Deferred tax assets and liabilities can mitigate a loss of own funds that results from a stress scenario used by an insurer to calculate its solvency capital requirement under Solvency II. A loss-mitigating effect arises in this context when deferred tax liabilities decrease, deferred tax assets increase or both things happen simultaneously. This effect, which is also known as the “loss-absorbing capacity of deferred taxes”, is taken into account as a reduction when calculating the solvency capital requirement (SCR) – in the standard formula under section 108 of the German Insurance Supervision Act (VAG) in conjunction with Article 207 of Delegated Regulation (EU) 2015/35 supplementing the Solvency II Directive (the “Delegated Regulation”).

As with the Solvency II balance sheet, insurers must prepare a recognition test for deferred tax assets so that they can be factored into the loss-absorbing capacity of deferred taxes – with the difference that this recognition test is based on a post-stress situation.

Recognition test based on a projection

The recognition test is performed on the basis of a projection – and this projection is based on the scenario of an adverse one-in-200 years loss event affecting own funds. The requirements regarding the recognition test for the purposes of the Solvency II balance sheet, as described in the expert article on the BaFin website dated 16 September, are applied to the recognition test in the post-stress situation. As a general rule, this is the case irrespective of whether a company determines its solvency capital requirement using the standard formula or an internal model.

The need to apply a hypothetical post-stress situation represents significant additional uncertainty for deriving future taxable profits. Compared with traditional accounting, this is a completely new aspect under Solvency II and requires insurers to integrate their processes for accounting, tax calculation, internal planning and risk management. It is therefore more difficult to perform a post-stress recognition test than a recognition test in the context of the Solvency II balance sheet; the post-stress recognition test should therefore be more prudent in nature. Due to the high level of uncertainty and the correspondingly strict requirements for the recognition test, as well as the increased effort associated with this, a prudent approach which is also reasonable from BaFin’s point of view is to limit the loss-absorbing capacity of deferred taxes in the post-stress situation to the amount of any excess of deferred tax liabilities over deferred tax assets in the Solvency II balance sheet. In simple terms, the reduction in the SCR resulting from deferred taxes is then limited to the amount on which the insurance company would have to pay tax in future periods from today’s perspective, i.e. before the stress. Any amounts in excess of this in the form of future tax benefits would then not be recognised.

Starting point is the post-stress situation

A key principle in the post-stress view is not to make assumptions that are more favourable for the company than those underlying the Solvency II balance sheet. The post-stress conditions, i.e. in a one-in-200-years loss event, form the starting point; as a general rule, an economically difficult situation would be expected in such conditions. The post-stress recognition test therefore requires a more in-depth analysis of the possible loss scenarios and the sources of loss.

From BaFin’s perspective, it is not appropriate for an insurer to make a sweeping assumption that a loss scenario will hit the entire industry at the same time and in the same way, and that the industry will recover in the short term. The causes of a loss may lie in market developments, but they may also result from a company’s specific risk profile, i.e. the causes may be idiosyncratic. This distinction has consequences in particular for the assumptions to be made for the recognition test, for instance about the volume of new business or the ability to adjust the prices of insurance contracts.

Safeguarding going concern status in a post-stress situation

To be able to pass a post-stress recognition test, the first step is to safeguard the company as a going concern in the challenging economic situation. Otherwise there would be insufficient future taxable profit against which the deferred tax assets could be offset. The deferred tax assets would no longer be recognised.

To provide evidence that they will be able to continue as a going concern, companies should be able to demonstrate, in a way that is verifiable and based on quantitative data, that the prudential capital requirements will be met after the stress event. Companies with a low solvency or minimum capital requirement (MCR) coverage before the stress event should be particularly cautious and, for example – as mentioned above – limit the loss-absorbing capacity of the deferred taxes to the amount of the excess of deferred tax liabilities over deferred tax assets in the Solvency II balance sheet.

