Natural disasters Hedge accounting

Natural disasters Hedge accounting, how to deal with this combination, contracts go on but the business dies….. Here is how to report such issues under IFRS.

The natural disaster and potential subsequent events can disrupt many business transactions that may be postponed or cancelled. For example, entities may have been forecasting purchases of local goods or sales of their goods to local entities. Natural disasters Hedge accounting

Prior to the disaster, many such transactions may have constituted ‘highly probable’ hedged transactions in cash flow hedges under IFRS 9 Financial instruments (or IAS 39, if still applicable). However, purchases and sales that were considered highly probable a few weeks prior to the natural disaster, may no longer be highly probable (in full or partially) or may not be expected to occur at all. Natural disasters Hedge accounting

Entities consider whether any hedges of forecast transactions may cease to qualify for hedge accounting (in full or partially) as a result of the disaster. The disaster could also affect the probability ofNatural disasters Hedge accounting hedged forecast transactions, occurring at the same time, in the same amounts and under the same terms as originally designated, which may result in higher levels of ineffectiveness in the hedging relationship going forward. Natural disasters Hedge accounting

If the occurrence of the forecast transaction is no longer highly probable, the entity must cease hedge accounting. If the forecast transaction is no longer expected to occur, the entity reclassifies the accumulated gains or losses on the hedging instrument from other comprehensive income into profit or loss as a reclassification adjustment. However, if the occurrence of the forecast transaction is no longer highly probable but still expected, the cumulative effective portion remains in other comprehensive income until the forecast transaction either occurs or is no longer expected to occur.

After a natural disaster, an entity must assess the effectiveness of hedge relationships and identify any changes in their risk management objective. In particular, under IFRS 9, an entity would have to discontinue hedge accounting if it were determined that there is no longer an economic relationship, or if credit risk dominates the hedging relationship as a result of the natural disaster. Natural disasters Hedge accounting

Furthermore, the hedge ratio may need to be adjusted if the hedged item and hedging instrument no longer move in relation to each other as originally expected. The entity has to assess whether it expects this to be the case going forward and, if so, to ‘rebalance’ the hedge ratio to reflect the change in the relationship between the value drivers in hedged item and hedging instrument. For entities that use statistical methods such as regression analysis to assess ongoing qualification for hedge accounting, new data incorporating the effects of the disaster must be added to the assessment and cannot be discarded. Natural disasters Hedge accounting

In the case of a natural disaster, it is likely that there will be an impact on the effectiveness of hedging relationships, that may be so significaNatural disasters Financial statement disclosurent that an entity may conclude that the eligibility criteria for hedge accounting are no longer met under IFRS 9 (or IAS 39, if still applicable). In such cases, an entity would need to identify the specific event or change in circumstances that caused the hedging relationship to fail, and continue to follow hedge accounting up until the precise date of such an event, which is likely to be the date of the initial disaster (e.g., earthquake and tsunami). Natural disasters Hedge accounting

A hedge relationship includes both a derivative and a hedged item or hedged forecasted transaction. Like all external events, the disaster could affect the probability of hedged forecasted transactions occurring at the same time and in the same amounts as designated at the inception of a hedge. Hedgers must evaluate the probability of forecasted transactions occurring to maintain hedge accounting as well as the probability that a forecasted transaction will not occur to determine whether to immediately reclassify to earnings balances from past changes in the fair value of derivative contracts that have accumulated in Accumulated Other Comprehensive Income. Natural disasters Hedge accounting

If a hedger concludes that hedge accounting is no longer appropriate, the hedger is permitted to identify the specific event or change in circumstances that caused the hedging relationship to fail the effectiveness criteria and to follow hedge accounting up until the precise date of such an event. For certain transactions, that may be the date of the natural disaster.

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IFRS 9 allows for designation of a non-financial component as a hedged item, and, accordingly, the volume of eligible hedging relationships might increase for entities exposed to commodity price movements. Such hedge relationships are more likely to be impacted by natural disasters. Natural disasters Hedge accounting

Hedged forecasted transactions ended – hedging relationship ends

A key requirement for obtaining cash flow hedge accounting is that the hedged forecasted transaction is probable of occurring. Natural disasters can affect operations, causing some transactions to be curtailed, delayed or canceled. Natural disasters Hedge accounting

Companies that have designated forecasted transactions in cash flow hedging relationships e.g., purchases or sales of goods, or interest payments on debt, may determine that

