Strategic Report | Governance | Financial Statements | 129
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 1.5 IFRS 17 accounting policies and note 26 Insurance contracts and related reinsurance. The discount rate for calculating the insurance contract liabilities (future cash flows and risk adjustment) is determined in IFRS 17 using a ‘top-down’ approach. In this approach the discount rate is set using the yield on a reference portfolio of assets (based on the actual assets held) with explicit deductions for both expected and unexpected credit default risk. The credit default assumptions are also used to determine the locked-in discount rate based on the target asset mix for new business written in the period (applicable to the contractual service margin). This is a key audit matter because the Group’s asset portfolio includes a material amount of illiquid assets for which the determination of credit default assumptions, including consideration of expected and unexpected default risk, requires a greater level of expert judgement.
We performed the following audit procedures to test the credit default assumptions: • Tested the methodologies used to derive the assumptions (including expected and unexpected risk) with reference to relevant rules and actuarial guidance and by applying our industry knowledge and experience; • Tested significant assumptions used by management against market observable data (to the extent available and relevant) and our experience of market practices. We have also considered the impact of current economic conditions on levels of expected and unexpected credit default risk; • Tested controls in respect of management’s review of internal credit ratings which includes Credit Committee oversight and review and challenge over asset managers ratings; • Tested controls over management’s analysis of change in discount rate (including credit default assumptions); • Assessed the impact of the recent Leasehold and Freehold Reform Bill and the associated consultation on potential restrictions to the level of residential ground rents on the credit ratings for residential ground rent assets and ensured this was reflected in credit default risk assumptions; • Tested the implementation of the credit default assumptions within the various tools used for current and locked-in discount rates for new business written in the period; and • Compared the assumptions selected against those adopted by peers using our independent annual benchmarking survey of assumptions (to the extent available). 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 1.5 IFRS 17 Accounting policies and note 26 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 project costs and future inflation. 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:
• Evaluated the design and, where applicable, tested the operating effectiveness of controls related to the expense assumption process; • 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; • Tested the completeness and accuracy of the total cost base and allocation of expenses to the appropriate cost centre; • 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), expected future improvements in efficiency, and the allocation of expenses between acquisition and maintenance and to products. This assessment also considered the appropriateness of the treatment of non-discretionary project spend where we expect these costs to be included in the ongoing cost base; • Assessed the appropriateness of the rate at which expenses are assumed to inflate in the future, taking into account current and future market expectations of both price and earnings inflation; and • 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. Based on the work performed and the evidence obtained, we consider the expense assumptions to be appropriate.
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