The loss-absorbing capacity of deferred taxes (LACDT) can have a major impact on an insurer’s Solvency Capital Requirement (SCR) and SCR cover on the South African regulatory basis. It can reduce the SCR by nearly a third—and, as diversification doesn’t apply to LACDT, a change to LACDT will often be more material than changes in SCR sub-modules or even full modules like underwriting risk or market risk.

LACDT can look deceptively simple. Attachment 5 of the Financial Soundness Standards for Insurers (FSI 4), which relates to LACDT, is less than a page out of the 333-page total solvency standards that outline solvency calculations. However, there are important factors to consider when you look more closely. This paper covers a single LACDT topic—the impact of ring-fenced capital losses and how they can decrease LACDT.

This paper is for information purposes only and should not be considered as tax advice. You should always seek professional tax advice on your specific tax situation.

Background to LACDT

LACDT represents the decrease in future tax cash outflows that will result from a 1-in-200-year stress; it can offset the reduction in Own Funds of the stress itself and therefore reduce the calculated SCR. This can either be the result of a decreased deferred tax liability (DTL) or an increase in deferred tax asset (DTA), provided it can be demonstrated that the DTA can be recovered post-stress.

The LACDT is a simple concept that is entirely consistent with the SCR being defined as the change in Own Funds from a 1-in-200-year stress. Because DTLs and DTAs are part of Own Funds, a change in either or both should impact the SCR.

The Financial Soundness Standard for Insurers (FSIs) introduce two specific requirements:

• Any DTA created must be recoverable within three years.
• The LACDT cannot be positive (i.e., it cannot increase the SCR).

Capital vs. revenue classification and ring-fencing of capital losses

Any discussion of tax and assessed losses needs to address the capital versus revenue nature of the asset or transaction, as this affects applicable tax rates and the nature of future income that can be used to offset the losses. (The South African Revenue Service uses the term “revenue” to denote trading income, as distinct from capital gains.)

In many jurisdictions with capital gains taxes, including South Africa, capital losses must be ring-fenced and recovered through future capital gains only. This is crucial because for many insurers future income is mostly revenue in nature (underwriting profits) rather than capital.

The definitions of capital versus revenue can be subject to interpretation and require professional tax advice for specific situations. The taxpayer's intention when acquiring and holding an asset is important in determining its nature. The regularity and nature of transactions can influence whether proceeds are considered capital or revenue.

In general:¹

• Capital assets are:
• Intended to be held for a considerable period to generate income or capital growth
• Not part of a profit-making scheme in the ordinary course of business
• Typically held for long-term investment purposes
• Revenue assets (or trading assets) are:
• Part of a profit-making scheme
• Acquired with the intention of resale at a profit
• Used in the ordinary course of trade

Assets must be classified based on the situation-specific facts, crucially including the intent of the entity at the time of purchase.

Bond classification

For insurers, bonds are typically classified as capital assets.

• Yield treatment: Despite their capital classification, bond yields (including coupons and pull-to-par) are treated as income for tax purposes. This is the income the holder intends to earn as they hold the asset under the characteristics of capital assets described before.
• Loss treatment: However, losses from defaults or market movements on bonds are considered capital losses. (Gains from interest rate decreases would then be classified as unrealised capital gains.) Sale of the instrument would realise these losses or gains. Maturity of the instrument would reverse the unrealised gain or loss.
• DTA recoverability: These capital losses create DTAs, but they can only be recognised if they can be recovered against future capital gains. The three-year maximum period to consider recoverability prescribed by the FSIs is a further restriction.

This classification might create a challenge for insurers without assets that are expected to generate capital gains.

In the 1-in-200-year stress scenario, insurers may face substantial capital loss on their bond portfolios. However, the ability to recover these DTAs is limited by the expectation of future capital gains, which may be minimal for a bond-focused portfolio. Thus, a DTA in respect of these capital losses might not be recoverable, or not fully recoverable, over the three-year period.

A cash, money market and bond portfolio is a common low-volatility high-liquidity portfolio for smaller insurers, life insurers with overall negative technical provisions and non-life insurers. This portfolio may result in little recoverability of capital losses on the bond portion of the portfolio, reducing LACDT and increasing SCR.

Estimating future capital gains

To determine the recoverability of these DTAs, insurers must estimate future capital gains over a three-year horizon. This process involves the four steps outlined in the following subsections.

