Guidance on the calculation of deferred taxes and the by mwo18667

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									                       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

2.     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.

3.     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


1
    Cf. Art. 107 of the EU Commission’s modified proposal.

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     (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.

5.   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.

6.   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).

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.

8.   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

9.   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.


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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


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    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.

2
 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.
3
 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.
4
  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)

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