Prudential Regulation Authority Rulebook

4.1

Neither IAS 12 nor Solvency II stipulates a maximum time frame for forward projections. As with any projection, the further out the prediction, the less credible it is likely to become. The PRA expects firms to consider and be able to support the credibility of timescales in their assessment of whether future profits are ‘probable’. In particular, firms wishing to make projections beyond their medium-term planning horizon would be expected to pay particular attention to their ability to do so with an appropriate degree of certainty.

4.2

Any projection of profit will require assumptions about the future. This is particularly difficult when projecting new business after a 1-in-200 shock. The PRA expects that a firm would consider assumptions regarding both the immediate effect of the stress and the way the market might subsequently develop. For example, the PRA expects a firm to pay particular attention to its assumptions both on new business volumes immediately after the stress and how the stress would influence subsequent growth patterns.

4.3

In projecting future profits, a firm may wish to reflect proposed management actions, including tax planning opportunities or changes in investment strategy. Where it does so, the PRA expects that the firm will be able to support the reasonableness of assumptions regarding management actions, including consideration of:

• the extent to which such actions would be consistent with the PRA’s expectations of the firm;
• what constraints to management actions would arise from the fact that other firms in the sector would have been subject to the same shock, and would therefore be likely to consider similar changes; and
• how the firm expects to be able to comply with any policyholder commitments or regulatory requirements regarding the make-up of its investment portfolio following such management actions.

4.3A

The PRA expects firms to consider carefully the use of generalised assumptions that some asset classes will earn above the risk-free rate of return after the SCR stress either as a result of an assumed market recovery (‘mean reversion’) or the emergence of risk premiums. The inherent complexity and significant judgements required in modelling such returns post-stress pose significant challenges to firms demonstrating the credibility of that assumption.

4.4

The PRA expects that firms will have identified the assumptions that are particularly critical to the projected outcome and hold evidence to support the reasonableness of each of these.

4.5

In order to support likely utilisation of LACDT from expected tax on new business, firms would need to project new business and the resulting tax payments. As these tax payments are calculated based on the accounting data, and the stress is calculated based on a Solvency II balance sheet, two means of calculating that tax appear possible:

• firms could develop future projections based on future Solvency II positions. These projections would then need to be adjusted to reflect the tax base positions in order to calculate the tax implications of those projections; and
• firms could develop future projections based on the statutory base. While this approach would likely give rise to simpler tax calculations, it would necessitate the preparation of a post-shock statutory balance sheet as a starting point, when projecting forward beyond the 1-in-200 event.

4.6

As both approaches should result in the same tax figures being projected, either approach, or both with reconciliation of any differences, would appear to be reasonable. The PRA has no expectation that one method should be used in preference to the other.

4.7

While income from assets in excess of liabilities in the post-stress scenario may be capable of providing taxable profits, the PRA expects that firms’ projections of income from such assets will reflect likely changes arising from the reduction in value to dividend levels, default rates of debt etc. after the 1-in-200 shock.

4.8

The PRA expects firms applying the standard formula to comply with Guideline 9 of EIOPA’s ‘Guidelines on the loss-absorbing capacity of technical provisions and deferred tax’.^[6]This makes clear that firms using the standard formula to calculate their SCR should only recognise the payment or benefit receivable to the extent that the deferred tax adjustment could be recognised (under Guideline 10) by the firm if not transferred.

4.9

Firms using an internal model to calculate the SCR may wish to assume that they can obtain value for the tax effects of the stress loss by selling tax losses to other group companies which have taxable profits. To be credible, such an assumption would be expected to take account of:

• the impact of the shock on the taxable profits of each company within the group (not just those falling under Solvency II);
• the combination of tax assumptions regarding each company within the group; and
• how sensitive the availability of taxable profits is to assumptions on the impact of the shock on non-Solvency II group members.

4.10

Before committing resources to such work, firms may find it useful to consider whether the results from such complex assumptions and inter-related calculations are likely to result in output of sufficient quality to justify the recognition of a tax effect. If the calculation is so complex that credibility is doubtful, then neither reflecting more inter-relationships nor increasing the volume of assumptions and data used in the modelling is likely to address any underlying concerns.