Additional guidance on the Loss Absorbing Capacity of Deferred Taxes
This Q&A provides additional guidance on the elements DNB considers when assessing the adjustment for the loss-absorbing capacity of deferred taxes (LAC DT). LAC DT is also part of the review Solvency II capital requirements in 2018. The outcome of that review as well as other new insights may result in amendments to this Q&A. DNB expects insurers to take account of these elements in the substantiation of their LAC DT as soon as possible, but at the latest in their figures over 2017Q2.
The key concepts and their definitions are listed below:
- Solvency II opening balance sheet: The pre-shock balance sheet prepared under Solvency II principles.
- bSCR*: the shock applied to the Solvency II opening balance sheet to calculate LAC DT, which equals the basic solvency capital requirement (bSCR) plus the capital requirement for operational risk plus the adjustment for the loss-absorbing capacity of technical provisions (Article 207(1) of Commission Delegated Regulation (EU) 2015/35).
- Tax deferrals: Accounting principles for the Solvency II balance sheet and the balance sheet for tax purposes differ, which results in temporary valuation differences that run off over time, as well as deferred tax assets (DTAs) and liabilities (DTLs). DTAs can also exist due to historic losses available for set-off against future taxable profits.
- Net DTA: A net DTA equals the difference between a DTA and a DTL in the balance sheet. The insurer substantiates a net DTA in the balance sheet by recognising taxed profits from the preceding year or future taxable profits.
- LAC DT: LAC DT equals the change in the net tax position due to the bSCR* shock loss, representing the difference between the net DTA in the Solvency II opening balance sheet and the net DTA in the post-shock balance sheet.
- Post-shock LAC DT: The insurer can only substantiate the post-shock net DTA with future profits if it meets the solvency capital requirement within the currently applicable recovery period. This is why the insurer determines its financial position in a post-shock situation again. To determine the financial position following the bSCR* shock, the insurer also needs to determine the post-shock SCR, part of which is a LAC DT again.
The insurer documents all assumptions, methods and calculations underlying the substantiation of the LAC DT in such a way that it provides insight into each step of the calculations and the substantiation.
Substantiation of existing tax deferrals
It is important that the insurer also includes the substantiation of the pre-shock net DTA in its substantiation of LAC DT. The insurer specifies the run-off pattern of the existing tax deferrals, including a clear description of the relevant assumptions. The periods over which tax deferrals run off are separate from the horizon over which the insurer chooses to project profits in the substantiation of the LAC DT.
Post-shock financial position
In determining the post-shock financial position, the insurer takes the following into consideration:
- Post-shock LAC DT: The post-shock LAC DT is nil unless the insurer can substantiate its amount. If the insurer substantiates the LAC DT in the pre-shock SCR with future profits, the LAC DT in the post-shock SCR will be lower than the pre-shock LAC DT as the post-shock financial position will be even lower, making it more difficult to achieve the future profits needed to substantiate the LAC DT in that case.
- Risk margin: The insurer does not recalculate the risk margin after the application of the shock.
- Applying LTG measures: Following the shock, the insurer does not recalculate any long-term guarantee (LTG) measures, which the insurer may have applied, to determine the post-shock technical provisions and own funds.
- Solvency II UFR extrapolation: The insurer does not re-extrapolate the post-shock interest rate term structure to determine the size of own funds.
Recovery from the shock
If the insurer substantiates the net DTA with future profits and ceases to meet its capital requirement after the loss due to application of the the bSCR* shock, the insurer takes measures to ensure renewed compliance. In doing so, the insurer does not anticipate on any extensions of recovery periods. Various measures may be considered to ensure renewed compliance with the capital requirement following the shock, including a reduction of risk positions to lower the capital requirements and recapitalisation to increase own funds.
If the insurer includes raising additional borrowed capital or own funds in its substantiation of LAC DT as a measure to establish renewed compliance with its capital requirement after the shock loss, the insurer factors in that the likelihood of recapitalisation declines as the solvency position decreases.
The undertaking completes various steps to raise additional capital. Factors that are decisive for the ultimate success of an issuance in terms of volume issued include the existence and size of a group of potential investors and, in the case of borrowed capital, the issuing institution's rating. The insurer takes account of these aspects when substantiating recapitalisation for LAC DT.
In the case of recapitalisation of one or multiple entities in a group as part of the substantiation of LAC DT the insurer demonstrates that:
- Following the assumed recapitalisation all entities in the group meet their solvency capital requirements within the currently applicable recovery period.
- To determine the capital needed by the specific entity whose LAC DT the insurer is substantiating, the insurer applies the bSCR* shock of that specific entity. To determine whether sufficient capital is available within the group to recapitalise that specific entity, the insurer considers the capital positions of the other entities in the group, working on the assumption that the other entities are simultaneously subject to their own relevant shocks. The relevant shocks for the other entities in the group is such that the sum of the relevant shocks for the other group entities plus the bSCR* shock of the specific entity whose LAC DT the insurer is substantiating equals the bSCR* of the group. The insurer allocates any diversification to the entities in the group, but not to the specific entity whose LAC DT the insurer is substantiating. For that specific entity, the shock loss equals its bSCR*. See Annex A for a detailed illustrative example.
- The capital transfer can be realised within the currently applicable recovery periods.
