Chapter 4 — Measurement of Expected Credit Losses

4.6 Credit Enhancements

ASC 326-20

30-12 The estimate of expected credit losses shall reflect how credit enhancements (other than those that are freestanding contracts) mitigate expected credit losses on financial assets, including consideration of the financial condition of the guarantor, the willingness of the guarantor to pay, and/or whether any subordinated interests are expected to be capable of absorbing credit losses on any underlying financial assets. However, when estimating expected credit losses, an entity shall not combine a financial asset with a separate freestanding contract that serves to mitigate credit loss. As a result, the estimate of expected credit losses on a financial asset (or group of financial assets) shall not be offset by a freestanding contract (for example, a purchased credit-default swap) that may mitigate expected credit losses on the financial asset (or group of financial assets).

Among other factors that may affect expected credit losses on a financial asset (or group of similar financial assets), an entity should consider whether the asset includes an embedded credit enhancement provided by a third-party guarantor (e.g., private mortgage insurance). In determining whether an enhancement feature is embedded or freestanding, an entity must consider the following definition of a freestanding contract in the ASC master glossary:

A freestanding contract is entered into either:

Separate and apart from any of the entity’s other financial instruments or equity transactions
In conjunction with some other transaction and is legally detachable and separately exercisable.

If the financial asset includes an embedded credit enhancement feature, the entity should consider how the cash flows associated with such a feature should be incorporated into the expectation of cash flows that are recoverable on the financial asset. By contrast, the entity must not consider cash flows associated with a freestanding credit enhancement contract (e.g., credit insurance purchased by the entity, including credit default swaps) even though the objective of obtaining such a contract is the same as if it were embedded in the financial asset (i.e., to mitigate credit exposure). To avoid double counting, an entity is prohibited from considering the effects of a freestanding credit enhancement feature when estimating expected credit losses. For example, the cash flows from a credit default swap that is a credit enhancement of a loan asset should not be included in the measurement of expected credit losses because such a swap would be recognized separately (e.g., as a derivative financial instrument if it is within the scope of ASC 815). Even if the freestanding credit insurance is not accounted for as a derivative, cash flows from freestanding credit insurance should not be considered in the estimation of expected losses on the related “covered” assets.

4.6.1 Freestanding Credit Insurance and Other Credit Risk Mitigation Contracts

Although ASC 326-20 is clear that an entity must not consider cash flows associated with a freestanding credit enhancement contract when estimating its expected credit losses, questions have arisen regarding how an entity must account for these freestanding contracts. ASC 326-20 does not address freestanding contracts that mitigate credit risk on financial assets.

To address these questions, the FASB staff stated, in response to a technical inquiry, that it would be appropriate for an entity that is applying ASC 326 to recognize an insurance recovery asset on a freestanding credit insurance contract at the time expected credit losses are recorded. The staff also noted that there may be other acceptable approaches to recognizing freestanding contracts, including recognition of the insurance recovery asset on an incurred basis. However, the staff clarified that its views on freestanding contracts pertain only to contracts that (1) qualify for the scope exception in ASC 815-10-15-13(c) or (d) related to applying derivative accounting and (2) pass the risk transfer test in ASC 340-30 and ASC 944-20.

Connecting the Dots

Recording the Recovery Asset

We believe that, in accounting for recoveries from freestanding insurance contracts, it is appropriate for entities to analogize to the guidance on indemnification assets in ASC 805. That guidance requires entities to measure an indemnification asset on the same basis as the indemnified item.

An approach in which a recovery asset is recorded at the same time an expected credit loss is recorded in earnings under ASC 326 is generally referred to as the “mirror image approach.” Under the mirror image approach, the expected recovery asset would be measured in a manner consistent with the expected credit loss; accordingly, the accounting for the insured instruments would be “matched” and the economics of the arrangement would be reflected. Further, the credit insurance recovery asset would be estimated by using the same assumptions as the loss estimate on the underlying assets and would result in the recording of equal amounts for the allowance for loan losses and the credit insurance recovery asset (provided that the insurance covered the full amount of the expected credit loss). Therefore, an entity would most likely recognize in earnings a “day one recovery of expected credit losses” on purchased credit insurance.

Keep in mind, however, that ASC 326-20 applies to the insurance recovery asset recognized on a freestanding insurance contract. That is, just as expected credit losses must be measured on a reinsurance receivable, an entity must measure expected credit losses on an insurance recovery asset.

Although the credit insurance recovery asset is measured by using assumptions that are consistent with those used to estimate expected credit losses, the credit insurance recovery asset should not be presented net or offset against the allowance for credit losses related to the insured instruments. Moreover, the amounts recorded in the income statement in connection with the credit insurance recovery asset should not be presented net against the related credit loss expense.

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