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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.
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