M
Mbotha
Member
This may be a bit of a silly question but how is tax allowed for in calculating technical provisions? Is it a matter of calculating minimum profit and I-E at each projected year (for proprietary companies)?
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Not a silly question!
You don't have to hold technical provisions against future shareholder profits, so the only allowance for tax would be for the policyholder tax part (on I-E) for BLAGAB products.
Simplistically, a company which is XSI and expects to remain so could use netted down expenses and investment returns (including the discount rate). [Note that the company would need to set up deferred tax liabilities for I-E tax on unrealised gains - this is similar to the ideas covered in Chapter 8.]
A more sophisticated model would, as you say, project minimum profit as well as I-E and test whether the company is XSI or XSE at each projection point and then adjust the taxation calculations accordingly.
The considerations will be similar to those described in Chapter 24 for allowing for taxation when pricing products under different taxation situations.
You don't have to hold technical provisions against future shareholder profits, so the only allowance for tax would be for the policyholder tax part (on I-E) for BLAGAB products.
Simplistically, a company which is XSI and expects to remain so could use netted down expenses and investment returns (including the discount rate). [Note that the company would need to set up deferred tax liabilities for I-E tax on unrealised gains - this is similar to the ideas covered in Chapter 8.]
A more sophisticated model would, as you say, project minimum profit as well as I-E and test whether the company is XSI or XSE at each projection point and then adjust the taxation calculations accordingly.
The considerations will be similar to those described in Chapter 24 for allowing for taxation when pricing products under different taxation situations.
M
Mbotha
Member
You don't have to hold technical provisions against future shareholder profits,
So does this mean that TPs for Non-BLAGAB products (proprietaries) don't make any allowance for tax (given that these are taxed on shareholder profits)?
Simplistically, a company which is XSI and expects to remain so could use netted down expenses and investment returns (including the discount rate).
So besides for having to set up a deferred tax liability, the EIOPA-published risk-free rate (plus any approved matching/volatility adjustment) is the only "investment return" item that needs to be netted down?
Yes - technical provisions don't have to include allowance for tax on shareholder profit, so there would be no allowance for tax within the technical provisions for non-BLAGAB products.
Yes, the main "investment return" item would be the EIOPA risk-free rate. I mentioned this as "including" the discount rate rather than only being the discount rate, because bear in mind that the risk-free rates are also used as the expected return on unit funds when projecting them forwards in order to determine cashflows for non-unit reserves, and also for projecting forward asset shares in order to determine future with-profits benefits. Also, if the company is using a stochastic model (eg to value guarantees), then bear in mind that the simulated investment returns within the economic scenarios would also have to be netted down where appropriate - and these would not be just the risk-free rate. Does that make sense?
Yes, the main "investment return" item would be the EIOPA risk-free rate. I mentioned this as "including" the discount rate rather than only being the discount rate, because bear in mind that the risk-free rates are also used as the expected return on unit funds when projecting them forwards in order to determine cashflows for non-unit reserves, and also for projecting forward asset shares in order to determine future with-profits benefits. Also, if the company is using a stochastic model (eg to value guarantees), then bear in mind that the simulated investment returns within the economic scenarios would also have to be netted down where appropriate - and these would not be just the risk-free rate. Does that make sense?
M
Mbotha
Member
bear in mind that the risk-free rates are also used as the expected return on unit funds when projecting them forwards in order to determine cashflows for non-unit reserves, and also for projecting forward asset shares in order to determine future with-profits benefits.
When projecting the unit fund and asset shares, would we use a stochastic investment return model with expected returns set to the EIOPA risk free curve (and assumptions for volatilities and correlations set to mirror the actual assets underlying the funds)? And so here, we would just net down the risk free rate.
Also, if the company is using a stochastic model (eg to value guarantees), then bear in mind that the simulated investment returns within the economic scenarios would also have to be netted down where appropriate - and these would not be just the risk-free rate.
I'm a bit confused by the modelling of the cost of guarantees. In general, the process would be to simulate the investment returns expected (stochastic model) on the underlying assets and these would be used to calculate the maturity value so as to be able to compare it to the guaranteed maturity value and determine the cost. However, for the purposes of the BEL, it needs to be a market consistent valuation. So do we then rather simulate risk-free rates (regardless of underlying assets) with the distribution around this expected risk-free return mirroring that of our underlying assets (via volatilities and correlations)? In the latter, it would mean just netting down the risk free rates.
