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4.6.1 Executory contract hosts

An executory contract may meet the definition of a derivative in its entirety; in that case, the contract would not be assessed under ASC 815-15-25-1 to determine whether it contains embedded derivatives that should be accounted for separately. If an executory contract, such as a purchase-and-sale agreement, meets the definition of a derivative in its entirety, the parties to the contract may elect to assess the contract under the normal purchases and normal sales scope exception in ASC 815-10-15-22. Alternatively, the parties to the contract could account for it as a freestanding derivative. However, executory contracts often do not contain net settlement provisions and therefore may not meet the definition of a derivative in their entirety. In such instances, executory contracts must still be evaluated for embedded features (e.g., caps, and floors) that may need to be separated. See DH 2 for information on the definition of a derivative and DH 3 for information on scope exceptions.
Executory contracts for the purchase and sale of raw materials, supplies, and services that are not derivatives in their entirety may include a variety of embedded derivatives, such as:
  • Foreign-currency swaps (with a settlement in a currency other than the functional currency of either party to the transaction)
  • Commodity forwards (agreements to transact a fixed quantity on a specified future date at a fixed price) and options
  • Purchase-price caps and floors (i.e., the purchase price may not exceed a cap or fall below a floor)
  • Price adjustments (i.e., the price stated in the contract is adjusted based on a specified index)
ASC 815-15-25-19 provides guidance on the economic characteristics of price caps and floors embedded in purchase contracts.

ASC 815-15-25-19

The economic characteristics and risks of a floor and cap on the price of an asset embedded in a contract to purchase that asset are clearly and closely related to the purchase contract, because the options are indexed to the purchase price of the asset that is the subject of the purchase contract. See Example 6 (paragraph 815-15-55-114) for an illustration of such options.

However, if the price in the contract is referenced to an underlying that is extraneous to the asset or the underlying is leveraged (i.e., the magnitude of the price adjustment based on the underlying is significantly disproportionate to the relationship of the underlying to the asset), then the embedded derivative is not considered clearly and closely related and may have to be separated.

4.6.2 Insurance hosts

Insurance contracts may also contain embedded derivatives. As discussed in IG 2.4.5, if a company has adopted Accounting Standards Update 2018-12, Financial Services— Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts (ASU 2018-12), companies must first evaluate insurance contracts for features that meet the definition of a market risk benefit (MRB) under ASC 944-40-25-25C and ASC 944-40-25-25D before the company evaluates whether an embedded derivative exists. Refer to Figure IG 2-1 for a decision tree for determining the accounting model for contract features in insurance and investment contracts that provide potential benefits in addition to the account balance, as detailed in ASC 944-40-25-25B. If an insurance policy contains an embedded derivative instrument, it may have to be separated if the embedded derivative is not clearly and closely related to the insurable risk that is covered under the insurance contract. Contracts such as equity-indexed annuities, equity-indexed life insurance, and dual-trigger property/casualty reinsurance that do not meet the requirements in ASC 815-10-15-55 may contain embedded derivatives.
ASC 815-10-15-67 provides a scope exception for investments in a life insurance contract that falls within the scope of ASC 325-30. This scope exception also applies to embedded derivative-like provisions that would otherwise have to be accounted for separately under ASC 815. Such insurance contracts include corporate-owned life insurance, bank-owned life insurance, and life settlement contracts. However, it should not be applied by analogy to contracts other than life insurance contracts subject to the provisions of ASC 325-30. In addition, the scope exception in ASC 815-10-15-67 applies only to the policyholder and does not affect the insurer’s accounting. See DH 3.2.9 for information on the scope exception for investments in life insurance contracts and LI 5.4 for the information on the accounting for investments in life insurance contracts.
Question DH 4-25 discusses whether certain embedded derivatives should be separated from the host insurance contracts.
Question DH 4-25
Should embedded derivatives in the following contracts be separated from the host insurance contracts?
  • A traditional whole life insurance contract in which insurance may be kept in force for a person’s entire life
  • A traditional universal life contract under which (a) premiums are generally flexible, (b) the level of death benefits may be adjusted, and (c) mortality, expenses, and other charges may vary
PwC response
No. The contracts have two components, a death benefit and a surrender benefit. The payment for the death-benefit component is based on an insurable event that is eligible for the scope exception in ASC 815-10-15-52. The cash surrender value payment is generally based on interest rates and is considered clearly and closely related to the debt host. In the case of whole life insurance, there is no interest rate explicitly provided—just surrender value—which fluctuates in value based primarily on interest rates and is therefore regarded as clearly and closely related. In the case of universal life insurance contracts, a minimum interest rate is usually stipulated (that is not above then-current market rates at issuance), above which additional interest payments are discretionary. Given the nature of interest features in traditional universal life contracts, they are generally regarded as clearly and closely related.
In contrast, nontraditional universal life contracts with guaranteed minimum benefits may have embedded derivatives requiring separation. However, if a company has adopted ASU 2018-12. these features may be considered market risk benefits and follow the accounting and classification guidance under ASC 944-40-25-25B through ASC 944-40-25-25D. The features should be assessed as potential market risk benefits prior to the assessment of whether they should be classified as embedded derivatives requiring separation.

