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6.2 Financial guarantee insurance
Publication date: 31 May 2022
us Insurance guide
Financial guarantee contracts provide protection to a guaranteed party against events of default. Financial guarantee contracts are often written by mono-line financial guarantee insurers in the form of insurance contracts, or they may be written by other types of financial institutions in other forms (e.g., in the form of an ISDA, or International Swap Dealers Association, contract). The scope of the detailed guidance in ASC 944 for financial guarantee contracts is quite restrictive. The scope is limited to financial guarantee insurance contracts written by financial guarantee insurance enterprises (such as guarantees on municipal bonds and asset-backed securities) and is not applicable to non-insurers (such as banks and other financial institutions) who may write similar contracts. It also does not apply to other insurance contracts written by insurance enterprises that are economically similar to financial guarantee insurance contracts in that they provide protection to the insured in the event of the default of a debtor of the insured (e.g., mortgage guaranty insurance and credit insurance on trade receivables).
No matter what its form, a financial guarantee contract should be evaluated to determine if it meets the definition of a derivative under ASC 815 and, if so, if it qualifies for the financial guarantee scope exception under derivative accounting (ASC 815-10-15-58). Financial guarantee contracts are not subject to the derivative guidance if they provide for payments to be made only to reimburse the guaranteed party for a loss incurred because the debtor fails to pay when payment is due, which is considered analogous to an identifiable insurable event, and if all the other criteria in ASC 815-10-15-58 are met. In contrast, financial guarantee contracts are subject to ASC 815, Derivatives and Hedging, if they provide for payments to be made in response to changes in an underlying (for example, a decrease in a specified debtor's creditworthiness) or if they fail any of the other ASC 815-10-15-58 criteria.
To qualify for the ASC 815-10-15-58 scope exception, the contract must meet all of the following requirements:
- The instrument subject to the guarantee must be a non-derivative contract
- The event triggering a payment under the contract must be failure to pay when payment is due, either (a) at pre-specified payment dates (i.e., failure to pay principal and/or interest in accordance with the terms of the instrument) or (b) at accelerated payment dates as a result of the occurrence of an event of default (as defined in the financial obligation covered by the guarantee contract) or notice of acceleration being made to the debtor by the creditor
- The amount paid can be no more than the amount past due, and must be past any contractual extensions or grace periods
- As a precondition for payment, the contract must specify that:
- the guaranteed party maintain direct legal ownership of the financial asset at inception and throughout the life of the contract, or
- the guaranteed party maintain a back-to-back arrangement with a third party that has direct legal ownership of the financial asset at inception and throughout the life of the contract.
- The guarantor must receive either:
- the rights to any payments subsequently advanced to the guaranteed party, or
- the delivery of the defaulted receivable upon the event of default.
The guaranteed party must relinquish to the guarantor its rights to receive payment from the debtor in order to receive payment from the guarantor. Bankruptcy alone is insufficient to meet the scope exception, and other events of default that do not result in a failure to pay when due are not valid triggering events. Certain invalid events of default common to ISDA contracts include:
- Obligation Acceleration: One or more obligations (not necessarily the referenced asset) is accelerated as a result of an event of default other than failure to pay
- Obligation Default: An event of default, as specified in the note agreement, other than failure to pay when payment due (e.g., debt covenants, such as failure to maintain certain ratios or cash balances) on any obligation, not just the referenced asset
- Repudiation / Moratorium: An entity or government authority disaffirms, disclaims, repudiates or rejects validity of one or more obligations, and not necessarily the referenced asset
- Restructuring: Restructuring of one or more obligations, not necessarily resulting in a failure to pay
- Bankruptcy (unless accompanied by a failure to pay)
Because the default provisions typically do not result in a failure to pay, these default events do not meet the requirements of ASC 815-10-15-58.
6.2.1 Financial guarantee premiums receivable and unearned premium liability
A liability for unearned premium revenue is recognized at the inception of a contract. If the entire contractual premium is received at inception (i.e., an "upfront" contract), the initial unearned premium revenue liability is measured as the amount received.
