FINANCIAL STATEMENTS
STRATEGIC REPORT
GOVERNANCE
17 FINANCIAL ASSETS AND LIABILITIES MEASURED AT FAIR VALUE continued Investment funds
Investment funds classified as Level 3 are structured entities that operate under contractual arrangements which allow a group of investors to invest in a pool of corporate loans without any one investor having overall control of the entity. There have not been any significant impacts to these investments in relation to COVID-19. Principal assumptions underlying the calculation of investment funds classified as Level 3 Discount rate Discount rates are the most significant assumption applied in calculating the fair value of investment funds. The average discount rate used is 7.0% (2020: 7.0%). Sensitivity analysis Reasonably possible alternative assumptions for unobservable inputs used in the valuation model either as at the valuation date or from a suitable recent reporting period where appropriate to do so could give rise to significant changes in the fair value of the assets. The sensitivity of the valuation of investment funds is determined by reference to the movement in credit spreads. The Group has estimated the impact on fair value to changes to these inputs as follows:
Credit spreads +100bps
Investment funds net increase/(decrease) in fair value (£m)
2021 2020
(8.9) (4.9)
Debt securities and other fixed income securities Debt securities classified as Level 3 are private placement bonds and asset-backed securities. Such securities are valued using discounted cash flow analyses. The impact of COVID-19 has been taken into account in the assessment of the future cash flows default risk at 31 December 2021. Due to the nature of these assets and the sectors in which they operate, the Group has assessed that there is not any significant impact from COVID-19 on the valuation at 31 December 2021. Principal assumptions underlying the calculation of the debt securities and other fixed income securities classified as Level 3 Credit spreads The valuation model discounts the expected future cash flows using a discount rate which includes a credit spread allowance associated with that asset. Redemption and defaults The redemption and default assumptions used in the valuation of private placement bonds are similar to the rest of the Group’s bond portfolio. Sensitivity analysis Reasonably possible alternative assumptions for upon observable inputs used in the valuation model either as at the valuation date or from a suitable recent reporting period where appropriate to do so could give rise to significant changes in the fair value of the assets. The sensitivity of the valuation of bonds is determined by reference to movement in credit spreads. The Group has estimated the impact on fair value to changes to these inputs as follows:
Credit spreads +100bps (124.6) (109.2)
Debt securities and other fixed income securities net increase/(decrease) in fair value (£m)
2021 2020
Derivative financial assets and liabilities Derivative financial assets and liabilities classified as Level 3 are the put options on property index (also referred to as NNEG hedges). The value of each NNEG hedge is made up of premiums payable to the counterparty less expected claims back from the option where losses are made. The expected claims are calculated through the Black-Scholes framework, with parameters set such that at outset the fair value of the NNEG hedge is zero. Principal assumptions underlying the calculation of the derivative financial assets and liabilities classified as Level 3 Property prices and interest rates are the most significant assumption applied in calculating the fair value of the derivative financial assets and liabilities. As described above, these assumptions are set at outset such that the fair value of the NNEG hedge is zero. The Group has assessed the possible impact of COVID-19 and economic uncertainty on current property assumptions. Details of the matters considered in relation to property assumptions at 31 December 2021 are noted in the section on Loans secured by residential mortgages further below. The future property price volatility assumption used in the fair value calculation of derivative financial assets and liabilities has been updated to 11% (2020: 9%). This assumption is based on upon property price index volatility only, consistent with protection provided by the underlying derivatives. Property growth assumptions used in the fair value calculation of derivative financial assets and liabilities have remained unchanged from 31 December 2020, consistent with the equivalent assumptions on loans secured by residential mortgages as noted below. The impact on derivative financial assets and liabilities from changes to property assumptions are noted in the sensitivity analysis below.
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