Natural disasters Financial impact overview
Princess Juliana airport, St Maarten after Hurricane Irma 2017

the hedged transaction is no longer probable of occurring within the originally specified time period, in which case hedge accounting should be discontinued prospectively. However, the related gains and losses in accumulated other comprehensive income should be reclassified in earnings only if it is probable that the forecasted transaction will not occur by the end of the period originally specified or within an additional two-month period thereafter. Natural disasters Hedge accounting

Natural disasters also may affect the eligibility for the “normal purchases and normal sales” scope exception to derivatives accounting for commodity contracts e.g., oil and gas. This exception is based on physical delivery and if that is no longer probable due to curtailment or cancellation of operations such that the contract instead would now settle net, the eligibility for applying this scope exception would no longer be met. Consequently, the contract should be recorded on the balance sheet at its current fair value and subsequently continue to be marked to fair value, similar to any other derivative. Natural disasters Hedge accounting

Disaster insurance for credit institutions

In a number of economies, micro-finance and other local credit institutions play an important role in ensuring access to credit for small entrepreneurs and business owners. In economies highly exposed to extreme weather events like torrential rain or strong wind, these institutions face significant financial risks related to natural hazards.

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Disaster insurance coverage for financial institutions enables these institutions to continue to provide financing in the aftermath of a disaster event and support the financial resilience of the broader economy. Natural disasters Hedge accounting

The cash flow of credit cooperatives in the Philippines, for instance, can be suddenly interrupted if member borrowers lose their livelihoods and assets in a storm and become unable to fulfil their debt obligations. Starting from the end of 2010, a group of partners (including Munich Re and GIZ), working in support of the Cooperative Life Insurance and Mutual Benefit Services (CLIMBS),26 have been implementing a weather-index-based micro-insurance product in the Philippines. Natural disasters Hedge accounting

This product is employed as a hedge for credit portfolios, enabling the cooperatives to manage their loan defaults and meet their social commitments in the event of a catastrophe. This extreme weather event insurance tool is based upon a parametric index for each municipality, developed by private sector partners, categorising wind speed and rainfall into 10-, 15-, and 20-year recurrence events. Using these benchmarks as pay-out triggers, CLIMBS compensates local cooperatives based on a pre-determined percentage of the value of their portfolios of loans, depending on the event intensity and corresponding category class. Natural disasters Hedge accounting

Shortly after a trigger event, the institution concerned receives an insurance payment which is then disbursed to its members in the form of emergency loans granted on favourable terms, according to specific needs (the insured cooperatives must make a commitment to pass on the insurance benefits to their members). The micro-insurance product, CLIMBS Catastrophe Protection Policy, appears to be beneficial to the cooperatives in helping manage their exposure to default risk as well as to the member borrowers or shareholders of these cooperatives by protecting their equity and investments in the cooperatives and by enabling them to rebuild their livelihoods after an extreme weather event. Natural disasters Hedge accounting

Similarly, the banking and financial sectors in Indonesia face severe earthquake exposures, especially those firms that have limited capacity to diversify geographically.27 Local credit institutions, such as rural banks and microfinance lenders, dominate the financial landscape in this economy and have the most comprehensive outreach to small and medium-sized enterprises, which in turn represent the backbone of Indonesia’s growing economy. Liquidity issues, capital base erosion, poor loan performance, limited access to second-tier financing and extra-costs are some of the key areas of concern for these financial institutions facing earthquake risk; supporting them in the management of their exposures, therefore, has important social and economic implications.

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A group of partners, in collaboration with PT. Asuransi MAIPARK, is developing index-based earthquake insurance to strengthen the resiliency of the financial sector that serves lower income households and SMEs. The “Earthquake Index Insurance” product (EQII) is designed to transfer portfolio risks of financial institutions, such as banks, financial services firms and credit unions, enabling them to expand access to financial services in vulnerable, under-served areas and to aid in local recovery through continued lending after an earthquake event.

An intensity index of geographically-mapped earthquake-induced ground motion is used as a trigger for EQII with the level of pay-out calibrated to the insured entity’s expectation of loan non-performance across its portfolio. Payment rates increase with the event intensity, and are weighted to reflect the geographic spread of the portfolio as well as population density. Using EQII to protect financial institutions and increasing their resilience to earthquake risk may have positive effects, including lower interest rates on loans and increased access to credit in the aftermath of a disaster event. Natural disasters Hedge accounting

Natural disasters Hedge accounting

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