LAM15300 - Excess expenses, losses and deficits: Loss reform: shock losses: Introduction CTA2010/SS269ZJ-269ZO

The loss reform rules contain special provisions to allow the loss restriction to be switched off where an insurer suffers a catastrophic shock event. These allow the losses arising in this scenario to be set off in full against future profits to allow the insurers to recover its solvency position as quickly as possible. Absent the insurance specific legislation in CTA2010/ SS269ZJ-269ZO for shock losses, the loss reform would also in some circumstances have had an impact on insurers‘ Solvency Capital requirement (SCR) calculations.

The SCR is a calculation of the amount of capital an insurer is required to hold under Solvency II based on an assessment of the risks to the insurer’s regulatory balance sheet. In simplistic terms, as part of the SCR calculation, the regulatory balance sheet is ‘stressed’ by the application of hypothetical ‘1-in-200-year’ events over a 12-month period: for example, one event might be a catastrophic fall in the bond market. In calculating the SCR insurers may be able to take account of the value of tax losses arising from a 1-in-200 stress event– i.e. the ability of the loss to be carried forward and set against future profits.

The regulatory balance sheet for a life insurance company will often include deferred tax liabilities. These could arise, for example, from the value of future profits held as an asset on the regulatory balance sheet or from other sources such as unrealised gains. . In those circumstances the ‘1 in 200’ loss in the SCR calculation may have a value to the extent that any loss arising within the calculation may reduce the deferred tax liability on those future profits. As the loss reform rules place a restriction on the amount of profits that can be covered by carried forward losses this reduces the potential value of the tax loss within the SCR calculation. The shock loss rules remove this potential negative capital impact by lifting the 50% restriction in these specified circumstances.

The shock loss legislation aims to mitigate this unintended consequence by lifting the loss restriction for insurers (life and non-life) in specified circumstances (see LAM15310). This limits the impact on the SCR by switching off the application of the loss restriction where a ‘solvency loss’ arises in excess of a ‘shock loss’ threshold, i.e. there is a ‘shock loss’.

The long-term nature of life companies’ liabilities and the prevalence of deferred tax liabilities being provided on future profits and unrealised gains, means that the shock loss provisions are more likely to impact life insurance companies than non-life companies.

An insurance company is required to make a claim for the loss of an accounting period to be treated as a shock loss (see LAM15350). An insurance company is defined as an insurance undertaking, a reinsurance undertaking or a third-country insurance undertaking. These terms are all as defined in Article 13 the Solvency II Directive (CTA10/S269ZP).

The shock loss can be set off in full against the same profits, i.e. trading losses must be set against trading profits, in later accounting periods until it has been used up. The loss must be used in priority against the same profits before the offset of any other losses or group relief. Shock losses do not benefit from the loss relaxation and so carried forward shock losses cannot be surrendered as group relief or be set against total profits.

Given that the shock loss rules only apply when circumstances give rise to a very significant stress, it is expected that claims are likely to be made only in exceptional circumstances.