For contracts where premium payments are received over the period of the contract (i.e., an "installment" contract), a receivable for future premiums is established at inception, and the initial unearned premium revenue liability is measured as the amount of the premium receivable. The premium receivable is determined as the present value of contractual premiums due or, if certain criteria are met, as the present value of premiums expected to be collected. Under either method, the discount rate should reflect the risk-free rate at the inception of the contract.
The discount on the premium receivable is accreted through earnings over the contractual period or the expected period that the insured obligation will be outstanding. The unearned revenue liability is not accreted with interest because, unlike the premium receivable, it is not a financial instrument. The liability is instead a stand-ready obligation of the insurer which is measured at the consideration received at inception of the contract. ASC 944 does not prescribe where the accretion of the premium receivable should be recorded in earnings. Accretion may be classified as part of premium revenue, investment income, or a separate line item in the income statement, with disclosure of the company's accounting policy.
In certain instances, the expected period of risk may be less than the contractual risk period due to expected prepayments of the insured obligation. This may occur when insured obligations are contractually prepayable, as is often the case with structured securities including securitizations relating to securitized mortgage loans. An expected contract period may be used to determine the initial receivable and unearned premium revenue liability only if a homogeneous pool of assets underlying the insured financial obligation is contractually prepayable. In that circumstance, prepayment assumptions may be used to determine an expected contract period if prepayments are probable and their timing and amount can be reasonably estimated. Companies should develop and maintain sufficient documentation to support the assertions that an insured obligation has a homogenous pool of underlying assets that are contractually prepayable, and that expected prepayments are probable and their timing and amount are reasonably estimable. The use of prepayment assumptions to determine an expected contract period is an accounting policy decision that must be elected for similar types of contracts. It is not available as a contract-by-contract election.
Use of an expected contractual period is not appropriate for individual callable insured financial obligations because an underlying pool of homogenous assets does not exist. Therefore, incorporating expectations of a future "refunding" of a traditional municipal bond to replace it with a new financial obligation, which is often done to obtain a lower interest rate, is not permitted.
When premiums are received in installments and the period outstanding is estimated based on expected prepayments, the premium receivable asset and unearned premium revenue liability are adjusted when prepayment assumptions change. The premium receivable asset is recalculated based on current prepayment assumptions and the current risk-free rate, and an adjustment is made for the difference between this revised balance and the balance based on original assumptions. An equal adjustment is made to the unearned premium revenue liability, resulting in no effect on earnings at the time of the adjustment. The revised unearned premium revenue liability is recognized in earnings using a newly computed constant rate. ASC 944-310-55-1 provides an example of a change in prepayment assumption.
When premiums are received in installments and contractual, rather than expected, obligation payments are used to measure the unearned premium liability, the premium receivable asset and unearned premium revenue liability are adjusted to reflect any expected reduction in premium receivable because of early principal payments as they occur. The premium receivable asset is recalculated based on remaining contractual principal and the current risk-free rate, and an adjustment is made for the difference between this revised balance and the balance based on original contract terms. An equal adjustment is made to the unearned premium revenue liability, resulting in no effect on earnings at the time of the adjustment.
This guidance applies to early principal payments of insured obligations relating to contracts with installment premium payments, and it equates the adjustment to the unearned premium revenue liability with the adjustment made to the premium receivable asset. ASC 944 does not provide specific guidance on how early principal payments of insured obligations relating to contracts with single premiums paid at inception (and, therefore, no premium receivable asset) should affect the unearned premium revenue liability and related premium revenue recognition. We believe that premium revenue should be recognized in proportion to the amount of insurance protection provided, and insurance protection provided is assumed to be a function of the insured principal amount outstanding. Therefore, if the principal amount outstanding has decreased, an acceptable approach would be to record a credit to earnings for the difference between the existing unearned premium revenue liability and the amount of unearned premium revenue liability that would have existed had the early principal payment been known at inception of the contract (i.e., a retrospective cumulative catch-up type of adjustment). This adjustment to the unearned premium revenue liability would be reflected in premium revenue.
