Regulatory Capital Planning and Deferred Tax Assets in a Post-Financial Crisis Environment

Abstract

Insurance regulators substantially relaxed rules on deferred tax asset (DTA) inclusion in regulatory capital calculations during and following the financial crisis. We find evidence firms use additional discretion in regulation to increase the level of DTAs admitted into regulatory capital. As DTAs are less liquid relative to other assets, our study raises the concern that insurance firms may appear more financially stable than the reality of their underlying economic condition. Consistent with this concern, we find firms with relatively low levels of regulatory capital engage in greater risk-taking than their peers, potentially as a means of qualifying additional DTAs for inclusion in regulatory capital. Higher levels of DTAs are also associated with a higher likelihood of insolvency, and investors appear to recognize the increased risk associated with increased inclusion of DTAs in regulatory capital. Our study has important implications for regulators considering changes to capital standards for other financial institutions.