FASB Discusses Technical Inquiry Related to Freestanding Credit Insurance Contracts
March 12, 2020
Yesterday, the FASB held a non-decision-making meeting to discuss a technical inquiry related to how an entity should account for freestanding credit insurance contracts when applying ASU 2016-13.1
Questions have arisen regarding the appropriate accounting model for entities that enter into credit protection agreements that are considered freestanding contracts under the ASU. ASC 326-20-30-12 notes that an entity would not consider freestanding contracts that mitigate credit losses when measuring an allowance for credit loss on a financial asset. However, the accounting guidance does not address freestanding contracts that mitigate credit risk on financial assets unless such contracts would be accounted for as derivative instruments under ASC 815.2
The FASB staff clarified that its views on the freestanding contracts would be limited to a contract that both:
- Meets the scope exception in ASC 815-10-15-13(c) or (d) related to applying derivative accounting.
- Passes the risk transfer test in ASC 340-30 and ASC 944-20.
The Board’s meeting handout states that for freestanding credit insurance contracts that are within the scope of this technical inquiry, “it would be appropriate for an insurance recovery asset to be recognized at the time of recording expected credit losses [when applying ASU 2016-13].” 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.
Connecting the Dots
The Board meeting handout indicates that “the guidance for indemnification assets within the business combination guidance in Topic 805, Business Combinations, is an appropriate area of the accounting guidance to analogize the accounting for recoveries from freestanding insurance contracts. [That] guidance . . . requires an indemnification asset to be measured on the same basis as the indemnified item.”
Recording a recovery asset 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 this approach, the expected recovery asset would be measured in a manner consistent with the expected credit loss, which will result in “matching” the accounting for the insured instruments and reflecting the economics of the arrangement. Under the mirror image approach, 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). This would most likely result in the recognition of a “day one recovery of expected credit losses” on purchased credit insurance that would be recognized in earnings.
The Board emphasized that 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. In addition, 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.
FASB Accounting Standards Update (ASU) No. 2016-13, Measurement of Credit Losses on Financial Instruments.
For titles of FASB Accounting Standards Codification (ASC) references, see Deloitte’s “Titles of Topics and Subtopics in the FASB Accounting Standards Codification.”