1. Identifying sources of future capital gains

Identify post-stress assets likely to generate capital gains, primarily equities and properties (but in some limited cases some portion of bonds).

There is a limited possibility of including capital gains on bonds to the extent that: the interest rate increases stress, default and spread risk is assumed to result in unrealised capital losses, the instruments are not sold for any reason or settled by a liquidator (which would realise the loss), the instruments are assumed to earn a yield higher than the original yield to maturity such that part of the return results in a partial reversal of the unrealised capital loss and that this can be reasonably determined and has a meaningful impact within the three-year period allowed.

If a large portion of the capital loss arises from an interest rate increase on shorter-duration bonds, then there may be a material impact here. In other scenarios (longer-duration bonds or spread and default contributing the majority of the SCR), it is likely that the benefit would not be material. Given the assumptions required around future returns and not realising losses, it would likely not be appropriate to include a material allowance for capital gains on bonds.

2. Estimating expected total returns

Estimating total returns, either using risk-free rates (consistent with the market-consistent valuation principles of the solvency basis) or by adding reasonable expected risk premiums.¹

These returns should be applied to post-stress asset values. Determining the post-stress asset values requires some judgement in allocating the diversification benefit, consistent with the single SCR scenario assumed in the calculation of the loss.

3. Estimating future capital gains consistent with total return

Subtracting expected dividend or rental yields or original yield to maturity (as appropriate for the asset class) to determine the expected annual capital gain.

4. Projecting these gains over three years

Projecting these gains over three years consistent with the requirement from the FSIs that only three years of future profits can be used to recover any DTA.

For simplicity, and to introduce slight conservatism into what is innately a subjective calculation, it may be appropriate to apply three times the annual expected capital gain rather than projecting a compound return over three years.

Assuming mean reversion of asset values in these calculations might be considered aggressive. This is because of the short timeframe allowed (three years), the severity of the stress scenario being modelled, the mixed evidence of the strength of the mean reversion and time to revert (often much longer than three years³) along with the inherent uncertainty in forecasting in the post-environment of a 1-in-200-year event to improve current SCR cover.

Implications for LACDT calculations

For bond-heavy portfolios, the ring-fencing of capital losses and limited expectations of future capital gains can potentially result in "stranded" losses that cannot be realised within three years. Consequently, the LACDT benefit from market stresses could be reduced for these insurers.

Not all assets face this capital/revenue mismatch.

Reinsurance transactions and cash holdings are typically classified as revenue assets. As a result, defaults on reinsurance or cash investments might be treated as income losses, allowing associated DTAs to be recovered against overall income.

Key takeaways

1. Seek appropriate tax advice as the issues are complex and the appropriate result will often be specific to your situation.
2. Seek appropriate actuarial input or review too. Each individual calculation may appear simple, but there is sufficient complexity in the overall calculation. There are many other complexities and considerations for LACDT not covered in this paper.
3. Carefully distinguish between revenue and capital treatments for different assets and risks.
4. When estimating future capital gains, balance conservatism with market consistency. Make sure your assumptions are reasonable, appropriate and internally consistent.
5. Consider the potential LACDT benefits from reinsurance and cash defaults separately from other market risks.
6. For portfolios with limited expected capital gains, be careful not to overestimate LACDT benefits from market risks arising from bond holdings.

¹ South African Revenue Services. Comprehensive Guide to Capital Gains Tax (Issue 9). Retrieved 17 October 2024 from https://www.sars.gov.za/wp-content/uploads/Ops/Guides/LAPD-CGT-G01-Comprehensive-Guide-to-Capital-Gains-Tax.pdf.

² The inclusion of risk premiums is not consistent with the market-consistent principles of the solvency basis. This is a grey area, but the FSIs do open the door to including risk premiums because the valuation approach for deferred taxes must be consistent with existing IFRS and tax principles rather than the specific risk-neutral approach required for technical provisions.

³ Spierdijk, L., Bikker, J. A., & van den Hoek, P. (2012). Mean reversion in international stock markets: An empirical analysis of the 20th century. Journal of International Money and Finance, 31(2), 228-249.
Kim, M. J., Nelson, C. R., & Startz, R. (1991). Mean reversion in stock prices? A reappraisal of the empirical evidence. The Review of Economic Studies, 58(3), 515-528.
Mukherji, S. (2011). Are stock returns still mean-reverting? Review of Financial Economics, 20(1), 22-27.