Fourth Quantitative Impact Study (QIS4) of Solvency II

Guidance on the calculation of deferred taxes and the risk absorbing effects of deferred taxes in the solvency balance sheet of QIS4

Introduction 1. The proposal of the European Commission for a Framework Directive relating to Solvency II states that so-called deferred taxes should be included in the valuation of assets and liabilities. The standard formula for the calculation of the SCR should take the risk absorbing effects of these balance sheet items into account.1 The way the proposal was implemented in the QIS4 Technical Specifications may not sufficiently clear and precise for the German market. With regard to the valuation of deferred taxes, section TS.I.A.6 explains: As Solvency II is not introducing any amendments in insurance accounting nor the valuation basis used for tax purposes, the difference stemming from the prudential revaluation of technical provisions for Solvency II purposes does not correspond to a one-off profit in the accounts and therefore does not create a one-off tax liability. Thus participants should not include in their solvency balance sheet a deferred tax liability specifically related to the change in value of technical provisions arising from the move from Solvency I to Solvency II. However, it is rather difficult to interpret this explanation, given the subsequent passage which provides that all anticipated tax liabilities should be considered in the solvency balance sheet. Deferred taxes are described not only in section TS.I.A.6 but also, in relation to IFRS, in the tables on pages 58 and 62 of the Technical Specifications. Sections TS.V.B.3, TS.VI.I and TS.VIII.C refer to the deduction to be made from the Basic SCR owing to the risk absorbing effects of deferred taxes. When discussing this issue at European level, the term "deferred should be used with caution since there are significant differences between the concepts of the underlying national law (section 274 of the German Commercial Code (Handelsgesetzbuch HGB)), the requirements of the IFRS

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Cf. Art. 107 of the EU Commissions modified proposal.

(IAS 12) and the possible interpretation of the QIS4 framework. Therefore, the term deferred taxes under Solvency II will be used in the following when referring to deferred within the meaning of the term used in Solvency II. 4. The definition of the item deferred taxes under Solvency II should differ from the definitions of the items provisions for taxation and other liabilities from taxes, which the German HGB accounting rules include in the balance sheet. Since the payment of these taxes is based on an existing liability, they should not be shown as deferred tax assets but should be regarded as normal liabilities also under Solvency II. On the other hand, the deferred taxes under HGB should not be shown in the solvency balance sheet under Solvency II. This item will be completely replaced by the deferred taxes under Solvency II. The following guidelines are meant to help companies with the interpretation of the Technical Specifications relating to deferred taxes under Solvency II and thus ensure that the results obtained for the German market are consistent and reliable. They are non-binding and were developed solely for the above mentioned purposes of QIS4. If QIS4 participants opt for a different interpretation, they should make note of it in the questionnaire under QS2 or QS5 (see TS.II.B.20). In particular, the proxy described on pages 58 and 62 of the Technical Specifications represents an alternative to the approach referred to in this Guideline, and a comment should be made when it is applied. If for practical reasons you did not perform a calculation of the deferred taxes under Solvency II, please leave fields F37 and F52 on sheet I. General empty (instead of filling in zeros).

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Valuation of deferred taxes in the solvency balance sheet 7. The following interpretation of the Technical Specifications seems possible: The deferred taxes under Solvency II correspond to the present value of anticipated tax liabilities which are not yet based on existing liabilities and should therefore be allocated to the present portfolio. It is assumed that the company will continue its business operations. The valuation is based on an analysis of the valuation reserves specified in the tax balance sheet of the insurer. For this purpose, the valuation of the tax balance sheet is compared with the solvency balance sheet prepared under Solvency II. The notional taxable valuation reserves can be reported as follows: ResSteuer = liabilities on tax balance sheet liabilities on solvency balance sheet + assets on solvency balance sheet assets on tax balance sheet

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The market values included in the solvency balance sheet are based on the definitions set out in QIS4, with the exception of the deferred taxes under Solvency II. The liabilities (liabilities within the meaning of the Framework Directive) comprise all liability items except capital.

