In the broadest sense, a credit derivative is a financial instrument designed to transfer credit risk from the party exposed to that risk (protection buyer) to a party willing to take on that risk (protection seller). A credit derivative primarily derives its value from the credit quality of a bond, loan, or other financial obligation or group of financial obligations of an underlying entity or entities (the reference entity). The most common credit derivatives are credit default swaps, total return swaps, and credit-linked notes.
A credit default swap is a contract under which the protection seller, in return for a premium, agrees to compensate the protection buyer for the financial loss it may incur following the occurrence of a credit event in relation to a specified obligation in return for a premium. The contract thereby allows one party to transfer the credit risk of a particular reference asset, which it may or may not own, to another party. The protection seller assumes the credit risk associated with the reference asset without directly owning it. A credit default swap contract can be tailored to provide protection for a number of potential credit events.
A total return swap is a contract under which one party (the total return payer) transfers the economic risks and rewards associated with an underlying asset to another counterparty (the total return receiver). The transfer of risks and rewards is effected by an exchange of cash flows that mirrors changes in the value of the underlying asset and any income derived from the underlying asset. The total return payer will make periodic payments to the total return receiver comprising the coupons/interest from the underlying asset and, either periodically or at maturity of the swap, an amount equivalent to the appreciation in the market value of the underlying asset. If the value of the reference asset depreciates, a payment would typically be made by the total return receiver to the total return payer. In contrast to a credit default swap, a total return swap transfers the credit risk and the market risk associated with the underlying asset. The economic effect for a total return receiver is equivalent to that derived from owning the asset. The total return receiver, however, does not incur the direct costs of funding the purchase of the underlying asset. As a result, the total return receiver makes a payment to the total return payer to compensate the latter for the funding costs. This payment, sometimes referred to as the premium or fee, is the other leg of the swap and usually comprises a one- or three-month benchmark based (e.g., Treasury or some other floating rate index) payment plus or minus a spread. The spread above or below the referenced interest rate index will be determined by the relative credit quality of the two counterparties as well as any collateral called for from a counterparty.
A credit-linked note is a contract under which one party issues a note to another party in return for cash or other consideration equal to the principal value of the note. The coupon on the note is linked both to the credit quality of the issuer and an obligation of a third party (the reference entity). In economic terms, it comprises a fixed income instrument and an embedded credit derivative.
Insurance-specific products that could potentially fall within the scope of ASC 815
and be subject to embedded derivative accounting include products for which a receivable, payable, deposit, account balance, commutation provision, or experience refund is credited or changes based on the realized or unrealized gains and losses of a specific pool of bonds, stocks, or mortgage loans. These products could include the following.
- Modified coinsurance and coinsurance with funds withheld arrangements (also referred to as modco or funds withheld arrangements)
These contracts are reinsurance arrangements in which payments are made to the reinsurer over time, and interest is credited on that payable based on the return of the ceding entity’s general account assets or a specified block of those assets (e.g., a specific portfolio of the ceding entity’s investments). At inception, the ceding entity does not meet the sale criteria in ASC 860
related to the cash and investments supporting the future benefit liabilities. In these arrangements, the ceding entity records a payable to the reinsurer, along with the reinsurance recoverable for the liabilities reinsured.
states that whether the modco or funds withheld arrangement is classified as a GAAP reinsurance contract or a GAAP deposit contract (e.g., because it “reinsures” annuity contracts that are classified as GAAP investment contracts or because it fails risk transfer due to certain risk limiting features), the embedded derivative analysis and conclusion as to whether the derivative is clearly and closely related will be the same.
- Certain reinsurance contracts with experience refund provisions
Certain contracts contain experience accounts or profit-sharing provisions that are based on a total return bond index, an equity index, or the total return on an investment portfolio. These provisions represent embedded derivatives requiring separate accounting.
Question IG 9-3
How should the embedded derivative in a modco agreement be characterized under ASC 815
There may be diversity in how the debt host is defined. ASC 815-15-25-25
states that “in the absence of stated or implied terms, it is appropriate to consider the features of the hybrid instrument, the issuer and the market in which the instrument is issued, as well as other factors, to determine the characteristics of the debt host contract.” Once the debt host is defined, the terms of the embedded derivative can be determined. In applying that guidance, typically the embedded derivative is determined to be either a credit derivative or a total return swap based on the particular facts and circumstances of the transaction. As a result of the judgment required, the conclusion around the terms of the embedded derivative may differ for the two counterparties of the same contract. The ceding entity may believe it has given away the total return on the investments it owns, while the assuming entity may believe it has just changed the credit risk in the contract.
Question IG 9-4
What circumstances should be considered in determining whether the embedded derivative is a credit in a reinsurance agreement is a credit derivative or a total return swap?
As discussed in Question IG 9-3, ceding and assuming entities should consider the guidance in ASC 815-15-25-25
in their assessment of whether the embedded derivative is a credit derivative or a total return swap.
At a minimum, credit risk exposure that is not clearly and closely related to that of the host contract exists. This is because the credit risk exposure is that of the underlying referenced bond portfolio rather than the credit risk exposure of the ceding entity.
This consideration should also include analysis of the cash flows under the contract. For example, if the fee paid to the reinsurer is primarily for surplus relief, and it is unlikely that there will be any variation in the payment unless there is a credit event on the underlying referenced portfolio, then an insurance entity may conclude that the derivative is a credit derivative. Alternatively, if the cash flows include incremental variability unrelated to credit, an insurance entity may conclude the derivative is a total return swap. In either case, the underlying terms of the agreement should be carefully considered in making this determination.
Question IG 9-5
Is there an embedded derivative in modco contracts that reinsure only the separate account portion of the variable annuity or variable life separate account products?
Yes, there are two potential embedded derivatives. However, the two derivatives would typically offset one another. For the assuming entity, the first embedded derivative would be in the liability that the assuming entity has taken on (the reinsurance of the variable annuity or variable life liability) because the liability promises to pay a total return on a referenced portfolio (that of the ceding entity separate account). For the ceding entity the first embedded derivative would be in the reinsurance recoverable (the reinsurance of the variable annuity or variable life liability). The second embedded derivative would be the reinsurer modco receivable/ceding entity reinsurance payable, which would typically be equal to the assumed liability/reinsurance recoverable and would also have the same total return on the referenced portfolio. ASC 815-15-25-7
requires that derivatives in a single contract be accounted for together as one compound derivative. Differences between the two derivative components could, in certain instances, result in a net balance for the compound derivative (e.g., if there were a risk that the assuming entity would be required to pay on the variable annuity or variable life liability in the event of a ceding entity insolvency).
Question IG 9-6
If a modco contract or similar arrangement provides a total return on the modco receivable/payable, but receivables/payables relating to the contract are accounted for on a net basis rather than a gross basis because the contract satisfies the right of offset requirements of ASC 210-20-45
, does ASC 815
Yes. Even if receivable/payables relating to the contract are recorded on the balance sheets on a net basis by either the reinsurer or ceding entity, if one of the terms of the contract provides for a total bond portfolio return based on some referenced amount (in this case the modco receivable/payable), an embedded derivative still exists as part of the modco arrangement that is required to be bifurcated and recognized at fair value with changes in fair value recognized currently in earnings.