FINANCIAL STATEMENTS
STRATEGIC REPORT
GOVERNANCE
17 FINANCIAL ASSETS AND LIABILITIES MEASURED AT FAIR VALUE continued The appropriateness of this valuation basis is regularly tested on the event of redemption of mortgages. The sensitivity of loans secured by 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 inflation, “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% (2020: 3.3%), with a volatility assumption of 13% per annum (2020: 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 impact of Brexit on the UK property market. As noted above, the Group has considered the uncertainties in relation to the property market as a result of the COVID-19 pandemic. House price growth over 2021 has been strong, and there has been an increase in market-implied RPI and CPI inflation expectations too. However, the impact of the pandemic on long-term property prices is uncertain at the current time without consensus that the pandemic will alter 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 2020. The sensitivity of loans secured by mortgages to changes in future property price growth, and to future property price volatility, are included in the table of sensitivities below. Voluntary redemptions Assumptions for future voluntary redemption levels are based on the Group’s recent experience analyses and external benchmarking. The assumed redemption rate varies by duration and product line between 0.5% and 4.1% for loans in JRL (2020: 0.5% and 4.1%) and between 0.6% and 6.8% for loans in PLACL (2020: 0.6% and 6.8%). No changes are assumed with regard to the COVID-19 experience. Compared to the prior period, a separate provision for potential higher short-term experience arising from additional remortgaging activity is also allowed for. Liquidity premium The liquidity premium at initial recognition is set such that the fair value of each loan is equal to the face value of the loan. The liquidity premium partly reflects the illiquidity of the loan and also spreads the recognition of profit over the lifetime of the loan. Once calculated, the liquidity premium remains unchanged at future valuations except when further advances are taken out. In this situation, the single liquidity premium to apply to that loan is recalculated allowing for all advances. Historically the liquidity premium has been set relative to LIBOR swap rates. Following the discontinuance of LIBOR from the end of 2021 SONIA has been adopted as the risk free index. The liquidity premium at 31 December 2021 has been adjusted such that the fair value of the loan is unchanged before and after this change in index. The average liquidity premium for loans held within JRL is 3.04% (2020: 2.87%) and for loans held within PLACL is 3.51% (2020: 3.20%). These average rates are relative to the risk free index used in each period. The movement over the period observed in both JRL and PLACL is therefore the effect of rebasing the liquidity premiums for the change in risk free rates, and a function of the liquidity premiums on new loan originations compared to the liquidity premiums on those policies which have redeemed or have been included in a portfolio sale over the period, both in reference to the average spread on the back book of business. Sensitivity analysis Reasonably possible alternative assumptions for unobservable inputs used in the valuation model could give rise to significant changes in the fair value of the assets. The Group has estimated the impact on fair value to changes to these inputs as follows:
Immediate property price fall -10%
Future property price growth -0.5%
Future property price volatility +1%
Maintenance expenses +10%
Base mortality -5%
Mortality improvement +0.25%
Voluntary redemptions +10%
Liquidity premium +10bps
Loans secured by residential mortgages net increase/(decrease) in fair value (£m)
(6.5) (5.9)
22.7 34.3
10.5 (114.6) 15.6 (136.1)
(82.3) (103.7)
(53.2) (64.5)
(5.2)
(78.0) (93.1)
2021 2020
(13.2)
The sensitivity factors are applied via financial models either as at the valuation date or from a suitable recent reporting period where appropriate to do so. The analysis has been prepared for a change in each variable with other assumptions remaining constant. In reality such an occurrence is unlikely due to correlation between the assumptions and other factors. It should be noted that some of these sensitivities are non-linear and larger or smaller impacts should not be simply interpolated or extrapolated from these results. For example, the impact from a 5% fall in property prices would be slightly less than half of that disclosed in the table above. The sensitivities above only consider the impact of the change in these assumptions on the fair value of the asset. Some of these sensitivities would also impact the yield on this asset and hence the valuation discount rate used to determine liabilities. For some of these sensitivities, the impact on the value of insurance liabilities and hence profit before tax is included in note 23(e). Other limitations in the above sensitivity analysis include the use of hypothetical market movements to demonstrate potential risk that only represents the Group’s view of reasonably possible near-termmarket changes that cannot be predicted with any certainty. Loans secured by commercial mortgages Loans secured by commercial mortgages are valued using discounted cash flow analysis using assumptions based on the repayment of the underlying loan. Principal assumption underlying the calculation of loans secured by commercial mortgages 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.
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