If the insurer uses existing cash reserves or committed credit lines (CCLs), the insurer sufficiently demonstrates that they are in fact available, in particular if CCLs contain material adverse change (MAC) clauses.
Substantiation of future profits
In substantiating future profits, the insurer takes as the starting point the post-shock balance sheet including the effect of any risk reductions and recapitalisation aimed at renewed compliance - within the currently applicable recovery period - with the capital requirements following the shock. In projecting returns on investments, the insurer takes as the starting point the annual risk-free rate of return from forward rates in the term structure for risk-free market interest rates. The insurer specifies any surplus returns over this risk-free return according to individual asset class. The starting point for these projected post-shock surplus returns is that they will be equal to the returns assumed in the pre-shock situation. With respect to losses caused by the spread shock the insurer takes as the starting point that they will also materialise for tax purposes.
In the projections of future profits in the existing portfolio, the insurer also considers the impact of the Solvency II UFR extrapolation method on annual profits and losses. This impact of the extrapolation method is being calculated in line with the impact that is reported in the national annual reporting templates on the impact of an alternative extrapolation method. The insurer takes account of the fact that this impact is the largest in the initial years and then diminishes, also following the shock. Similarly, the insurer considers the impact on future profits of any LTG measures applied.
If the insurer can substantiate that it will also write new business following the shock, including renewals, the insurer assumes as your starting point lower new business than actually realised in the years before the shock. This is because the impact of the shock on the post-shock financial position will affect the writing of profitable new business. The insurer includes in its documentation a comparison of the assumed profitability of new business and actual profitability of past new business, as well as the trend observed.
If the insurer uses future profits to substantiate LAC DT, it takes account of dividend distributions in line with its capital and dividend policy.
Uncertainty of future profits
In substantiating LAC DT, the insurer considers the fact that projected income and expenses are subject to uncertainty. Importantly, the insurer takes the asymmetric nature of LAC DT into account. For example, higher surplus returns do not necessarily result in a much higher LAC DT, whereas lower surplus returns may result in a sharply lower LAC DT. The insurer factors this uncertainty into the amount of any post-shock net DTA, as well as into the pre-shock net DTA. One of the options for doing so is averaging various outcomes resulting from upward or downward adjustments of assumptions in the substantiation of LAC DT, for example by (1) doubling expected surplus returns and assuming more new production once; and (2) setting expected surplus returns and new production to nil once.
Time of materialisation of bSCR* shock for tax purposes
The loss resulting from the bSCR* shock will materialise immediately in the Solvency II balance sheet, but not in the balance sheet for tax purposes. For this reason, the insurer takes into account, for each individual element of the shock loss, when and to what extent the loss will materialise for tax purposes in substantiating the net DTA with future profits. Both the pattern and the volumes over the projection horizon are relevant. Shock losses incurred on assets whose returns are tax-exempt, such as specific shareholdings exempt from Dutch corporate income tax under the participation exemption (deelnemingsvrijstelling) are unavailable for set-off against taxable profits. For this reason, they directly result in a reduction of the maximum LAC DT to be achieved.
Illustrative example of diversification in substantiation of recapitalisation in LAC DT
An insurance group comprising of two entities, entity A and entity B, is assumed.
Substantiation of entity A's LAC DT
Following its bSCR* shock of 200, entity A has own funds of 125 at an assumed post-shock capital requirement of 200. It shall try to achieve renewed compliance with the capital requirements within the applicable recovery periods through risk reduction measures or recapitalisation. One recapitalisation option is withdrawing own funds from entity B to supplement entity A's own funds. To determine entity B's actual own funds, the insurer first applies the shock that is relevant to entity B to entity B's balance sheet. That shock is such that the sum of all shocks applied to the entities equals the bSCR* for the group. The bSCR* for the group is 250 and the shock applied to entity A is 200, which means that the insurer applies a shock of 50 to entity B in order to determine its post-shock available own funds. This shock need not be broken down into risk drivers or be specified in a comprehensive post-shock entity B balance sheet, as this merely concerns establishing entity B's actual own funds available following the shock for entity A's recapitalisation. Following the shock, entity B will have 125 in own funds at an assumed post-shock capital requirement of 100. Depending on the group's policy on the minimum capitalisation of its entities, there may be room for transferring a maximum of 25 in own funds from entity B in order to recapitalise entity A. This would bring entity A's own funds to 150 at an assumed capital requirement of 200, after which the insurer could eliminate the remaining capital deficit through recapitalisation or risk reduction measures.
Substantiation of entity B's LAC DT
In the same group, following its bSCR* shock of 100, entity B has own funds of 75, which is insufficient to meet the assumed post-shock capital requirement of 100. To consider whether entity A has room to fully or partly recapitalise entity B, the insurer first applies the relevant shock to entity A's balance sheet. The relevant shock is 150 here, representing the bSCR* for the group of 250 less the bSCR* shock of 100 applied to entity B. Entity A's loss of own funds of 150 results in post-shock own funds of 175. This means that entity A fails to meet its assumed capital requirement of 200, which leaves no room for entity A to recapitalise entity B. Accordingly, to substantiate recapitalisation as part of the substantiation of entity B's LAC DT, the insurer must apply other risk reduction or recapitalisation measures to ensure that entity B restores compliance with its capital requirements following the shock.