STRATEGIC REPORT
GOVERNANCE
financial statements
17 FINANCIAL ASSETS AND LIABILITIES MEASURED AT FAIR VALUE continued Mortality
Mortality assumptions have been derived with reference to England & Wales population mortality using the CMI 2021 model for mortality improvements. These base mortality and improvement tables have been adjusted to reflect the expected future mortality experience of mortgage contract holders, taking into account the medical and lifestyle evidence collected during the sales process and the Group’s assessment of how this experience will develop in the future. This assessment takes into consideration relevant industry and population studies, published research materials and management’s own experience. The Group has considered the possible impact of the COVID-19 pandemic on its mortality assumptions and has included an allowance for the expected future direct and indirect impacts of this. Further details of the matters considered in relation to mortality assumptions at 31 December 2022 are set out in note 23(b). Property prices The approach in place at 31 December 2022 is to calculate the value of a property by taking the latest Automated Valuation Model “AVM” result, typically as at 30 September 2022 or latest surveyor value if more recent, indexing this to the balance sheet date using Nationwide UK house price indices and then making a further allowance for property dilapidation since the last revaluation date. To the extent that this reflects market values as at 31 December 2022, no additional short-term adjustment is allowed for. 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% (2021: 3.3%), with a volatility assumption of 13% per annum (2021: 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 impacts of Brexit, the COVID-19 pandemic and a higher interest and inflation rate economic environment on the UK property market. House price growth over 2022 continued to be strong initially, but has experienced falls in the latter part of the year. Whilst it is becoming more likely that short term falls in property prices may be experienced, at this stage our view is that there is no clear indication of a change in 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 2021. 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 analyses. The assumed redemption rate varies by duration and product line between 0.5% and 4.1% for loans in JRL (2021: 0.5% and 4.1%) and between 0.6% and 6.8% for loans in PLACL (2021: 0.6% and 6.8%). In the prior period, a separate provision for potential higher short-term experience arising from additional remortgaging activity was also allowed for. The sharp increase in loan interest rates observed over the year and reductions in maximum loan-to-value ratios available for new business significantly reduce the opportunities for customers to benefit from remortgaging. Consequently, this separate provision has been removed. 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. The average liquidity premium for loans held within JRL is 3.2% (2021: 3.04%) and for loans held within PLACL is 3.5% (2021: 3.51%). The movement over the period observed in both JRL and PLACL is 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:
Future property price volatility +1%
Future property price growth -0.5%
Liquidity premium +10bps
Voluntary redemptions +10%
Immediate property price fall -10%
Mortality improvement +0.25%
Base mortality -5%
Maintenance expenses +10%
Loans secured by residential mortgages net increase/(decrease) in fair value (£m)
2022 2021
(5.2) (6.5)
(13.9)
(6.3)
(75.2) (114.6)
(48.5) (82.3)
(32.1) (53.2)
19.7
(47.8) (78.0)
22.7
10.5
(5.2)
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. Sensitivities are generally of a smaller magnitude compared to the prior period due to the discounting effect of interest rate rises over the period. These interest rate rises also underpin the directional change in the mortality and voluntary redemption sensitivities.
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