Solvency Assessment and Management: Steering Committee Position Paper (v 3) Loss-absorbing capacity of deferred taxes

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1 Solvency Assessment and Management: Steering Committee Position Paper (v 3) Loss-absorbing capacity of deferred taxes EXECUTIVE SUMMARY SAM introduces a valuation basis of technical provisions that is likely to be different to the basis on which firms profits are taxed. This means that deferred tax assets/liabilities are created on the balance sheet to incorporate this difference. Similarly, these items are available to absorb losses in 1-in-200 year events related to the calculation of the SCR. This discussion document sets out an approach as to how the loss-absorbing impact of these deferred tax positions should be determined. This document does not consider a range of likely future tax bases under SAM (still a source of uncertainty) but rather discusses the application of principles agnostic of a specific tax basis. An assumption that may be true to a greater or lesser extent is that a future tax basis is unlikely to correspond to the upfront recognition of profits to the same degree as the SAM basis. The impact of the various options in this discussion document will be subject to the ultimate tax basis. For life insurance companies this means that the assumption is that the structure of the four funds regime would remain in place. Given this assumption, the document focuses on the tax on profits (transfer tax) as opposed to the tax within the various funds (trustees tax as well as tax on investment return within the corporate fund). The key points which are discussed relate to the extent to which deferred tax assets are allowed to be created in the SCR calculation. On the one hand, these stress conditions incorporate best estimate assumptions following the stress and there may be little justification for any future profits. On the other, it is important to understand some of the assumptions underlying the calculation of the SCR which may result in profits that could be utilised against a deferred tax asset. The recommendation is to allow the creation of a tax asset using the same principles followed when assessing the availability of such an asset in the base case. This means that IFRS principles will apply in recognising the asset, but no prescribed calculation is employed to limit the quantity. Some specific examples of what items should typically be excluded have been included by the task group. It is recommended that the implications of the recommended allowance is assessed once the tax basis has been finalised so as to inform whether additional limitations would be proportional to the additional complexity for the purposes of the standard formula. 1. INTRODUCTION AND PURPOSE When drawing up a SAM balance sheet, amounts that would have been held previously as regulatory or discretionary margins are released into own funds (in addition to amounts released/committed due to different assumptions being used). The tax basis recognises 1 Position Paper 112 (v 3) was approved as a FINAL Position Paper by the SAM Steering Committee on 27 March 2015.

2 profit transfers on the liabilities produced by the current statutory valuation method. As such, there may be some profits (losses) that are recognised on an economic balance sheet that have not yet given rise to a tax liability (asset). A deferred tax liability (asset) is set up to take account of these profits (losses). For the remainder of this document it will be explicitly stated when profits/liability cannot be used interchangeably with losses/asset. When performing SCR calculations, it is important to take into account that the adverse scenarios would have an impact on these unrecognised profits (as far as the tax basis is concerned) and hence there should be an adjustment to the deferred tax liability. This adjustment is made by the item called loss-absorbing capacity of deferred tax. This document discusses some of the assumptions used in the calculation of this impact. Particular focus is given to the extent to which deferred tax assets should be recognised on the SAM balance sheet following the events used in the calculation of the Basic SCR. The document is written against the background of the current dispensation for the taxation of life and non-life insurance business, but should be readily adaptable to any new dispensation. 2. INTERNATIONAL STANDARDS: IAIS ICPs ICP 17.6 refers to the structure of capital requirements. In particular refers to the reasoning behind a going concern basis being applied and the availability of capital to meet losses in a wind-down scenario: Capital should also be capable of protecting policyholders if the insurer were to close to new business. Generally, the determination of capital on a going concern basis would not be expected to be less than would be required if it is assumed that the insurer were to close to new business. However, this may not be true in all cases, since some assets may lose some or all of their value in the event of a winding-up or run-off, for example, because of a forced sale. Similarly, some liabilities may actually have an increased value if the business does not continue (e.g. claims handling expenses). ICP speaks to the availability of capital to meet losses under both going concern and wind-up bases. In general this applies to assets in the base case, but for the purposes of this discussion it should also be applied to assets in a stressed scenario. 3. EU DIRECTIVE ON SOLVENCY II: PRINCIPLES (LEVEL 1) Article 101 Calculation of the Solvency Capital Requirement 1. The Solvency Capital Requirement shall be calculated in accordance with paragraphs 2 to The Solvency Capital Requirement shall be calculated on the presumption that the undertaking will pursue its business as a going concern. 3. The Solvency Capital Requirement shall be calibrated so as to ensure that all quantifiable risks to which an insurance or reinsurance undertaking is exposed are taken into account. It shall cover existing business, as Page 2 of 11