10. The deferred taxes under Solvency II can now be reported as follows: Deferred taxes = income tax rate ResSteuer 11. The income tax rate consisting of corporation tax, solidarity surcharge and trade tax is subject to, among other things, local corporation tax rates and must therefore be individually determined by each company. The tax rates for 2008 must be applied. 12. Whether or not the amount calculated as described above reflects the anticipated tax liabilities accurately must be determined on a case by case basis. Reasons for not using the above formula could be, in particular: Valuation reserves and unrealised losses cannot be offset against each other because there are different considerations of the corresponding income and expenses. Losses cannot be carried forward indefinitely and do not reduce tax liabilities. 13. If the resulting amount of deferred taxes under Solvency II is positive, it should be reported as deferred tax liability. If the result is negative, the amount should be reported as deferred tax asset. Quantification of the risk mitigating effect of deferred taxes 14. The risk mitigating effect of the balance sheet item deferred taxes under Solvency II is based on the fact that in the event of losses deferred tax liabilities and deferred tax assets can be reduced or increased respectively. When calculating the SCR the adjustment for the deferred taxes AdjDT should be determined by using the shock scenario SCR shock. AdjDT = reduction in deferred taxes under Solvency II | SCR shock 15. In the above formula, deferred taxes refers to the difference between deferred tax liabilities and deferred tax assets. The reduction in deferred taxes is therefore the following amount: Deferred tax liabilities before shock test - deferred tax liabilities after shock test - deferred tax assets before shock test + deferred tax assets after shock test 16. The SCR shock is an immediate loss in the amount BSCR AdjFDB + SCROp. The amount corresponds to the SCR before considering the risk mitigating effects of deferred taxes under Solvency II. (BSCR is the Basic SCR, SCROp refers to the capital requirement for operational risk and AdjFDB stands for the risk mitigating effect of future profit sharing.) It should be noted that tax liabilities are positive. 17. In order to calculate the reduction volume, a new determination of the deferred taxes under Solvency II, based on the values of the hypothetical

loss, must be made. Under the assumption that the losses can be completely deducted from tax, the maximum reduction of the deferred taxes is AdjDT = income tax rate( BSCR AdjFDB + SCROp). 18. In certain circumstances, the above defined maximum amount is likely to overestimate the mitigating effect. If this is the case, adjustments must be made. The reasons for such adjustments are, in particular: Losses (of companies with good solvency) cannot be carried forward long enough to be offset against future income and thus do not reduce tax liabilities. Part of the loss (of companies with good solvency) is probably not tax effective. The recoverability of deferred tax assets assumed on the basis of shock tests should be critically examined. For instance, deferred tax assets may not be recovered if losses cannot be brought forward indefinitely, or if the possibility of offsetting losses against future income is unrealistic because the losses of the SCR shock would cause the insurer to withdraw from the market.2 Any assumed deferred tax assets should be specified in the Qualitative Questionnaire under question QS0. Interpretation of results 19. As stated in the introduction, the approach to valuing deferred taxes in accordance with Solvency II presented here is not the only one possible within the framework of the Technical Specifications. There are, for instance, indications that certain valuation reserves must not necessarily be included if it is to be expected that they will not be released within the liability period.3 However, there are several reasons which speak in favour of an approach that considers all the valuation reserves: In a testing situation such as QIS4 it is always better to underestimate the own funds than to overestimate them. The calculation of valuation reserves which are not expected to be released is not reliable and can be complex, depending on the individual case. If particular valuation reserves are not taken into account, the quantification of the effects of the SCR shock often becomes problematic.4 The approach is consistent with the provisions of IAS 12. 20. Interpretation of the results should take into account the unreliability factor for decisions about the valuation approach and the valuation of the SCR shock.
In extreme cases deferred taxes could even have a risk-increasing effect: If deferred tax assets were recognised before shock test, which appear unrecoverable after shock test because no new business is written, then AdjDT is negative. The principle of ongoing concern could be involved here. Cf. Question 3 on Valuation of Assets and Liabilities in the QIS4 paper Questions and Answers. For instance, an assessment was made of whether or not the equalisation provision should be excluded from valuation reserves. When calculating the shock result the question arose which part of the total loss BSCR AdjFDB + SCROp leads to a reduction in the equalisation provision (and is therefore not buffered by deferred taxes) and which part leads to a reduction of the considered valuation reserves (and is therefore buffered in part). This is not a trivial question.
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21. Compared with treating deferred taxes as own funds, the approach prescribed by QIS4 will result in a decrease in own funds and, simultaneously, a reduction in solvency requirements. Irrespective of the actual valuation of the deferred taxes, this could result in considerable distortion of the solvency margin. It would therefore make sense to not only include the ratio calculated on the basis of the above described rules, but to additionally take into account a coverage ratio prior to consideration of the effects of deferred taxes, i.e. a ratio representing the own funds prior to deduction of deferred taxes and showing the SCR without the corresponding risk absorbing effects.5

5 Standard solvency ratio: Own funds/SCR Alternative solvency ratio: (Own funds + deferred taxes + FDB)/(BSCR + SCROp)