Strategic Report Governance
Financial Statements
175
(v) Infrastructure loans Infrastructure loans are valued using a discounted cash flow model. The contractual cash flows from the loans are discounted by a risk-free discount rate plus additional spreads to allow for credit and illiquidity risks. The additional spreads used in the discount rate are calculated using an internally developed methodology, which takes into consideration the credit rating of each loan and refers to external market spread indices to assess market movements in spreads and the impact of changes in credit ratings. (vi) Lifetime mortgages Methodology and judgement underlying the calculation of lifetime mortgages The valuation of lifetime mortgages is determined using internal models which project future cash flows expected to arise from each loan. Future cash flows allow for assumptions relating to future expenses, future mortality experience, voluntary redemptions and repayment shortfalls on redemption of the mortgages due to the NNEG. The fair value is calculated by discounting the future cash flows at a swap rate plus a liquidity premium. Under the NNEG, the amount recoverable by the Group on eligible termination of mortgages is capped at the net sale proceeds of the property. A key judgement is with regard to the calculation approach used. The Black 76 variant of the Black-Scholes option pricing model has been used in conjunction with an approach using best estimate future house price growth assumptions. Cash flow models are used in the absence of a deep and liquid market for lifetime mortgages. The bulk sales of the portfolios of Just LTMs in recent years represented market prices specific to the characteristics of the underlying portfolios of loans sold, in particular: loan rates; loan-to-value ratios; and customer age. This was considered insufficient to affect the judgement of the methodology and assumptions underlying the discounted cash flow approach used to value individual loans in the remaining portfolio. The pricing of these portfolio sales did not indicate a bias in either direction and, as such, any suggestion that the current valuation approach was inappropriate. The methodology and assumptions used would be reconsidered if any information is obtained from future portfolio sales that is relevant and applicable to the remaining portfolio. Principal assumptions underlying the calculation of lifetime mortgages Gains and losses arising from lifetime mortgages are largely dependent on the term of the mortgage, which in turn is determined by the longevity of the customer. Principal assumptions underlying the calculation of lifetime mortgages include the items set out below. These assumptions are also used to provide the expected cash flows from the lifetime mortgages which determine the yield on this asset. This yield is used for the purpose of setting valuation discount rates on the liabilities supported, as described in note 22(b). Maintenance expenses Assumptions for future policy expense levels are based on the Group’s recent expense analyses. The assumed future expense levels incorporate an annual inflation rate allowance of 3.7% (2023: 3.6%). Mortality Mortality assumptions have been derived with reference to England and Wales population mortality using the CMI 2023 (2023: CMI 2022) model for mortality improvements. These base mortality and improvement tables have been adjusted to reflect the expected future mortality experience of mortgage contract holders, taking into account the medical and lifestyle evidence collected during the sales process and the Group’s assessment of how this experience will develop in the future. This assessment takes into consideration relevant industry and population studies, published research materials and management’s own experience. The Group has considered the possible impact of the COVID-19 pandemic on its mortality assumptions and has included an allowance for the expected future direct and indirect impacts of this and wider UK mortality trends, updated from that which applied at 31 December 2023. Further details of the matters considered in relation to mortality assumptions at 31 December 2024 are set out in note 22(b). Property prices The approach in place as at 31 December 2024, which is the same as at 31 December 2023, is to calculate the value of a property by taking the latest Automated Valuation Model “AVM” result, or latest surveyor value if more recent, indexing this to the balance sheet date using Nationwide UK house price indices and then making a further allowance for property dilapidation since the last revaluation date. The appropriateness of this valuation basis is regularly tested on the event of redemption of mortgages. The sensitivity of lifetime mortgages to a fall in property prices is included in the table of sensitivities below. Future property price In the absence of a reliable long-term forward curve for UK residential property price inflation, the Group has made an assumption about future residential property price inflation based upon available market and industry data. These assumptions have been derived with reference to the long-term expectation of the UK consumer price index inflation metric, “CPI”, plus an allowance for the expectation of house price growth above CPI (property risk premium) less a margin for a combination of risks including property dilapidation and basis risk. An additional allowance is made for the volatility of future property prices. This results in a single rate of future house price growth of 3.3% (2023: 3.3%), with a volatility assumption of 13% per annum (2023: 13%). The setting of these assumptions includes consideration of future long and short-term forecasts, the Group’s historical experience, benchmarking data, and future uncertainties including the possible impacts of the COVID-19 pandemic and a higher interest and inflation rate economic environment on the UK property market. Increases in house price indices have been observed over 2024, albeit this only represents a short time period in relation to the long-term assumption being considered here. As such, at this stage our view is that there is no clear indication of a change in the long-term prospects of the housing market. In light of this, the future house price growth and property volatility assumptions have been maintained at the same level as assumed at 31 December 2023. The sensitivity of lifetime mortgages to changes in future property price growth is included in the table of sensitivities below.
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