3 well as the new business expected to be written over the following 12 months. With respect to existing business, it shall cover only unexpected losses. It shall correspond to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99,5 % over a one-year period. 4. The Solvency Capital Requirement shall cover at least the following risks: (a) non-life underwriting risk; (b) life underwriting risk; (c) health underwriting risk; (d) market risk; (e) credit risk; (f) operational risk. Operational risk as referred to in point (f) of the first subparagraph shall include legal risks, and exclude risks arising from strategic decisions, as well as reputation risks. 5. When calculating the Solvency Capital Requirement, insurance and reinsurance undertakings shall take account of the effect of risk-mitigation techniques, provided that credit risk and other risks arising from the use of such techniques are properly reflected in the Solvency Capital Requirement. Article 103 Structure of the Standard Formula The Solvency Capital Requirement calculated on the basis of the standard formula shall be the sum of the following items: (a) the Basic Solvency Capital Requirement, as laid down in Article 104; (b) the capital requirement for operational risk, as laid down in Article 107; (c) the adjustment for the loss-absorbing capacity of technical provisions and deferred taxes, as laid down in Article 108. Article 108 Adjustment for the loss-absorbing capacity of technical provisions and deferred taxes The adjustment referred to in Article 103(c) for the loss-absorbing capacity of technical provisions and deferred taxes shall reflect potential compensation of unexpected losses through a simultaneous decrease in technical provisions or deferred taxes or a combination of the two. That adjustment shall take account of the risk mitigating effect provided by future discretionary benefits of insurance contracts, to the extent insurance and reinsurance undertakings can establish that a reduction in such benefits may be used to cover unexpected losses when they arise. The risk mitigating effect provided by future discretionary benefits shall be no higher than the sum of technical provisions and deferred taxes relating to those future discretionary benefits. For the purpose of the second paragraph, the value of future discretionary benefits under adverse circumstances shall be compared to the value of such benefits under the underlying assumptions of the bestestimate calculation. 4. MAPPING ANY PRINCIPLE (LEVEL 1) DIFFERENCES BETWEEN IAIS ICP & EU DIRECTIVE The level 1 directive specifies a going concern basis, whereas the ICPs refer to both a going concern and wind-up basis. 5. STANDARDS AND GUIDANCE (LEVELS 2 & 3) 5.1 IAIS standards and guidance papers No further guidance papers were referred to, other than the additional CP issued by the PRA (UK) Page 3 of 11

4 5.2 CEIOPS CPs (consultation papers) CP54 speaks to the loss-absorbing capacity of technical provisions and deferred taxes. The text below is from the Level II implementing measures: Calculation of the adjustment for loss-absorbing capacity of deferred taxes The calculation of the adjustment for loss-absorbing capacity of deferred taxes should be consistent with the calculation for loss-absorbing capacity of technical provisions The loss-absorbing capacity of deferred taxes should take into account decreases in deferred tax liabilities and increases in deferred tax assets. The latter should, however, only be taken into account up to the amount that stays available under stressed situations. Where under stress the asset may disappear, no allowance should be made The value of the deferred tax liability or asset should be recalculated under the single equivalent scenario. As described above, it is assumed that all the shocks making up the single equivalent scenario occur simultaneously. Furthermore it should be assumed that the undertaking makes an operational risk loss equal to SCRop within the equivalent scenario. This ensures that the loss-absorbing capacity of deferred taxes is properly captured The adjustment for loss-absorbing capacity of deferred taxes is based on the difference between the value of deferred taxes as included on the balance sheet and the value of deferred taxes under the single equivalent scenario However where the adjustment for loss absorbency of technical provisions is calculated using the modular approach, a further adjustment should be made to reflect the loss-absorbing capacities of deferred taxes. As in QIS4, this adjustment should be calculated as follows: The Basic Solvency Capital Requirement (BSCR) should be calculated on the basis that the current (pre-stress) liability in respect of deferred taxes is excluded from the current (pre-stress) balance sheet. The capital requirement for operational risk should be added to the BSCR. The outcome is reduced by the adjustment for the loss absorbing capacity of technical provisions. The result of this calculation is called SCR shock. The liability or asset in respect of deferred taxes should then be calculated under the assumption that the undertaking made an immediate loss equal to the SCR shock The adjustment to the basic SCR for the loss-absorbing capacity of deferred taxes is equal to the change in the deferred tax liability and/or asset Note that advice on the valuation of deferred tax assets and liabilities is included in CEIOPS advice on valuation of assets and other liabilities (CEIOPS-DOC-35/09) 2 CP35 has been considered by the Assets Task Group in their recommendations for the valuation of other assets and liabilities. The QIS5 report mentions that some supervisors were concerned with the qualitative assessment as to whether deferred tax assets could be realised within a reasonable time frame. The text below is from Part I of the Long-Term Guarantee Assessment: 2 (This last reference is incorrect in the CP and should be CEIOPS-DOC-31/09, but reference is made to an earlier CP35.) Page 4 of 11

