Insurers have to take account of deferred taxes when they prepare their Solvency II balance sheet. As a rule, deferred taxes have a material impact on the amount of own funds and the solvency capital requirement, and therefore also on the solvency ratio. Deferred taxes arise because of temporary differences between the Solvency II balance sheet and the tax base. This is because measurement under Solvency II differs from measurement under tax law.

Companies can only recognise deferred tax assets if it is probable that there will be a tax benefit in the future. And it is precisely that – the probable existence of taxable profits in the future – that insurers must provide evidence of to BaFin, and they must do this in a way that is transparent and comprehensible. Not all recognition tests meet these standards, which is a good reason for BaFin to take a closer look at this issue.

How differences in measurement result in deferred taxes

Solvency II is a supervisory regime that – in contrast to the local GAAP stipulated in the German Commercial Code – places greater emphasis on the concept of fair value. As a result, the measurement of assets and liabilities in the Solvency II balance sheet results in measurement differences compared with the German GAAP carrying amounts – which can be considerable in some cases. Due to the prevailing principle in Germany that tax values are derived from financial accounting, i.e. on the basis of local GAAP, for companies taxable in Germany these differences, for the most part, also appear when the Solvency II amounts are compared with the tax base. As a consequence, the deferred taxes recognised under Solvency II differ significantly from those recognised in the German GAAP financial statements.

The majority of these measurement differences are temporary and reverse over time. The concept of “deferred taxes” is now established in the accounting world for recognising future tax charges or benefits, and it has also been adopted in the Solvency II regulatory regime, more specifically in Article 15 in conjunction with Article 9 of Delegated Regulation (EU) 2015/35 (the “Delegated Regulation").

How deferred tax liabilities and assets impact own funds

Deferred tax liabilities reduce own funds. They result from temporary differences that will result in taxable amounts payable when the carrying amount of the asset or liability is recovered or settled. Deferred tax assets increase own funds if reversal of the temporary difference when the carrying amount of the asset is recovered or the liability is settled will reduce taxable profit. This is why it is necessary that deferred tax assets only be recognised for regulatory purposes if it is probable that a tax benefit will actually arise in the future.

How deferred taxes affect the solvency capital requirement

Deferred assets under Solvency II are not only recognised in the Solvency II balance sheet from an accounting perspective, but also play a role in the determination of the solvency capital requirement (SCR). The loss-absorbing capacity of deferred taxes governed by section 108 (1) of the VAG in conjunction with Article 207 of the Delegated Regulation is based on the notion that the emergence of an adverse extreme scenario can have consequences for deferred taxes that, under certain conditions, may reduce the solvency capital requirement. A further expert article to be published on the BaFin website will address this issue (see info box on page XY) .

Because of this overall situation – with, in some cases, considerable temporary differences between the Solvency II balance sheet and the tax base, and consequences for own funds and the solvency capital requirement – deferred taxes have the potential to significantly affect the solvency ratio of insurers supervised in Germany under Solvency II. And this effect could be seen across all segments.

There needs to be an improvement in the recognition tests

The complex issue of deferred taxes has been a key focus for BaFin for several years, and the authority has already issued two interpretative decisions on this topic. Now it is turning its attention to another key aspect of this issue: the recognition test. This is required in order for deferred tax assets to be recognised in the Solvency II balance sheet and, in the post-stress situation, for the determination of the solvency capital requirement. Insurers must demonstrate in the recognition test that it is probable that there will be future taxable profit against which the deferred tax asset can be utilised.

The quality and comprehensibility of the recognition test is therefore crucial for recognising deferred tax assets and hence for a company’s solvency ratio. The test depends in large part on the company reliably generating profits in future. But if a company finds itself in a distressed situation where its own funds are supposed to be available, profits may permanently erode away, compromising the recognition of deferred tax assets. This effect may lead to a further loss of own funds. It is not without reason that an excess of deferred tax assets over deferred tax liabilities can only be recognised as Tier 3 own funds under Solvency II.

BaFin’s analysis of the current situation

In autumn 2020, BaFin looked into how German insurers handle deferred taxes and the recognition test. It had already conducted a comparable analysis in 2017. Some of the results of the 2020 survey were sobering: many descriptions were of little informative value. BaFin will therefore further specify and systematise its expectations about the recognition test, and will also discuss these expectations directly with the insurers.

Recognition test for deferred tax assets: a multi-step process

The procedure for recognising deferred tax assets is generally a multi-step process, with the following two steps being particularly relevant from a Solvency II perspective:

• In the first step, insurers may use the deferred tax liabilities reported in the Solvency II balance sheet as part of the recognition test for deferred tax assets. Any timing restrictions and limits on offsetting must be taken into account.
• In a second step, they can only recognise deferred tax assets over and above this if they can demonstrate that they will have sufficient future taxable profit. According to Article 15(3) of the Delegated Regulation, a positive value can only be ascribed if it is probable that future taxable profit will be available against which the deferred tax asset can be utilised.

