the prepayment option (the embedded derivative) has a fair value of zero at all times.

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.