5 Adjustment for loss absorbency of deferred taxes SCR The adjustment for the loss-absorbing capacity of deferred taxes should be equal to the change in the value of deferred taxes of undertakings that would result from an instantaneous loss of an amount that is equal to the following amount: SCRshock = BSCR + AdjTP + SCROp where BSCR is the Basic SCR, AdjTP is the adjustment for the loss-absorbing capacity of technical provisions and SCROp denotes the capital requirement for operational risk. SCR For the purpose of this calculation, the value of deferred taxes should be calculated as set out in the section on valuation. Where a loss of SCRshock would result in the setting up of deferred tax assets, insurance and reinsurance undertakings should take into account the magnitude of the loss and its impact on the undertaking's financial situation when assessing whether it is probable that future taxable profit will be available against which the deferred tax asset can be utilized in accordance with the section on valuation. SCR For the purpose of this calculation, a decrease in deferred tax liabilities or an increase in deferred tax assets should result in a negative adjustment for the loss-absorbing capacity of deferred taxes. SCR Where the calculation of the adjustment results in a positive change of deferred taxes, the adjustment shall be nil. SCR Undertakings should calculate the adjustment for deferred taxes in accordance with the valuation principles as set out in the section on valuation. Those principles require the calculation of the adjustment for the loss-absorbency capacity of notional deferred taxes by stressing the Solvency II balance sheet and determining the consequences on the undertaking s tax figures. The notional deferred taxes should then be calculated on the basis of temporary differences between the stressed Solvency II values and the corresponding figures for tax purposes. Following the principles set out in the section on valuation, notional deferred taxes should be recognized in relation to all assets and liabilities that are recognized either for Solvency or tax purposes. Items not recognized for Solvency or tax purposes should be valued at zero. SCR If undertakings do not set up a stressed Solvency II balance sheet, supervisory authorities should allow a calculation with methods based on average tax rates, if undertakings demonstrate that this approach avoids material misstatement of the adjustment. SCR Undertakings should ensure that the calculation of the loss-absorbing capacity of notional deferred taxes is performed at a level of granularity that reflects all material relevant regulations of all applicable tax regimes. SCR Where it is necessary to allocate the loss SCRshock to its causes in order to calculate the adjustment for the loss-absorbing capacity of deferred taxes, undertakings should allocate the loss to the risks that are captured by the Basic Solvency Capital Requirement and the capital requirement for operational risk. The allocation should be consistent with the contribution of the modules and sub-modules of the standard formula to the Basic SCR. The level of granularity of loss-allocation should be sufficient to allow for all material relevant regulations of applicable tax regimes to be taken into account. Adjustment for loss absorbency of notional deferred taxes: Recognition SCR Undertakings should recognize notional deferred tax assets conditional on their temporary nature. The recognition should be based on the extent to which offsetting is permitted according to the relevant tax regimes, which may include offset against past tax liabilities, or current or likely future tax liabilities. SCR Where an approach based on average tax rates is employed, undertakings should ensure that deferred tax liabilities in the unstressed Solvency II balance sheet are not double counted for the purpose of recognition. They can either support recognition of deferred tax assets in the unstressed Solvency II balance sheet, or notional deferred tax assets in the SCR calculation, but not both. Hence, the recognition of notional deferred tax assets cannot be supported by deferred tax liabilities which are already supporting the recognition of deferred tax assets in the balance sheet for valuation purposes. SCR These restrictions should be implicit if a stressed Solvency II balance sheet is set up. The recognition of notional deferred tax assets in a stressed Solvency II balance sheet should follow the principles set out in the section on Valuation of assets and liabilities other than TP. SCR If the recognition of notional deferred tax assets is supported by future profit assessments, the notional deferred tax asset recognized to the extent that it is probable that the entity will have sufficient taxable profit available after it suffered the instantaneous loss. SCR Appropriate techniques should be employed to assess the temporary nature of the notional deferred tax asset and the timing of future taxable profits. The assessment should be undertaken in accordance with the section on valuation of assets and liabilities other than TP. Projections should take into account the prospects of the undertaking after suffering the instantaneous loss. Page 5 of 11

