Regulatory Capital and Deferred Tax Assets

Abstract

Insurance regulators substantially relaxed rules on deferred tax asset (DTA) inclusion in regulatory capital calculations during and following the financial crisis. Despite prior studies documenting mixed findings on whether financial institutions manage earnings through tax accounts, we find evidence life insurers use additional discretion in regulation to increase the level of DTAs admitted into regulatory capital, especially when they have greater incentives to do so. As DTAs are less liquid relative to other assets, our study raises concerns that life insurers may appear more financially stable than the reality of their underlying economic condition. We find that higher levels of DTAs are associated with greater risk-taking and higher risk of insolvency. We additionally find evidence that insurers treat illiquid DTA capital as a substitute for more liquid forms of capital. Our study has important implications for regulators considering changes to capital standards for other financial institutions.

Keywords: Deferred Tax Assets, Regulatory Capital, Insurance, Regulation

JEL Classification: G18, G22, H25, M41, M48