A loan may have a credit enhancement, such as a guarantee or credit insurance feature provided by a third party. Whether the credit enhancement should be considered in the determination of the ALLL requires careful consideration. Certain third party-provided credit enhancements of a loan or lease receivable, such as pool mortgage insurance, financial guarantees or a credit default swap, may be required to be accounted for separately as a derivative under ASC 815. If the credit enhancement is separately accounted for as a derivative, whether embedded (e.g., private mortgage insurance that "follows the loan") or transferable from the loan, the benefit received from the guarantee is recognized separately from the loan. Similarly, the proceeds of a non-derivative credit enhancement that is transferable from the loan or lease such that its benefits do not follow with, or are extinguished, if the loan or lease were to be sold or otherwise conveyed, would also be accounted for separately. Therefore, any expected recoveries from credit enhancements that are derivatives or that do not "follow-the-loan" may not adjust (reduce) the estimated ALLL otherwise attributable to the impaired loan.

In all instances when the credit enhancement is accounted for separately from the loan, the accounting for the ALLL provision and recovery from the guarantee would result in a gross-up of certain accounts on the income statement for those losses expected to be recovered from the guarantee. A gross up on the income statement would occur because the creditor would recognize a provision or loss on the loan and income on the guarantee. The balance sheet would also be impacted because an ALLL would be recognized as a contra account to the loan with an offsetting increase in the balance of the guarantee asset. The subsequent accounting for the loan and guarantee may impact the financial statements in different periods because of their separate measurement models.

However, if the credit enhancement meets a scope exception in ASC 815 (i.e., is not accounted for as a derivative) and is embedded in the loan, such that it always travels with the loan upon its sale, the proceeds of such enhancements may be considered in the ALLL estimation. The creditor should consider all the cash flows associated with the credit enhanced loan when measuring the incurred loss in individually impaired loans and in determining the adequacy of the ALLL. Therefore, an ALLL may not need to be created for losses expected to be recovered from the credit enhancement for such loans, so long as there is evidence that the third party providing the credit enhancement of the loan is creditworthy.