6 SCR Where an approach based on average tax rates is employed, undertakings should take care that notional deferred tax assets arising from the instantaneous loss cannot be supported by future taxable profits already supporting the recognition of deferred tax assets for valuation purposes. SCR To avoid double counting, future profits for the recognition of deferred tax assets in the Solvency II balance sheet should be deducted from the post-stress projections of future profits. Only the remaining amount may be recognized to demonstrate eligibility of the notional deferred tax asset. 5.3 PRA CPs The Prudential Regulatory Authority (PRA) in the UK issued CP3/14 during February 2014 which expanded on issues that require consideration when performing the calculations. These considerations affect the valuation of deferred tax assets in the base case, in the Risk Margin calculations and in the SCR. Only comments relating to the calculation of the SCR are included in the discussion below. Although the CP outlines these focus areas, it does not contradict earlier notes in the former CP35 that IAS12 principles should be applied in the base case as well as stressed scenarios to ascertain recoverability. 2.3 A firm can also recognise the tax effects of the 1-in-200 stress for the purposes of calculating its SCR if it can demonstrate that the tax loss created could be: set against tax due in the period of the stress; or carried back to reclaim tax paid in the twelve months prior to the loss scenario. 2.4 Judgement both by firms and supervisors will be required to decide whether future taxable profits are probable in accordance with IAS 12 and can be used to justify recognition of relevant DTAs. Double counting of deferred tax liabilities 3.2 If firms have both DTA and DTL in the SII balance sheet, any DTL they wish to use to support utilisation of the tax effects of the SCR shock should not already be in use to support utilisation of the balance sheet DTA. SII contract boundary assumptions 3.3 Different contract boundaries as between statutory accounting and SII may be a credible source of future taxable profits. If firms calculate this impact separately from projections of new business, they are reminded to take care to prevent double counting. Risk margin 3.4 Article 77 of the SII Directive makes clear that the risk margin is an integral part of technical provisions and will need to be determined each time a firm calculates its solvency position. 3.5 The SII regime assumes that firms will continue in business after the shock, and as such, the risk margin is maintained from year to year. Any risk margin released on liabilities which run off would usually be replaced with risk margin to be provided in respect of new liabilities. Where this is the case, it is not appropriate to include the amount of the current risk margin as an element of future taxable profits in a firm s projections. 3.6 Different considerations might apply to firms which are completely closed to new business. These firms would be expected to have regard to the: time the firm has already been in run-off; Page 6 of 11

