FASB Exception Related to Physical Variables

FASB: Exception Related to Physical Variables

Derivatives Implementation Group

Statement 133 Implementation Issue No. C1

Title: Scope Exceptions: Exception Related to Physical Variables
Paragraph references: 10(c), 10(e)(1), 252, 254
Date cleared by Board: February 17, 1999

QUESTION

If a contract's payment provision specifies that the issuer will pay to the holder $10,000,000 if aggregate property damage from all hurricanes in the state of Florida exceeds $50,000,000 during the year 2001, is the contract included in the scope of Statement 133? Alternatively, if the contract specifies that the issuer pays the holder $10,000,000 in the event that a hurricane occurs in Florida in 2001, is the contract included in the scope of Statement 133?

RESPONSE

If the contract contains a payment provision that requires the issuer to pay to the holder a specified dollar amount based on a financial variable, the contract is subject to the requirements of Statement 133. In the first example above, the payment under the contract occurs if aggregate property damage from a hurricane in the state of Florida exceeds $50,000,000 during the year 2001. The contract in that example contains two underlyings — a physical variable (that is, the occurrence of at least one hurricane) and a financial variable (that is, aggregate property damage exceeding a specified or determinable dollar limit of $50,000,000). Because of the presence of the financial variable as an underlying, the derivative contract does not qualify for the scope exclusion in paragraph 10(e)(1) of Statement 133.

In contrast, if the contract contains a payment provision that requires the issuer to pay to the holder a specified dollar amount that is linked solely to a climatic or other physical variable (for example, wind velocity or flood-water level), the contract is not subject to the requirements of Statement 133. In the second example above, the payment provision is triggered if a hurricane occurs in Florida in 2001. The underlying in that example is a physical variable (that is, occurrence of a hurricane). Therefore, the contract qualifies for the scope exclusion in paragraph 10(e)(1) of Statement 133.

However, if the contract requires a payment only when the holder incurs a decline in revenue or an increase in expense as a result of an event (for example, a hurricane) and the amount of the payoff is solely compensation for the amount of the holder's loss, the contract would be a traditional insurance contract that is excluded from the scope of Statement 133 under paragraph 10(c).

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.