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FINANCIAL STATEMENTS
17 FAIR VALUE continued Sensitivity analysis
Reasonable 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 sensitivity of the valuation of bonds to the default assumption 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 (109.2)
Debt securities and other fixed income securities net increase/(decrease) in fair value (£m)
2020 2019
(52.5)
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 no-negative equity guarantee (“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. The Group has assessed the possible impact of COVID-19 restrictions and economic uncertainty on current property assumptions, and has retained its existing property valuation assumptions at 31 December 2020. Details of the matters considered in relation to property assumptions at 31 December 2020 are noted in the section on Loans secured by residential mortgages further below. The impact on derivative financial assets and liabilities from changes to property assumptions are noted in the sensitivity analysis below. Sensitivity analysis Reasonable possible alternative assumptions for unobservable inputs used in the valuation model could give rise to significant changes in the fair value of the assets and liabilities. 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%
Interest rates +100bps
Net increase/(decrease) in fair value (£m)
Derivative financial assets 2020
(6.5) (1.9)
24.0
24.1
10.2
2019
5.9
6.4
2.2
Derivative financial liabilities 2020
(1.8)
6.3 n/a
6.8 n/a
2.8 n/a
2019
n/a
Loans secured by residential mortgages Methodology and judgement underlying the calculation of loans secured by residential mortgages
The valuation of loans secured by mortgages is determined using internal models which project future cash flows expected to arise from each loan. Future cash flows allow for assumptions relating to future expenses, future mortality experience, voluntary redemptions and repayment shortfalls on redemption of the mortgages due to the no-negative equity guarantee (“NNEG”). The fair value is calculated by discounting the future cash flows at a swap rate plus a liquidity premium. Under the NNEG, the amount recoverable by the Group on eligible termination of mortgages is generally capped at the net sale proceeds of the property. A key judgement is with regard to the calculation approach used. We have used the Black 76 variant of the Black-Scholes option pricing model in conjunction with an approach using best estimate future house price growth assumptions. There has been significant academic and market debate concerning the valuation of no-negative equity guarantees in recent years, including proposals to use risk-free based methods rather than best estimate assumptions to project future house price growth. We continue to actively monitor this debate. In the absence of any widely supported alternative approach, we have continued in line with the common industry practice to value no-negative equity guarantees using best estimate assumptions. The real world assumptions used include future property growth and future property price volatility. Cash flowmodels are used in the absence of a deep and liquid market for loans secured by residential mortgages. The sale of the portfolio of LTMs represents a single market price but this is insufficient to affect the judgement of the appropriateness of the methodology and assumptions used by the cash flow approach for individual loans. Principal assumptions underlying the calculation of loans secured by residential mortgages All gains and losses arising from loans secured by mortgages are largely dependent on the term of the mortgage, which in turn is determined by the longevity of the customer. Principal assumptions underlying the calculation of loans secured by mortgages include the items set out below. These assumptions are also used to provide the expected cash flows from the loans secured by residential mortgages which determines the yield on this asset. This yield is used for the purpose of setting valuation discount rates on the liabilities supported, as described in note 23(b). Maintenance expenses Assumptions for future policy expense levels are based on the Group’s recent expense analyses. The assumed future expense levels incorporate an annual inflation rate allowance of 3.6% (2019: 3.9%).
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