Derivatives Implementation Group

Statement 133 Implementation Issue No. B28

QUESTION

May the scope exception in paragraph 15 be applied during the period between the inception of the contract and the loss occurrence date by analogy to an insurance contract in which losses are denominated in either (a) the functional currency of one of the parties to that contract or (b) the local currency of the country in which the loss is incurred?

BACKGROUND

Insurance contracts that provide coverage for various types of property and casualty exposure are commonly executed between U.S.-based insurance companies and multinational corporations that have operations in foreign countries. The contracts may be structured to provide for payment of claims in the functional currency of the insurer or in the functional currency of the entity experiencing the loss and will typically specify the exchange rate to be utilized in calculating loss payments.

Example
A contract provides for the payment of losses in U.S. dollars (that is, the functional currency of the insurer). Losses are reported to the insurance company in the functional currency of the entity experiencing the loss, but losses are paid by the insurer in U.S. dollars. From the perspective of the insurer, the contract terms may provide that the rate of exchange to be used to convert the losses from the functional currency of the foreign entity to the U.S. dollar for purposes of claim payments be one of the following:

1. the rate of exchange as of the settlement date (payment date) of the claim
2. the rate of exchange as of the loss occurrence date
3. the rate of exchange at inception of the contract.

Paragraph 10(c)(2) of Statement 133 indicates that traditional property and casualty insurance contracts are not subject to the requirements of the Statement because the payment of benefits is the result of an identifiable insurable event (for example, theft or fire) instead of changes in a variable. Paragraph 10(c) also states, "…some contracts with insurance or other enterprises combine derivative instruments ... with other insurance or nonderivative contracts, for example … property and casualty contracts that combine traditional coverages with foreign currency options. ... Contracts that consist of both derivative portions and nonderivative portions are addressed in paragraph 12." The contract described in this issue does not qualify as traditional insurance under paragraph 10(c)(2) because it contains a foreign currency element.

Paragraph 15 of Statement 133 states:

    An embedded foreign currency derivative instrument shall not be separated from the host contract and considered a derivative instrument under paragraph 12 if the host contract is not a financial instrument and it requires payment(s) denominated in (a) the functional currency of any substantial party to the contract....Unsettled foreign currency transactions, including financial instruments, that are monetary items and have their principal payments, interest payments, or both denominated in a foreign currency are subject to the requirement in Statement 52 to recognize any foreign currency transaction gain or loss in earnings and shall not be considered to contain embedded foreign currency derivative instruments under this Statement. [Emphasis added.]

Because the insurance company does not record a claim liability until losses are incurred in accordance with FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, no foreign-currency-denominated liability exists (that would otherwise be subject to FASB Statement No. 52, Foreign Currency Translation, as contemplated by paragraph 15) during the period between the inception of the insurance contract and the loss occurrence date. Also, insurance contracts are financial instruments that are not covered by the scope exception in the first part of paragraph 15 that applies to non-financial contracts. Therefore, the insurance contract must be assessed to determine whether it contains an embedded foreign currency derivative under paragraph 12 of Statement 133.

This issue addresses whether insurance contracts in which losses are denominated in either (a) the functional currency of one of the parties to that contract or (b) the local currency of the country in which the loss is incurred during the period between the inception of the contract and the loss occurrence date, that would otherwise be deemed to contain embedded foreign currency derivatives, may be excluded from the scope of Statement 133 by analogy to paragraph 15.

RESPONSE

Yes. Although the exception in the first part of paragraph 15 of Statement 133 does not apply to financial instruments, paragraph 15 applies to this situation in which a normal insurance contract involves payment in the functional currency of either of the two parties to the contract. Paragraph 311 in the basis for conclusions states, "The Board decided that it was important that the payments be denominated in the functional currency of at least one substantial party to the transaction to ensure that the foreign currency is integral to the arrangement and thus considered to be clearly and closely related to the terms of the lease." The insurance contracts described in this issue are similar to operating leases, which are covered by the exception in paragraph 15, because neither contract gives rise to a recognized asset or liability that would be measured under Statement 52 until an amount becomes receivable or payable under the contract. Therefore, the exception in paragraph 15 also applies to insurance contracts that involve payment of losses in the functional currency of either of the two parties to the contract. In addition, the paragraph 15 exception would also apply to those contracts if it involves payment in the local currency of the country in which the loss is incurred, irrespective of the functional currencies of the parties to the transaction.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.