FINANCIAL STATEMENTS
STRATEGIC REPORT
GOVERNANCE
Key audit matter
How our audit addressed the key audit matter
Valuation of insurance contract liabilities – Credit default assumptions (Group) Refer to Group Audit Committee Report, Accounting policy 1.21 Insurance liabilities and note 23 Insurance contracts and related reinsurance. The credit default assumptions are applied as a deduction to the We performed the following audit procedures to test the credit default assumptions:
valuation rate of interest and therefore have a significant impact on the valuation of the insurance contract liabilities. The appropriate deduction is subjective and requires expert judgement. The Group’s investment portfolio primarily consists of corporate bonds and a material amount of illiquid assets, including Lifetime Mortgages, where there is greater uncertainty. For corporate bonds, the assumption is based upon historical observed default rates with an additional allowance when current observed spreads are in excess of an assumed long-term level. For Lifetime Mortgages, the assumption is set with reference to the No Negative Equity Guarantee (“NNEG”) and for other illiquid assets, the assumption is set as an adjustment to the equivalent corporate bond assumption. In addition, a margin for prudence is applied to the credit default assumptions.
• Assessed the methodologies used to derive the assumptions (including margin for prudence) with reference to relevant rules and actuarial guidance and by applying our industry knowledge and experience; • Assessed significant assumptions used by management against market observable data (to the extent available and relevant) and our experience of market practises; Tested the controls in place over the application of credit default assumptions within the valuation interest rate calculation; • Considered the impact of COVID-19, including whether any changes in future expected default levels are appropriately reflected; • Considered the appropriateness of any changes made to the credit default methodology as a result of the transition from LIBOR to SONIA as the benchmark risk-free rate in UK; • Compared the assumptions selected against those adopted by peers using our annual survey of the market (to the extent available); • Assessed the appropriateness of the margin for prudence for each asset class individually and in aggregate and its consistency over time; and • Assessed the disclosure of the credit default risk assumptions and the commentary to support the impact, if any, from changes in these assumptions over the period. Based on the work performed and the evidence obtained, we consider the assumptions used for credit default risk to be appropriate.
Valuation of insurance contract liabilities – Expense assumptions (Group) Refer to Group Audit Committee Report, Accounting policy 1.21 Insurance liabilities and note 23 Insurance contracts and related reinsurance.
Future maintenance expenses and expense inflation assumptions are used in the measurement of the insurance contract liabilities. The assumptions reflect the expected future expenses that will be required to maintain the in-force policies at the balance sheet date, including an allowance for unavoidable project costs and a margin for prudence. The assumptions used require judgement, particularly with respect to the allocation of expenses to future maintenance.
We performed the following audit procedures to test the expense assumptions: • Tested the design and, where applicable, the operating effectiveness of controls related to the expense assumption setting process; • Tested the completeness and accuracy of the total cost base and allocation of expenses to the appropriate cost centre; • Assessed the methodology used by management to derive the assumptions with reference to relevant rules and actuarial guidance and by applying our industry knowledge and experience; • Assessed the appropriateness of significant judgements in application of the methodology, including excluded costs (for example, due to costs either not relating to the insurance business or being non-recurring in nature), the allocation of expenses between acquisition and maintenance costs and the allocation of costs to products; • Assessed the appropriateness of the rate at which expenses are assumed to inflate in the future, taking into account both price and earnings inflation; • Assessed the appropriateness of the margin for prudence and its consistency over time; • Tested the policy counts used in the derivation of per policy expense assumptions and considered whether any adjustments are required to reflect changes in future expected policy volumes, for example, to allow for diseconomies of scale; and • Assessed the disclosure of the maintenance assumptions and the commentary to support the impact, if any, from changes in these assumptions over 2021. Based on the work performed and the evidence obtained, we consider the expense assumptions to be appropriate.
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