Strategic Report | Governance | Financial Statements | 159
1. MATERIAL ACCOUNTING POLICIES continued Note Item involving estimate
Critical estimates and assumptions
1.5, 26 Measurement of insurance contract liabilities – present value of future cash flows
The critical estimates used in measuring insurance liabilities include the projected future annuity payments and the cost of administering payments to policyholders. The Group considers any maintenance expenses to be directly attributable if they are required to be incurred to enable the insurance entities to continue to operate as insurance companies maintaining the contracts in force. The key assumptions used in the determination of future cash flows are the mortality and annuity escalations assumptions and the level and inflation of costs of administration. Mortality assumptions are derived from the appropriate standard mortality tables, adjusted to reflect the future expected mortality experience of the policyholders. Maintenance expenses are determined from expense analyses and are assumed to inflate at market-implied rates. Further detail can be found in note 26(b). The present value of future cash flows are discounted based on discount rates as at the valuation date. Discount rates for gross insurance contract liabilities are based on the yield of a reference portfolio after deducting allowances for expected and unexpected credit default losses. Factors that may affect future levels of defaults, including historic trends and current spread levels, are closely monitored when determining deductions for credit risk. The critical estimates used in measuring the value of reinsurance assets and liabilities include the projected future cash flows arising from the reinsurers’ share of the Group’s insurance liabilities including the risk adjustment. The key assumptions used in the valuation include discount rates and mortality experience, as described above, and assumptions around the reinsurers’ ability to meet their claims obligations. Consistent discount rates are used for calculation of reinsurance CSM as used for the underlying business. In instances where reinsurance cover is in place when underlying contracts are written, the reinsurance CSM is calculated using discount rates as at the start of the relevant treaty notice period. In instances where reinsurance is transacted subsequently to the underlying business being written, the reinsurance CSM is calculated using discount rates as at the start date of the reinsurance treaty. Allowance is made for reinsurer credit default risk within the expected cash flows based on the net balance held with the reinsurer after allowing for collateral arrangements. The critical estimates used in valuing loans secured by residential mortgages include the projected future receipts of interest and loan repayments, future house prices, and the future costs of administering the loan portfolio. The key assumptions used as part of the valuation calculation include future property prices and their volatility, mortality, the rate of voluntary redemptions and the liquidity premium added to the swap curve and used to discount the mortgage cash flows. Assumptions based on unobservable inputs are used in the measurement of the fair value of financial investments where there is not a quoted price available and limited market activity. The fair value is estimated using valuation techniques including discounted cash flows and pricing from asset managers. The assumptions used in making this significant estimate include management’s expectations regarding credit spreads for determining the discount rate for such investments including residential ground rents. The Group has considered the proposals set out in the government consultation regarding potential restrictions to the level of residential ground rents and has also considered the alternative proposal put forward by the ABI. In determining the fair value of residential ground rents the Group has concluded that it is appropriate to include an allowance for increased uncertainty and this has been made by making adjustments to the rating framework to reflect the Group’s estimate of the impact that a third party would consider. Specifically by adjusting two key parameters in the ratings model, the amortisation benefit and the cap rate, for the purposes of providing a valuation overlay.
1.5, 26 Determination of discount rate for insurance and reinsurance contracts 1.5, 26 Measurement of the fulfilment cash flows arising from reinsurance arrangements
1.6, 20(a), 20(d)
Measurement of fair value of loans secured by residential mortgages, including measurement of the no-negative equity guarantee
20(a)
Measurement of fair value of other illiquid financial investments
20
Determination of the appropriate adjustment to the value of residential ground rents as a result of the publication of the government consultation.
The valuation of residential ground rents is adjusted to reflect an expected increase in credit spread. The increased spread would also increase the credit risk deduction for defaults. These adjustments have been applied to the valuation of IFRS insurance contract liabilities by increasing the credit risk deduction for defaults to reflect a lower rating and hence the valuation of liabilities. Further information regarding management’s consideration of the impact on the valuation of residential ground rents as a result of Government consultation can be found in note 20(d)(v). 1.18, 21 Recoverability of deferred tax The adoption of IFRS 17 has created tax losses on transition which can be offset against future taxable profits. The Group has assessed that these tax losses will be fully recoverable based on the Group’s five-year business plan and projection thereafter.
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