137
FINANCIAL STATEMENTS
16 FAIR VALUE continued Derivative financial assets Derivative financial assets classified as Level 3 is the put option on property index. Principal assumptions underlying the calculation of the derivative financial assets 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. 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 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%
Immediate property price fall -10%
Derivative financial assets net increase/(decrease) in fair value (£m)
Interest rates +100bps
2019
(1.9)
5.9
6.4
2.2
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 regards 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. 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 following items. 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 22(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 3.9% (2018: 4.1%). Mortality Mortality assumptions have been derived with reference to England &Wales population mortality using the CMI 2017 dataset and model mortality tables for both base table rates and mortality improvements (2018: CMI 2017 mortality tables for both base table rates and 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. Property prices The value of a property at the date of valuation is calculated by taking the latest valuation for that property and indexing this value using the Office for National Statistics monthly index for the property’s location. The appropriateness of this valuation basis is regularly tested on the event of redemption of mortgages. Future property prices 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 retail price inflation, “RPI”, plus an allowance for the expectation of house price growth above RPI (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 3.8% (2018: 3.8%), with a volatility assumption of 13% per annum (2018: 13%). The derivation 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. Voluntary redemptions Assumptions for future voluntary redemption levels are based on the Group’s recent analyses and external benchmarking. The assumed redemption rate varies by duration and product line between 0.5% and 4.1% for loans written by JRL (2018: 0.7% and 3.8%) and between 0.6% and 2.0% for loans written by PLACL (2018: 0.9% and 3.2%). The real world assumptions used include future property growth and future property price volatility. Principal assumptions underlying the calculation of loans secured by residential mortgages
Powered by FlippingBook