[Note that the company would need to set up deferred tax liabilities for I-E tax on unrealised gains - this is similar to the ideas covered in Chapter 8.]
In unit fund pricing, we look at whether the fund is contracting or expanding as this indicates when we can expect the unrealised losses or gains to materialise. The BEL, however, is based on policies in force so it's essentially a shrinking book. So does it mean that we always allow for tax in the same way as for a contracting unit fund? Or do we need to assess net cashflows in each projected year to determine whether premiums are expected to be sufficient to cover claims and expense cashflows in that year (and if they are, we wouldn't need to sell assets to fund the shortfall and hence we can treat that year as an "expanding fund")?
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Re stochastic modelling: the economic scenarios would first be simulated on a gross (pre-tax) basis. The economic scenario generators will be calibrated in order to produce a risk-free return on average across all simulations, with the variability of returns around that expectation varying according to the underlying asset and the assumed corresponding volatility (or distribution) of returns for each asset type. To the extent that these scenarios are used to project or model BLAGAB products, whatever investment return has been simulated in that particular scenario would be netted down.
In unit fund pricing, we look at whether the fund is contracting or expanding as this indicates when we can expect the unrealised losses or gains to materialise. The BEL, however, is based on policies in force so it's essentially a shrinking book. So does it mean that we always allow for tax in the same way as for a contracting unit fund? Or do we need to assess net cashflows in each projected year to determine whether premiums are expected to be sufficient to cover claims and expense cashflows in that year (and if they are, we wouldn't need to sell assets to fund the shortfall and hence we can treat that year as an "expanding fund")?
The Solvency II balance sheet should be assessed on a "going concern" basis: the company can be assumed to remain open to new business (assuming that it is not already closed) when setting assumptions such as expenses and tax (although of course liabilities do not have to be held for future new business). As for unit pricing, the deferred tax liability will be based on high level assumptions rather than detailed cashflow modelling.
M
Mbotha
Member
Thanks so much, Lindsay.
Just to confirm that in understand correctly (re allowance for tax in the BEL for BLAGAB products):
Just to confirm that in understand correctly (re allowance for tax in the BEL for BLAGAB products):
- If the company is XSI and expected to remain so: net down expenses and investment return
- If the company is XSE, expenses and investment income are also netted down, allowing for the time projected to elapse before the company moves back to an XSI position (this is the approach detailed in ch24)
- Does this mean that, for the time that it's expected to be XSE, we don't net down anything and, for the period after it is expected to become XSI, we net it all down again? So essentially we use gross expenses until the company is expected to be XSI and net expenses after that? And in terms of the discount rate, there will be two: gross of tax discount rate for the first period and net discount rate for the period thereafter (and similarly for investment returns in the case of UL and WP BEL calculations)?
Yes re XSI and expected to remain so.
For companies that are currently XSE, there are different ways that this could be done. The more complex approach would be that the company could program the cashflow projection model to determine whether it is XSI or XSE in each future year and the model could then adjust the taxation approach accordingly for each period (eg as you say gross/gross for XSE years and net/net for XSI years).
Alternatively, if the company expects to return to an XSI position at some point, it could still just net down all of the I and E in its calculations in every projection year. This is because the "excess E" arising will get carried forward and, at some point, used to offset the I arising - so it is OK just to net it all down in the calculations. [There may be a small adjustment made to allow for that fact that in practice the tax relief on the excess E won't happen in the same year that the E arises, there will be a slight deferral.]
For companies that are currently XSE, there are different ways that this could be done. The more complex approach would be that the company could program the cashflow projection model to determine whether it is XSI or XSE in each future year and the model could then adjust the taxation approach accordingly for each period (eg as you say gross/gross for XSE years and net/net for XSI years).
Alternatively, if the company expects to return to an XSI position at some point, it could still just net down all of the I and E in its calculations in every projection year. This is because the "excess E" arising will get carried forward and, at some point, used to offset the I arising - so it is OK just to net it all down in the calculations. [There may be a small adjustment made to allow for that fact that in practice the tax relief on the excess E won't happen in the same year that the E arises, there will be a slight deferral.]
M
Mbotha
Member
Oh, I see. Thank you!!