IAN – Embedded derivatives – Draft 1 – September 2017

1. What is a derivative and an embedded derivative?

Derivatives and embedded derivatives are formally defined in IFRS 9 (Financial Instruments) and not in IFRS
17. IFRS 9 includes criteria for identifying derivatives and conditions for separating a derivative embedded
in a non-derivative contract.

A derivative, as set out Appendix A to IFRS 9, can be summarised as a financial instrument or other contract Commented [HS1]: Is this a summary or the actual
with the characteristics that its value changes in response to a change in financial variable or another definition. If not the latter, why don’t we include it?
variable (provided in the case of a non-financial variable that the variable is not specific to a party to the
contract), it typically requires no initial net investment and it is settled at a future date.

An embedded derivative is a component of a contract that also includes a non-derivative host with the
effect that some of the cash flows of the combined contract vary in a way similar to a stand-alone
derivative. Commented [HS2]: Does the embedded derivative need
to meet the defn of a derivative? I don’t know. I might
have worded it that an embedded derivative is a derivative
2. What are the IFRS 17 requirements on the accounting for embedded derivatives? that is part of another contract (the non-derivative host)
that meets the definition of a derivative. But I’m not sure
The requirements in IFRS 17 on the accounting for embedded derivatives are limited. As set out in this is correct.
paragraph 11(a) of the standard, entities are required to apply IFRS 9 to determine whether there is an
embedded derivative to be separated from an insurance contract and, if so, how the separate component is
accounted for.

An embedded derivative is separated if, and only if:

a. The economic characteristics and risks of the embedded derivative are not closely related to the
economic characteristics and risks of the host (the remaining insurance contract).
b. A separate instrument with the same terms as the embedded derivative would meet the definition of a
derivative.
c. The contract is not measured at fair value with changes in fair value recognised in profit or loss

Condition (c) will always be met for an insurance contract as under IFRS 17 insurance contracts are not
measured at fair value. Commented [HS3]: Is this true? I get confused but I
thought some contracts are measured at fair value, at least
The accounting under IFRS 9 is requires the entity to measure the embedded derivative at fair value with all at transition.

changes in measurement recognised in profit or loss immediately (commonly known as ‘fair value through
profit or loss’).

Embedded derivatives that are not required to be separated (under IFRS 9) are considered as part of the
insurance contract and accounted for under IFRS 17.

3. Are the IFRS 17 requirements on embedded derivatives different from those in IFRS 4?

The requirements may be different.

In IFRS 4 (paragraphs 7 to 9), embedded derivatives were required to be separated and accounted for
applying IAS 39 (Financial Instruments)1 unless the embedded derivative is itself an insurance contract. In
addition, there was an explicit exception to IAS 39 where separation was not required for certain surrender

1
IAS 39 is the precursor IASB standard that is replaced by IFRS 9 (Financial Instruments).

1
options within insurance contracts. In particular, a policyholder’s option to surrender an insurance contract
for a fixed amount (or for an amount based on a fixed amount and interest rate). The exception applied to
insurance contracts and investment contracts with a discretionary participation feature (that is all contracts
in scope of IFRS 4). In addition, the IFRS 4 implementation guidance (IG3 and 4) provided 20 examples of
products, some with and some without embedded derivatives requiring separation.

Experience of IFRS 4 showed that in many countries the majority of insurance products do not contain
embedded derivatives which require separation.

In IFRS 17, there is no exception for surrender options and such options are required to be assessed under
IFRS 9. In addition, the IFRS 4 implementation guidance has not been included. As a consequence, there Commented [HS4]: In what?
could be a difference in the scope of embedded derivatives requiring separation. This will require an
assessment based on the nature of individual contract types.

4. Are there specific disclosure requirements for embedded derivatives?

For embedded derivatives that are not separated and so are part of an insurance contract, there are no
additional specific disclosure requirements in IFRS 17. For reference in IFRS 4, paragraph 39(e) specifically
required that information about the exposure to market risk be disclosed if such embedded derivatives are
not measured and presented at fair value through profit or loss.

For embedded derivatives that are separated, the disclosure requirements are as set out in IFRS 9.

5. What are some examples of policy provisions that are likely to produce an embedded derivative that
needs to be separated?
6. What are some examples of policy provisions that may appear to be embedded derivatives but likely
do not need to be separated?