Question DH 4-26 discusses whether certain insurance products contain an embedded credit derivative that should be accounted for separately.
Question DH 4-26
Insurance Co issues a traditional variable-annuity product that contains a provision under which benefit payments will vary according to the investment experience of the separate accounts to which the premium deposits are allocated. Does the insurance product contain an embedded credit derivative that should be accounted for separately?
PwC response
No. The traditional variable annuity component of the product, as described in ASC 815-15-55-54 and ASC 815-15-55-55 and in ASC 944-20-05-18, contains no embedded derivatives. This component is not considered a derivative because of the unique attributes of traditional variable annuity contracts issued by insurance companies, as further described in ASC 944-815-25-1 through ASC 944-815-25-4. However, variable-annuity products may contain nontraditional features, such as guaranteed minimum accumulation benefits and guaranteed minimum withdrawal benefits. If a company has adopted ASU 2018-12, these features first should be evaluated to see if they meet the definition of a market risk benefit and follow the accounting and classification guidance under ASC 944-40-25-25B through ASC 944-40-25-25D. If they do not meet the definition of a market risk benefit, these features would typically constitute embedded derivatives requiring separate accounting under ASC 815, as further described in ASC 944-815-25-5. In such instances, the variable annuity host contract would continue to be accounted for under existing insurance accounting guidance.

Question DH 4-27 discusses whether an equity-indexed annuity contract is a hybrid instrument that should be separated.
Question DH 4-27
Is an equity-indexed annuity contract a hybrid instrument that should be separated?
PwC response
Yes. The host is an investment contract under ASC 944 (i.e., a debt host) with multiple embedded derivatives (a contract holder prepayment option and a contingent equity-return feature). The prepayment option would typically require payment of the contract account balance less a specified non-indexed surrender charge to the contract holder, and thus would generally be clearly and closely related to the debt host, provided it does not contain an embedded interest rate derivative under the guidance in ASC 815-15-25-26. However, the contingent equity-return feature is not clearly and closely related to the debt host. If a company has adopted ASU 2018-12, this feature should first be evaluated to see if it meets the definition of a market risk benefit and follow the accounting and classification guidance under ASC 944-40-25-25B through ASC 944-40-25-25D. However, if it does not meet the definition of a market risk benefit, the embedded equity derivative must be separated from the host contract.