Premiums receivable should be adjusted for uncollectible premiums with a corresponding adjustment to earnings. Uncollectible premiums must also be considered in the recognition and measurement of the claim liability. The guidance assumes that the contract cannot be cancelled because of non-payment of premium. Therefore, adjustment for uncollectible premiums represents a current-period bad debt expense that should not be offset by an adjustment to the unearned premium revenue liability. The unearned premium revenue liability represents the insurer's stand-ready obligation to perform under the contract. As this obligation is not reduced by non-payment of premium, no adjustment should be made to the unearned premium revenue liability. However, in certain limited situations, the contract may provide for a reduction in the claim payment amount to the extent of any uncollectible premium, which would be netted in the claim liability.
6.2.2 Financial guarantee premium revenue recognition
Premium revenue is recognized over the period of the contract in proportion to the amount of insurance protection provided, which is assumed to be a function of the insured principal amount outstanding. As premium revenue is recognized, the unearned premium revenue liability is reduced. This approach results in a revenue recognition pattern that reflects the reduction in insurance protection being provided both (1) as the insured principal balance is repaid and (2) due to the passage of time.
Applying this principle results in the recognition of a portion of the overall contractual premium as revenue each period at a constant rate. The rate is based on the relationship between the insured principal amount outstanding in that reporting period and the sum of each of the insured principal amounts outstanding for all periods. Mechanically, this is accomplished by multiplying the insured principal amount outstanding for that reporting period by the ratio of (a) the total present value of the premium due or expected to be collected over the period of the contract to (b) the sum of all insured principal amounts outstanding during each reporting period over the period of the contract. Example IG 6-1 provides an illustration.
EXAMPLE IG 6-1
Premium recognition for financial guarantee insurance
Premium recognition for financial guarantee insurance
Insurance Company issues a $10 million bond with the following terms:
- a 10-year term
- no principal payments until maturity
- a single upfront premium of $500,000
How should Insurance Company recognize and measure the premium revenue in each period?
Analysis
Insurance Company should recognize $50,000 of premium revenue each year.
If Insurance Company uses an "expected contract period" for recognizing and measuring premiums receivable and the unearned premium revenue liability, rather than the actual contractual period, the constant rate is based on, and premium revenue is recognized over, the expected contract period. If prepayment assumptions change, the constant rate should be recalculated based on the new prepayment assumptions (and the current risk-free rate) and applied to the principal amounts outstanding for the remaining expected period of the contract.
When the financial obligation being insured has a single principal payment at maturity and no contractual interest payments (such as a zero-coupon bond), the insurance protection (and the principal amount outstanding for each period) is based on the accreted principal amount outstanding.
Therefore, in each year, $50,000 of premium revenue would be recorded, calculated as $10 million outstanding in each period × $500,000 premium/$100 million ($10 million/year for 10 years).
6.2.3 Financial guarantee refundings
In some instances, the issuer of the guaranteed obligation may retire the obligation before its maturity and replace it with a new financial obligation (often referred to as "refunding"). This often occurs, for example, when interest rates decrease and the issuer decides to refinance the debt at a lower interest rate. If the financial guarantee contract has been extinguished (there are no future obligations from the original contract such as to cover a refinancing term), the insurer would immediately recognize any non-refundable unearned premium associated with the contract as premium revenue, and any unamortized acquisition costs as an expense. If the insurer insures the new obligation, an unearned premium revenue liability on the new financial obligation is recognized at an amount commensurate with the premium that would be charged to insure a similar financial obligation in a separate, standalone transaction. If this premium differs from the premium actually charged, the difference should be recognized currently in earnings.