To demonstrate this in the recognition test, insurance companies must perform a projection, meaning that they must project the future performance of the company on the basis of numerous assumptions. The recognition test must be appropriate and comprehensible. All assumptions made in the projections should be transparent and their derivation sound to ensure and demonstrate that the reported deferred tax assets reflect the company’s economic reality. Generalised references to industry trends are not sufficient for BaFin.

Insurers must appropriately reflect their actual assets and liabilities, as well as any specific structural characteristics. In addition, they must take appropriate account of particular information from their business planning – such as the planned transfer of insurance portfolios to another insurance company. They must also ensure that profits are not double-counted in the projection: taxable profit resulting from the reversal of temporary differences cannot be included again in the projection of future taxable profit if it was already used to justify the recognition of deferred tax assets in the recognition test. Many of the recognition tests submitted to date are still inadequate in this respect.

Determining future taxable profit

The starting point for determining future taxable profit is the forecast of taxable income used by the company’s management. For companies taxable in Germany, this will generally be based on their separate tax accounts. The projection needed for the recognition test is based on the forecast of taxable income. The projection of the tax base involves statements of assets and liabilities that are derived from the German GAAP balance sheet, reflecting income tax requirements, and are therefore significantly influenced by German GAAP rules.

Under Solvency II, the effects from the reversal of deferred taxes resulting from temporary differences reversing in the future are a further significant element. The final result of this projection is referred to in the following as “projected taxable profit under Solvency II”. When future taxable profit is mentioned in the context of recognition tests, this is what is being referred to.

For the recognition test, various metrics therefore need to be considered together: it is not sufficient to only consider the Solvency II perspective, such as changes in own funds under Solvency II, or to only consider the tax base perspective. Both have to be adequately taken into account. In the reversal of temporary differences from technical provisions, it is not appropriate to focus solely on isolated components of technical provisions under Solvency II such as the risk margin. The deferred taxes from the technical provisions result from the temporary differences between the total amount of technical provisions in the Solvency II balance sheet and the corresponding carrying amounts in the tax base. The effects from the reversal must be incorporated comprehensively in the projection.

Uncertainties in the projection

Uncertainties arise in the projection because the assumptions may deviate from the reality and predicted profits may not materialise to the extent projected. And there is one further uncertainty: the timing of the effects from the reversal of temporary differences. Although these are also a key factor in financial reporting, the forecast horizons under Solvency II are normally longer, which means that the importance of these effects increases when determining whether deferred taxes can be recognised. The allocation of reversal amounts to the individual projection years and the resulting profits is typically based on estimates. There is scope for discretion in these estimates, which must be used appropriately. The length of the projection horizon also affects the uncertainty of the results: the longer the horizon, the bigger the uncertainty will be. In most cases, profits can only be estimated reliably for a limited future period.

Uncertainty must be analysed

The uncertainty of projected profits, which increases as the projections run further into the future, must be estimated and taken into account adequately to assess the probability of these future profits for the recognition of deferred tax assets. The uncertainty of projected profits must be fully analysed before these profits can be used in the recognition test. The uncertainty of these projected profits must then be taken into consideration, for example by using defined haircuts.

What is probable

The question of precisely what probability can be associated with the term “probable” is the subject of controversial debate in the literature. Adopting the accounting perspective alone does not appear to be appropriate for Solvency II purposes. In the case of deferred taxes under Solvency II, it should be noted that the primary objective of regulation and supervision is to deliver adequate protection for policyholders and beneficiaries, and that this objective is not necessarily identical to the objective of the primary addressees of IFRS financial statements. From a supervisory perspective, it is appropriate when measuring deferred tax assets to apply a different and more conservative standard of probability in quantifying uncertainty than is needed for measuring a deferred tax asset in IFRS financial statements.

Validating the projection

Once a projection has been prepared, the insurer should validate its quality; this should include a comparison with previous other projections, specifically those prepared as part of the business planning, with actual profits. The insurer must also analyse how relevant the assumptions made in the recognition test are for the level of profits. This can be done, for example, by using sensitivity analyses, i.e. by considering how changes in the key assumptions affect the level of future profits.

Among other things, the business planning or the selected planning horizon is based on an estimate of the number of years for which reliable projections can be prepared. If the time horizon of the projection prepared for the recognition test exceeds that of the detailed business planning, the uncertainty of the projection used for the recognition test can no longer be demonstrated solely by using a historical comparison of expectations from previous business planning and actual observations. Insurers can therefore only include profits beyond the projection horizon of the business planning in the recognition test if they apply correspondingly higher haircuts.