See Question DH 4-28 for discussion of an embedded derivative related to a property/casualty insurance contract.
Question DH 4-28
Does a property/casualty insurance contract under which the payment of benefits is the result of an identifiable insurable event (e.g., theft or fire), with payments based on both changes in foreign currency (or another index) and insurable losses contain an embedded derivative that should be separated?
PwC response
Maybe. ASC 815-15-55-12 specifies that dual-trigger contracts under which the insurable loss is highly probable to occur do not meet the scope exception in ASC 815-10-15-52. Therefore, the embedded derivative must be separated if the insurable loss is highly probable and the other criteria in ASC 815-15-25-1 are met. In addition, if payments could be made without the occurrence of an insurable event or in excess of the actual loss, the entire contract may be a derivative or may contain embedded derivatives that would require separate accounting.

Question DH 4-29 discusses if a disaster bond with a contingent payment feature contains an embedded derivative that requires separate accounting. 
Question DH 4-29
Does a disaster bond with a payment feature that is contingent on specific insurable losses of the issuer contain an embedded derivative that requires separate accounting? Would the answer change if the disaster bond had a payment feature indexed to industry loss experience measured as if it were a dollar-based index?
PwC response
The disaster bond with a payment feature that is contingent on specific insurable losses does not contain an embedded derivative that should be separately accounted for as a derivative. Although the payment feature is not clearly and closely related to the debt host, the payment feature is contingent on an insurable event and meets the scope exception in ASC 815-10-15-52. In such instances, the investor is essentially providing a form of insurance or reinsurance coverage for the issuer.
However, the answer would change if the payment feature was indexed to industry loss experience. Then the payment feature would not be contingent on insurable losses of the issuer so would not be clearly and closely related. Therefore, it would not qualify for the ASC 815-10-15-52 scope exception. As a result, the embedded derivative must be separated from the host contract if the other criteria of ASC 815-15-25-1 are met.

Question DH 4-30 discusses if a modified coinsurance arrangement with specified terms contains an embedded derivative that should separately accounted.
Question DH 4-30
Does a modified coinsurance arrangement in which the terms of the ceding company’s payable provide for the future payment of a principal amount plus a return 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) contain an embedded derivative that should be separately accounted for?
PwC response
Yes. In accordance with ASC 815-15-55-108, the return on the receivable by the assuming company is not clearly and closely related to the host because the yield is based on a specific proportion of the ceding company’s return on a block of assets. Some contend that modified coinsurance arrangements are insurance contracts and therefore should be exempt from ASC 815 under the ASC 815-10-15-52 exception. However, as described in ASC 815-10-15-54, insurance contracts can have embedded derivatives that need to be separated. ASC 815-15-55-108 notes that whether the host contract is considered to be an insurance contract or the modified coinsurance receivable/payable component of the arrangement, the embedded derivative provisions of ASC 815 are still applicable.

