Tax is a key component of the capital requirement for insurers, with the potential to reduce it by 20 percent or more. However, to date, tax has been underrepresented in Solvency II implementation at both the firm and the regulatory levels. We believe this is something that requires addressing urgently. We have seen a wide variety of practices in the approach taken by insurers to calculating tax for Pillar 1 - there is not yet a clear consensus on what will be the industry norm. KPMG’s recent survey of the UK actuarial profession indicated a clear reason for this divergence of practice - all of those surveyed did not feel the guidance from the regulator on tax was sufficient.
Those responsible for managing a company’s capital position should question how effectively tax is reducing the SCR. Too little may indicate undue conservatism in assumptions and may place the company at a disadvantage to competitors. Conversely, a result which is close to statutory tax rates will likely attract regulatory scrutiny and the quality of supporting evidence would need to be tested.
The absence of final Technical Standards, and the risk that the standards relating to taxes may be more conservative than QIS 5, is contributing to uncertainty. The impact may differ for Internal Model and Standard Formula companies. For example, it is not clear how a regulator will view an Internal Model whose tax treatment diverges significantly from the final standards. Conservatism in the standards may not be of uniform concern to all in Europe. Those in jurisdictions where current tax is based on a prudent local GAAP, and therefore should have substantial deferred tax liabilities in the economic balance sheet, should be less affected than those where current tax is based on accounts which closely mirror Solvency II liabilities.
For some companies, there are questions of interpretation and judgement unlikely to be settled by external standards and guidance. For example, the tax relief reflected in the SCR is sensitive to the assumptions made about future profits. These future profits might include a contribution from future new business, release of the risk margin and the effect of management actions such as tax planning or recapitalisations. The validity of some of these items could be subject to challenge and the approaches companies are developing in this area differ. Some of these items have will have to be consistent with companies’ broader modelling, for example assuming new business would not be appropriate if the company would likely be placed into run off after a shock event. Given the potential for different interpretations, and the possibility of excessively prudent or bullish stances, it is important that material assumptions are considered in the round and companies are comfortable with their stance on prudence.
Understanding and managing the impact that tax has on the capital position, deserves management attention. The level of variance in the implementation methodology should ring alarm bells right up to board level. What is acceptable practice needs to be established as a priority, as until this is done the validity of capital requirement projections will remain in doubt.