6.2.4 Financial guarantee claim liabilities
The insurer is required to recognize a claim liability on a financial guarantee insurance contract when the insurer expects, based on the present value of expected net cash outflows to be paid under the insurance contract, that a claim loss will exceed unearned premium revenue for that contract. The analysis is done on a contract-by-contract basis each period. A claim liability must be recorded prior to an event of default (the insured event) to the extent that expected losses exceed the unearned premium liability (the stand ready obligation). An important distinction between financial guarantee contracts and property and casualty contracts is that the claim liability for a financial guarantee contract is not an entity’s best estimate based on an incurred claim; instead, it is a probability weighted expected value liability which reflects the likelihood of all possible outcomes.
The amount to be recorded as the claim liability is the excess of the present value of expected net cash outflows over the remaining unearned premium revenue liability. These two components (the claim liability and the remaining unearned premium revenue liability) together represent the insurer's total obligation under the financial guarantee contract. The unearned premium revenue liability should continue to be amortized to premium revenue in periods after a claim liability is recognized. The claim liability is adjusted in subsequent periods for any additional changes in estimated net cash outflows, changes in the risk-free interest rate, accretion of interest on the claim liability balance, and adjustment resulting from the reduction in the unearned premium revenue liability caused by its amortization.
The "net cash outflows" to be used in determining whether an additional claim liability is required represent potential payments from the insurer to the holder of the insured financial obligation, net of potential recoveries, and excluding reinsurance. "Expected net cash outflows" represent the probability-weighted cash flows that reflect the likelihood of all possible outcomes (as compared to a "best estimate" approach, which represents the single most likely outcome). These cash flows must be discounted using a risk free rate. In subsequent periods, the rate used to discount cash flows relating to the claim liability should be updated to reflect changes in the risk-free rate. Expected net cash outflows should also be revised for changes in estimates of the likelihood of a default and the related amounts of net cash outflows. Once established, the claim liability should not be reduced below zero.
ASC 944 does not specify the number of possible outcomes (scenarios) that should be included in expected net cash outflows. The range of possible outcomes should consider remote outcomes in addition to outcomes that are probable and reasonably possible. Judgment is required in determining both the probability and number of scenarios, and will likely vary depending on the nature of the insured obligation.
6.2.5 Representation and warranty recoveries or “putbacks”
A financial guarantee insurer may insure selected tranches of collateralized securities. If a loan is placed in the trust, and subsequently is determined not to have met the underwriting standards contractually agreed to by the lender through representations and warranties provided at the inception of the securitization, the lender is typically required to make the structure whole, either through a cash payment, or by replacing the loan. This process is known as "putting back" the loan to the lender (putbacks) or representation and warranty recoveries. ASC 944-40-30-32 defines expected net cash outflows as "cash outflows, net of potential recoveries, expected to be paid to the holder of the insured financial obligation, excluding reinsurance." As such, representation and warranty recoveries would be considered potential recoveries under the contract.
If a financial guarantee insurer determines that it has a contractual right to collect representation and warranty recoveries, it should include these potential recoveries within its expected net cash outflows measured on a consistent basis (i.e., probability weighted). The measurement is often based on an evaluation of the financial guarantee insurer’s specific loan portfolio, credit worthiness of its counterparties, transactions occurring in the marketplace, and status of any related litigation.
6.2.6 Bond buybacks
A financial guarantee insurer may purchase debt securities that they have previously guaranteed. These transactions are often referred to as bond buybacks. There are two alternative accounting treatments for bond buybacks used by financial guarantee insurers in practice, both of which we believe are acceptable. In the first alternative, the insurance policy is considered to be extinguished. Proponents of this view believe that the bond purchase is seen as effectively extinguishing the written guarantee, given that the financial guarantee insurer has no ultimate liability to any external party. Proponents of this view also believe that this best represents the economic substance of the transaction. In the second alternative, the guarantee is not considered to be extinguished. Proponents of this view believe that this best reflects the legal form of the transaction. The financial guarantee insurer’s policy is not written to itself; rather, it was written at the time the insured bonds were issued to a trustee as beneficiary for all security holders and is contractually embedded within the terms of the debt security indenture.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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