7 nature of the firm s business and business model; availability of historical data regarding differences between actual and projected experience; likely period until run-off is complete; and credibility of the planning period of the firm. 5.4 Other relevant jurisdictions (e.g. OSFI, APRA) These jurisdictions were not assessed for the purposes of this discussion document. Based on the qualitative feedback in QIS3, some insurers do take credit for the loss-absorbing capacity of deferred taxes in the current regulatory regime. The specifications currently do not preclude this. 5.5 Mapping of differences between above approaches (Level 2 and 3) Any differences in approach do not relate to principle-based or technical aspects of the calculation, but to recoverability. Within a European context, there are likely to be a number of different approaches to recoverability as a number of tax regimes are involved. The approach relating to recoverability of the notional deferred asset should however be broadly consistent across jurisdictions. 6. ASSESSMENT OF AVAILABLE APPROACHES GIVEN THE SOUTH AFRICAN CONTEXT It should be noted that the discussion below focuses on allowing for the loss-absorbing capacity of transfer tax. Within the market risk sub-modules, allowance should be made for any offsetting impact (primarily capital gains tax) following asset stresses. The recoverability relating to any deferred tax asset created in this way would need to be assessed per shock. This poses less of a problem as on a best estimate basis assets are assumed to still earn the risk-free rate following a shock which would mean that unrealised capital gains tax assets are expected to be utilised. The latter point as not deliberated any further. The discussion of available approaches has been divided into two sections. The first relates to the structure of the calculation and the second to recoverability/limitations that may relate to deferred tax assets. 6.1 Structure of calculation Given that the SAM SCR is only performed on a modular basis, the available approaches would be to: 1) allow for the loss-absorbing capacity per shock and then adjust for the fact that calculations are performed at solo or group level as appropriate or, 2) as per Solvency II, only perform a global adjustment where an intermediate calculation of SCRshock is required see section 2.17 under 5.2. The second approach has been tested in a variety of SA QIS exercises. (Some of the amendments tested related to the extent that deferred tax assets could be set up in the SCR calculation dealt with in the section on recoverability.) Page 7 of 11

8 6.1.1 Discussion of inherent advantages and disadvantages of each approach If the first calculation is performed, then some adjustment would be required to reflect the level at which the entity is taxed. (This would need to be performed to limit the potential double-counting of loss-absorbing capacity.) It may be difficult to develop an approach that would be suitable across industry yet appropriate to the standard formula. The second calculation is computationally simple, yet corresponds to the objectives in Article 101 in that it performs a combined adjustment to all other components of the SCR. No adjustment to limit double-counting is required. The main sensitivity to both calculations relates to the rates of taxation to apply. An assessment of the appropriate rate may become computationally intensive, e.g. if the effective rate of transfer tax from the various policyholder funds on life business needs to be allowed for. Similarly, capital losses to shareholder funds would not receive the same tax credit due to the incorporation of an inclusion rate. The assertions around the appropriateness of approximations to allow for this would need to be re-assessed following developments to the tax basis, especially those for life funds Impact of the approaches on EU 3 rd country equivalence Neither approach should impact 3 rd country equivalence, but the second is clearly more aligned with that followed in Solvency II Conclusions on preferred approach The second approach is preferable mainly as a result of: 1) It being performed at the same level at which tax is calculated for the entity 2) It being computationally simple 6.2 Extent of recoverability Two approaches have been put forward: 1) Limit the loss-absorbing capacity of deferred taxes to the sum of that which is required to expunge any deferred tax liabilities on the SAM balance sheet. 2) Do not apply any formulaic limits, but rely on the approach relating to recoverability of deferred tax assets set out in the section on valuation to also apply to the stressed scenario Discussion of inherent advantages and disadvantages of each approach The first approach is computationally simple. It does not require projections or any other supporting calculations relating to the recoverability of deferred tax assets on the stressed SAM balance sheet. Under the current tax regime, this approach may not ultimately result in a limitation for many life insurers. It would lead to a consistent, if conservative, application relating to recoverability. Page 8 of 11

