Solvency II requires that an insurer holds sufficient capital to withstand a 1 in 200-year shock event. EIOPA permits the insurer to take account of the tax effect of such an event when calculating the Solvency Capital Requirement (SCR).
This gives rise to a number of questions:
- On what date is the “instantaneous” shock loss assumed to occur? Do I need to allocate the loss to a risk?
- What are my sources of future profits post shock?
Some of the answers depend on the tax profile of the company. For example, if the company is only paying tax at the main rate of corporation tax, then allocation to a risk is potentially unnecessary. The date of the instantaneous loss also impacts the periods to which the loss can be carried back for tax purposes. Thus there is no single answer.
In order to recognise the LADT benefit the company needs to prove, as per IAS12, that it is more likely than not that the DTA will be utilised. To do this, “easy win” sources of future profits could include:
- derecognition of deferred tax liabilities in the Solvency II base balance sheet,
- loss carry back,
- the projected investment return on post shock capital, and
- release of margins in excess of the best estimate.
As Solvency II valuation principles appear to allow companies to assume a going concern basis post shock, one challenge is often obtaining post-shock profit projections for new business.
Mutual businesses can and do recognise I-E deferred tax assets on their UK GAAP or IFRS balance sheets. LADT essentially reflects how such balances move under stress. Importantly, the size of the LADT is not necessarily related to the size of instantaneous loss.
It is also important to consider the tax assumptions in the calculation of best estimate liabilities for consistency with how unit pricing policies and asset share policies would deal with the recognition of a deferred tax asset on the instantaneous loss.
Various adjustments can be made to the tax assumptions for the ORSA including whether to depart from IAS 12 principles, e.g. with regard to the discounting of deferred tax balances, with a knock on impact on the value of deferred tax.
The compressed time line for Pillar 3 reporting will also impact the tax function; which information is most useful to management should be considered.
This should include:
- Reviewing your current and projected tax profile and how to take advantage of the “quick wins” for LADT,
- Considering whether the approach to LADT in Pillar 1 and Pillar 2 is consistent with group risk appetite,
- Documenting the tax methodology to the same standard and principles as for the rest of the Solvency II program, and
- Ensuring the tax department is included in any streamlining of the reporting process for Pillar 3.
If you would like to discuss matters raised in this article please contact Gordon Gray, Jeanette Cook or your usual tax contact.