4.6.3 Lease hosts

The approach for determining whether an embedded derivative is clearly and closely related to a lease host is similar to the approach used for a debt host. As discussed in ASC 815-15-25-21 through ASC 815-15-25-22, an embedded derivative that alters lease payments is considered clearly and closely related to the lease host if (1) there is no significant leverage factor and (2) the underlying is an adjustment for inflation on similar property or an interest rate index.
In assessing if there is significant leverage relating to an underlying that is an interest rate index, the guidance in ASC 815-15-25-26 should be assessed. See DH 4.4.2 for additional information.
Oftentimes, embedded derivatives in lease agreements qualify for the scope exception in ASC 815-10-15-59 for contracts not traded on an exchange. For example, an operating lease that requires lease payments that vary based on sales by the lessee (e.g., rent payable at a base of $10,000 plus 3% of the lessee’s sales each month) would not have to be separated because the embedded feature in the lease qualifies on a standalone basis for the scope exception in ASC 815-10-15-59(d) applicable to a non-exchange-traded contract whose underlying is specified volumes of sales by one of the parties to the contract. Similarly, an option embedded in an operating lease agreement on an office building that gives the lessee the option of buying the leased asset would qualify for the ASC 815-10-15-59(b)(2) scope exception on a standalone basis because the settlement is based upon the leased asset, which is a nonfinancial asset of one of the parties. The same would apply to more complex lease arrangements, such as an operating lease with a terminal rental adjustment clause indexed to the specific asset under lease, assuming the lease is not exchange-traded and the subject of the lease is a nonfinancial asset or liability of one of the parties that is not readily convertible to cash, as discussed in ASC 815-10-15-119.
Example DH 4-5 and Example DH 4-6 illustrate the analysis of embedded features in lease agreements.
EXAMPLE DH 4-5
Purchase option and option to extend lease embedded in a finance lease
Lessee Corp enters into a property lease (land and building) with Lessor Corp. The following table summarizes information about the lease and the leased asset.
Lease term
10 years
Renewal option
One 2-year renewal option
If exercised, the annual lease payments are reset to then-current market rents.
Economic life
12 years
Fair value of the leased property
$5,000,000
Purchase option
Lessee Corp has an option to purchase the property at the end of the lease term for $1,000,000 when the expected fair value at the end of year ten is $1,500,000.
Annual lease payments
The annual lease payments are $600,000, with increases of 3% per year thereafter.
Lessee Corp concludes that the lease is a finance lease under the guidance in ASC 842, Leases, because at lease commencement the fixed price purchase option available to Lessee Corp at the end of the initial lease term (i.e., after 10 years) is reasonably certain to be exercised by Lessee Corp. As a result, Lessee Corp has effectively obtained control of the underlying asset.
Under the guidance in ASC 842, Lessee Corp would record a lease liability and a right of use asset at the present value of the lease payments plus the present value of the option purchase price using its incremental borrowing rate. See LG 4 for information on the accounting for leases under ASC 842.
Is either the renewal option or purchase option an embedded derivative that should be separated from the lease contract?
Analysis
A right to extend a finance lease is a right to extend the maturity of the lease liability. This extension option does not meet the definition of a derivative because it does not contain a net settlement provision. Since the option to extend the lease would not be accounted for as a derivative if it were freestanding, it does not meet the requirement in ASC 815-15-25-1(c) and should not be separated from the lease host contract.
If Lessee Corp exercises its purchase option, it would recognize this as an extinguishment of the lease liability. The repayment of debt at maturity is not a derivative.
EXAMPLE DH 4-6
Purchase option and option to extend lease embedded in an operating lease
Lessee Corp leases an automobile from Lessor Corp. The following table summarizes information about the lease and the leased asset.
Lease term
3 years
Renewal option
3 year renewal option
If exercised, the annual lease payments are reset to then-current market rates.
Economic life of the automobile
6 years
Purchase option
Lessee Corp has the option to purchase the automobile for $20,000 upon expiration of the lease.
Monthly lease payments
$500
Other
  • Title to the automobile remains with Lessor Corp upon lease expiration
  • The fair value of the automobile is $30,000; Lessee Corp does not guarantee the residual value of the automobile at the end of the lease term
Lessee Corp concludes that the lease is an operating lease because none of the criteria in ASC 842-10-25-2 and ASC 842-10-25-3 to classify a lease as a finance lease have been met.
Is either the renewal option or purchase option an embedded derivative that should be separated from the lease contract?
Analysis
A right to extend an operating lease beyond the lease term is a right to acquire the use of a nonfinancial asset for an additional period. The extension option in this case does not meet the definition of a derivative because it simply provides the right to execute a new lease and does not contain a net settlement provision. Since the option to extend the lease would not be accounted for as a derivative if it were freestanding, it does not meet the requirement in ASC 815-15-25-1(c) and should not be separated from the lease host contract.
The purchase option does not meet the definition of a derivative because it does not contain a net settlement provision.
  • To exercise the option, Lessee Corp must pay the purchase price in cash, and Lessor Corp must deliver the asset. This is done on a gross basis, and there is no provision in the contract that would permit net settlement.
  • There is no market mechanism to facilitate net settlement.
  • The asset to be delivered is not readily convertible to cash.
Since the purchase option would not be accounted for as a derivative if it were freestanding, it does not meet the requirement in ASC 815-15-25-1(c) and should not be separated from the lease host contract.
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