9 The first approach is based on the principle that SCR calculations do not allow for an improvement in assumptions following a stress and that there would be no sources of taxable profit on the best estimate basis required for SAM against which to offset this asset. The assertions supporting the first approach have been challenged in working group discussions on the following grounds: 1. The unwinding of the risk margin is expected to lead to profits as the business in question winds down. Counter-argument: The re-calculation of the risk margin has not necessarily been included in the change to NAV calculations on which the SCR is based, but here we have a technical provision that we know will facilitate the establishment of a deferred tax asset to some extent. The Risk Margin itself could not be assumed to contribute in its entirety as the SCR is calculated on a going concern basis which would require a Risk Margin to be set up following the stress events as well. The exception to this would be where companies are in run-off. In addition, the risk margin includes some allowance for expected tax outflows (as per DD113) which would not be able to be offset against losses. 2. The tax asset could be accessible to a third party buying out the insurer. Counter argument: There is no market consistent way of assessing whether other insurers would be able to access losses, so this may not be a valid argument for the SCR calculation. 3. The first approach aligns with the technical provision calculation in that no new business is allowed for, but some SCR components, especially non-life underwriting risk does in fact allow for new business (which could be a source of basic own funds on the SAM balance sheet). In addition, the SCR structure is based on the implicit assumption that some new business is written during the course of the next year to replace existing business. So some allowance needs to be made for any new business included in the SCR calculation, which the first approach does not support. Where business with short contract boundaries are written and the expectation is that this business will continue to be written, profits from this business would also be able to contribute to the unwinding of deferred tax assets. The second approach would address the points above. The main disadvantage of the second approach is that significant judgement as well as supporting calculations would be required to assess recoverability so as to address the counter arguments above. Performing the calculations to support the creation of a deferred tax asset post an event of the magnitude of the SCR in a robust fashion could result in either significant practical difficulties and/or significant reliance being placed on simplifying assumptions. The complexity and discretion employed may be beyond what would otherwise be required in a standard formula context. This may lead to a variety of approaches employed by industry. By way of an example, the QIS3 exercise demonstrated a range of approaches followed by industry, ranging from the first approach to a spread of: a) new business, b) the risk margin or c) tax loss transfer or d) combinations of the above Page 9 of 11

10 used across industry. The use of DTAs to absorb losses was more prevalent in the nonlife (re) insurance industry. In addition, proposal have been put forward that recoverability should be assessed at a product or tax fund level as opposed to an entity level, but these proposals were not developed further based on feedback from the first version of this discussion document Impact of the approaches on EU 3 rd country equivalence The first approach is more conservative than the approach adopted under Solvency II. It should nevertheless not impact 3 rd country equivalence. The conservatism may help to demonstrate capital adequacy for individual insurers. The second approach is directly comparable with the Solvency II approach and should not impact 3 rd country equivalence Comparison of approaches with prevailing framework The prevailing framework does not make explicit allowance for the loss-absorbing capacity of deferred taxes where the latter relates to differences between the taxation basis and the basis on which technical provisions are calculated. The impact of tax is not explicitly considered in the CAR calculations set out in SAP104. Any loss-absorbing capacity of deferred taxes allowed for in the calculation would be subject to the same judgement governing the application of any other part of the standard Conclusions on preferred approach The second approach is preferred as: 1. It does not introduce additional conservatism 2. It can be consistent with calculations where additional own funds are incorporated in the SCR calculation (to the extent that new business is allowed for) The second approach would require projections which support recoverability on a SAM basis which introduces a range of practical difficulties and/or simplifying assumptions which need to be tested for appropriateness. Additional guidance relating to what should be considered would need to be developed as this was a major concern for a variety of industry participants during the QIS3 exercise. A particular area of judgement is the extent to which new business should be allowed for following the stress event and how this needs to be different to the base case assumption. The calculations would relate to the level at which an entity is taxed, i.e. license level. 7. RECOMMENDATION Page 10 of 11

11 The adjustment for the loss-absorbing capacity of deferred taxes should be equal to the change in the value of deferred taxes of undertakings that would result from an instantaneous loss of an amount that is equal to the following amount: SCRshock = BSCR + SCRpart + SCROp where BSCR is the Basic SCR and SCROp denotes the capital requirement for operational risk. The adjustment above relates to the loss-absorbing capacity of reduced taxes on future profits (as recognised on the relevant tax basis). For asset shocks within modules, the effect of investment return taxation (i.e. not the tax on profits) should be allowed for in the shock itself. The rate to be applied to this shock should be no higher than the effective rate of taxation used to establish the deferred tax position on the balance sheet. Additional guidance relating to the rate employed may be required once there is more clarity on the ultimate tax basis. No limits should be applied to the loss-absorbing capacity, but when setting up deferred tax assets in the SCR calculation, the following items should be considered when assessing recoverability: The impact of new business (discretion as to how much is allowed for); Any recourse to payables from previous periods. The task group recommends that the following should not be allowed for when assessing recoverability: Any credit already used to demonstrate recoverability of deferred tax assets in the base case balance sheet so as to avoid double-counting of the credit on the postshock balance sheet. Any element that is not expected to be released into surplus on the projected basis following the stress, including an appropriate allowance for the impact of new business on these elements. A specific example of the above bullet would relate to the release of the risk margin, which should not be allowed for. Page 11 of 11