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Adjustment for the loss-absorbing capacity of deferred taxes

By Yannis Pitaras, Principal Consultant

and Jessica Ukendi, Associate Consultant

Introduction

One of the most interesting changes, brought by the 2018 Solvency II review, is the introduction of additional guidelines for the standard formula calculation of the loss-absorbing capacity of deferred taxes.

The stated purpose of these amendments is mainly to standardise the setting of assumptions to be put in place for the projection of future profits and hence reduce the degree of subjectivity in the calculation.

This follows from the fact that practices between Member States in the recognition of the capacity of deferred taxes to absorb present losses are widely divergent.

The European Commission and EIOPA expect these amendments to have a limited impact on the overall capital requirements at EU level (0.9% of the sum of Solvency Capital Requirements before loss-absorption). Another established fact is that only a limited number of undertakings across Europe make use of the adjustment for the loss-absorbing capacity of deferred taxes.

Many stakeholders are of the opinion that this is probably not because insurers are usually not entitled to the LACDT adjustment, but more likely because they are unsure as to whether they meet all the regulatory criteria and apply the approach which would pass supervisors’ scrutiny.
 

Benefiting from the LACDT

The Loss Absorbing Capacity of Deferred Taxes adjustment is meant to reflect the fact that new deferred tax assets would have to be booked in the event the insurance undertaking incurred unexpected losses, hence resulting in the increase of Own Funds on the Solvency II balance sheet. 

 

The outline of the typical approach to be followed in order to benefit from the adjustment for the LACDT is as follows:

  1. Estimate the amount of deferred taxes to be booked on the prudential balance sheet.
    • This is not as trivial as it seems as it requires understanding how taxes impact the balance sheet and demonstrating that the so-called recoverability test is passed.
  2. Calibrate a single equivalent 1 in 200 years scenario (exceptional loss scenario) and assess its impact on the Solvency II balance sheet and on the amount of deferred taxes.
  3. Demonstrate that the post 1 in 200 years event deferred taxes pass the recoverability test.
    • This requires setting assumptions in relation to macro-economic conditions, the insurer’s business plan and possible and realistic management actions after an exceptional loss scenario. Setting these assumptions can prove to be challenging given the poor historical data on how economies, markets and insurance undertakings have recovered a 1 in 200 years event.
    • These assumptions serve as the basis for the projection of the post 1 in 200 years event business plan, P&L accounts and Solvency II balance sheets over usually the next 5 years. 

Steps for the calculation on LACDT Adjustment

2018 Solvency II amendments to the calculation of LACDT

The amendments first and foremost aim at refraining insurers from being overly optimistic in setting their assumptions when projecting future taxable profits after an exceptional loss scenario.

Indeed, the new text now explicitly states that new business sales projected for the purposes of the insurer’s business planning after an exceptional loss cannot be more favourable than those used for the business planning on a “going concern” basis.

Additionally, the rates of return on the insurer’s investments following an exceptional loss should be assumed to be equal to the implicit returns of the forward rates derived from the relevant shocked risk-free interest rate term structure obtained after that loss, unless the insurer is able to provide credible evidence of likely returns in excess of those implicit returns for the valuation and utilisation of deferred tax assets.

Both of the aforementioned new requirements are not expected to bring significant changes to the way insurers currently project their future taxable profits, but may contribute to confirming their choices when they have chosen to take a prudent approach.

The amendments also include new provisions in relation to the governance around the setting of assumptions after an exceptional loss. Notably, the involvement of the relevant key functions in selecting and assessing methods and assumptions to demonstrate the amount and recoverability of the loss-absorbing capacity of deferred taxes is now a requirement, as well as a description of how the outcome of that assessment is reported to the Board.

The new text also states that the assessment of the underlying assumptions applied for the projection of future taxable profit and an explanation of any concerns about those assumptions, should be carried out in each case by either the actuarial function or the risk management function.

These new Pillar II requirements are now expected to be incorporated in the risk management policy.

Although these new governance requirements are not impacting the amount of LACDT directly, it is thought by many stakeholders that they are quite restrictive as insurers should be able to define themselves the governance that best suits their organisation.

The amendments also aim at increasing transparency in relation to how the adjustment for LACDT is calculated and its relative importance in the insurer’s Own Funds. As part of the SFCR, insurers will now have to disclose the following in relation to the LACDT:

  • the amount with which the SCR has been adjusted for the loss-absorbing capacity of deferred taxes, and a description of the deferred tax liabilities, carry-back and probable future taxable profit used to demonstrate likely utilisation
  • where the amount of deferred tax assets is material, a description of the underlying assumptions used for the projection of probable future taxable profit after an exceptional loss.

 

Conclusion

The 2018 amendments to LACDT go in the right direction in terms of ensuring consistency across Member States, but probably fail to provide more certainty to insurers as to whether their calculation of the LACDT adjustment will ultimately pass supervisory scrutiny. Indeed, the part of the legislation relating to the calculation of the LACDT will, to a large extent, still be subject to interpretation by supervisors and, as such, insurers should put all chances on their side by selecting the right approach, establishing the appropriate governance and making sure that their assumptions and calculations are thoroughly documented. 
It should also be noted, that these amendments are part of the wider set of changes introduced by 2018 Solvency review. We have written an article outlying all the changes introduced by this review.