Reflecting increased uncertainty after a stress event

Insurers should take appropriate account of the increased uncertainty of future taxable profit in the post-stress analysis by only including such profits with appropriate haircuts. This applies in particular to the uncertainty affecting profits beyond the horizon of the business planning. It can be expected in this context that the haircuts in the post-stress analysis will normally be higher than for the purposes of the Solvency II balance sheet. If a company recognises deferred tax assets in the Solvency II balance sheet and the post-stress analysis, it must ensure that profits are not used in both recognition tests and that there is therefore no double-counting.

For companies that calculate their solvency capital requirement under Solvency II using the standard formula, the requirement that particularly high standards be applied to the post-stress recognition test was emphasised by the legislature through the amendments to the Delegated Regulation. Since 1 January 2020, Article 207 of the new Delegated Regulation (EU) 2019/981 has imposed additional strict requirements for the recognition test, such as an explicit limit on new business sales.

Additional requirements for companies that apply transitional measures

If an insurer applies the Solvency II transitional measures under sections 351 or 352 of the VAG, the situation that the company would be in if the transitional measures were not applied is also of interest to the supervisor. This situation is also notified to BaFin in quantitative reporting form S.22.01 and published in the Solvency and Financial Condition Report (SFCR).

Not applying the transitional measures generally results in a significant change in the amount of deferred tax liabilities. In the case of the transitional measure under section 352 of the VAG, the adjustment amount for the technical provisions only increases own funds proportionally; the remaining portion is attributable to an increase in deferred tax liabilities. A company that still reported an excess of deferred tax liabilities over deferred tax assets in the Solvency II balance sheet when the transitional measure was applied may have an excess of deferred tax assets if the transitional measure is not applied. The post-stress situation may also change significantly as a consequence.

Even if the current solvency position is calculated without applying the transitional measures, the requirements for the recognition test outlined above – in both the Solvency II balance sheet and post-stress – must be taken into account and presented accordingly in the supervisory reporting. In doing so, insurers should also exercise caution, for example by limiting the loss-absorbing capacity of deferred taxes in the post-stress situation to the amount of any excess of deferred tax liabilities over deferred tax assets in the hypothetical Solvency II balance sheet, without taking transitional measures into account. When it comes to choosing a sufficiently prudent approach, and with regard to the recognition test where transitional measures are not applied, BaFin believes that many companies are still lagging behind.

In an expert article on the BaFin website dated 15 February 2021, BaFin addressed the progress reports that insurers must submit during the transitional period. BaFin also examined the recognition of deferred tax assets in the transitional period to ensure that companies can navigate the transition to Solvency II regardless of any deferred tax assets and the recognition tests that would be required for such deferred tax assets.

Reporting not particularly informative in the past

Reporting to BaFin on the calculation of deferred taxes and the recognition test in the ORSA report (Own Risk and Solvency Assessment) and the Regular Supervisory Report (RSR) is often too brief and of little informative value. It is not enough for insurers to only report on the outcome of the recognition test. A more in-depth explanation is necessary especially in cases where deferred tax assets play a very significant role in the Solvency II balance sheet or in the context of the loss-absorbing capacity of deferred taxes for the solvency position.

BaFin specifies the general reporting requirements in its Guidelines on Solvency II Reporting for Primary and Reinsurance Undertakings and Insurance Groups (Hinweise zum Solvency-II-Berichtswesen für Erst- und Rückversicherungsunternehmen sowie Versicherungsgruppen – only available in German). According to these guidelines, insurers are expected to report on the performance of recognition tests in the RSR – specifically in the section on valuation for solvency purposes. In this report, insurers should describe the fundamentals of their approach, i.e. they should explain, for instance, which sources of profit they take into account and the way in which they reflect the uncertainty of the projection as the time horizon increases.
They should then describe in depth the steps taken to conduct the recognition test in the ORSA report. In doing so, they should avoid repeating information from the RSR. Insurers not only have to report the extent to which deferred tax assets have been taken into account in the projections of the future solvency position, they must also address what material assumptions they have made. In the post-stress situation, they should additionally describe the analysed loss and the company’s situation, including information about the post-stress solvency position, so that they can show why it would still be possible for them to generate profits in future in the post-stress situation.