Note 2

2 
  

Key management assumptions
In preparing the financial statements estimates and assumptions are made that could affect the reported amounts of assets and liabilities within the next financial year. Estimates and judgements are continually evaluated and are based on factors such as historical experience and current best estimates of uncertain future events.

2.1 

Credit impairment losses on loans and advances
Performing loans
The group assesses its loan portfolios for impairment at each balance sheet date. In determining whether an impairment loss should be recorded in the income statement, the group makes judgements as to whether there is observable data indicating a measurable decrease in the estimated future cash flows from a portfolio of loans before the decrease can be allocated to an individual loan in that portfolio. Estimates are made of the duration between the occurrence of a loss event and the identification of a loss on an individual basis. The impairment for performing loans is calculated on a portfolio basis, based on historical loss ratios, adjusted for national and industry-specific economic conditions and other indicators present at the reporting date that correlate with defaults on the portfolio. These include early arrears and other early indicators of potential default. These annual loss ratios are applied to loan balances in the portfolio and scaled to the estimated loss emergence period. At the year end, the group applied the following loss emergence periods:
  Average loss  
  emergence  
  period Sensitivity1
  2005 2005
  Months Rm
Personal & Business Banking SA 3-6 110
Corporate & Investment Banking SA 15 27
Rest of Africa 3-18 6
Corporate & Investment Banking International 3 30
    173
1Sensitivity is based on the effect of a change of one month in the emergence period on the value of the impairment.
 
Non-performing loans
Retail loans are individually impaired if amounts are due and unpaid for three or more months. Corporate loans are analysed on a case-by-case basis taking into account breaches of key loan conditions. Management’s estimates of future cash flows on individually impaired loans are based on historical loss experience for assets with similar credit risk characteristics. The methodology and assumptions used for estimating both the amount and timing of future cash flows are reviewed regularly to reduce any differences between loss estimates and actual loss experience. Recoveries of individual loans as a percentage of the outstanding balances are estimated as follows:
  Recoveries as a percentage Impairment loss
  of impaired loans sensitivity1 
  2005 2004 2005 2004
  % % Rm Rm
Personal & Business Banking SA 62 55 19 14
Corporate & Investment Banking SA 41 57 2 4
Rest of Africa 46 9 1 –
Corporate & Investment Banking International 11 1 – –
      22 18
1Sensitivity is based on the effect of a change of one percentage in the value of the estimated recovery on the value of the impairment.

2.2 

Fair value of derivatives
The fair value of financial instruments that are not quoted in active markets is determined by using valuation techniques. Where valuation techniques (for example, models) are used to determine fair values, they are validated and periodically reviewed by independent qualified senior personnel. All models are certified before they are used, and models are calibrated and back tested to ensure that outputs reflect actual data and comparative market prices. To the extent practical, models use only observable data, however areas such as credit risk (both own and counterparty), volatilities and correlations require management to make estimates.
 

2.3 

Impairment of available-for-sale equity investments

The group determines that available-for-sale equity investments are impaired and recognised as such in the income statement, when there has been a significant or prolonged decline in the fair value below their cost. This determination of what is significant or prolonged requires judgement. In making this judgement, the group evaluates among other factors, the normal volatility in share prices. In addition, impairment may be appropriate when there is evidence of a deterioration in the financial health of the investee, industry and sector performance, changes in technology, and operational and financing cash flows.

Had the declines of financial instruments with fair values below cost been considered significant or prolonged, the group would suffer an additional loss of R24 million (2004: R7 million) in its financial statements, being the transfer of the negative revaluations within the available-for-sale reserve to the income statement.
 

2.4 

Securitisations and special purpose entities

The group sponsors the formation of special purpose entities (SPEs) primarily for the purpose of allowing clients to hold investments for asset securitisation transactions and for buying or selling credit protection. The group consolidates SPEs that it controls in terms of IFRS. As it can sometimes be difficult to determine whether the group controls an SPE, it makes judgements about its exposure to the risks and rewards, as well as its ability to make operational decisions for the SPE in question. In many instances, elements are present that, considered in isolation, indicate control or lack of control over a SPE, but when considered together make it difficult to reach a clear conclusion.

The group has consolidated SPEs with assets of R17 747 million (2004: R9 966 million) and profit of R10 million (2004: Rnil). The group has not consolidated SPEs with assets of R250 million (2004: Rnil) and no profit (2004: Rnil) as these entities were not considered to be controlled by the group.
 

2.5 

Held-to-maturity investments
The group follows the guidance of IAS 39 on classifying certain non-derivative financial assets with fixed or determinable payments and fixed maturity, as held-to-maturity. This classification requires judgement of the group’s ability to hold such investments to maturity. If the group fails to keep these investments to maturity other than for specific defined circumstances, it will be required to classify the entire class as available-for-sale. The investments would therefore be measured at fair value and not amortised cost. If the entire class of held-to-maturity investments were tainted, the fair value would increase by R67 million (2004: R357 million), with a corresponding entry in the available-for-sale reserve in shareholders’ equity.
 

2.6 

Income taxes
The group is subject to direct taxation in a number of jurisdictions. There may be transactions and calculations for which the ultimate tax determination has an element of uncertainty during the ordinary course of business. The group recognises liabilities based on estimates of the quantum of taxes that may be due. Where the final tax determination is different from the amounts that were initially recorded, such differences will impact the income tax and deferred tax expense in the period in which such determination is made.
 

2.7 

Financial risk management
The group’s risk management policies and procedures are disclosed in risk management and control starting on Risk management control of the annual report. The repricing analysis on Risk management control - Market risk forms part of the audited annual financial statements.
 

2.8

Long-term insurance contracts – process used to decide on assumptions, changes in assumptions and sensitivity analysis

The value of insurance liabilities is based on best estimate assumptions of future experience plus prescribed margins as required in terms of PGN 104, plus additional discretionary second tier margins determined by the statutory actuary.

The process of deriving the best estimate assumptions relating to future mortality, morbidity, medical, withdrawals, investment returns, maintenance expenses, expense inflation and tax are described below.

Mortality
An appropriate base table of standard mortality is chosen depending on the type of contract and class of business. Industry standard tables are used for smaller classes of business, while company specific tables are used for larger classes.

Investigations into mortality experience is performed annually. The period of investigation extends over the latest three full years for larger classes of business. Investigations relating to smaller classes usually extend over five years in order to gain sufficient credibility of the data.

The results of the investigation are used to set the valuation assumptions, which are taken as an adjustment to the respective standard table.

In setting the assumptions, provision is made for the expected increase in AIDS-related claims. In general, Actuarial Society of South Africa (ASSA) models are used to allow for AIDS-related claims. The practice differs by class of business, however for major classes of business, a basic allowance for AIDS-related deaths is included in the base mortality rates against which annual mortality investigations are conducted. A further discretionary margin is then held using the ASSA2000lite model.

For contracts insuring survivorship, an allowance is made for future mortality improvements based on trends identified in the data and in the continuous mortality investigations performed by independent actuarial bodies.

Morbidity
The incidence of disability claims is derived from industry experience studies, adjusted where appropriate for Liberty Life’s own experience. The same is true for the incidence of recovery from disability.

Medical
The incidence of medical claims is derived from the risk premium rates determined from annual investigations. This is adjusted where appropriate to allow for future expected experience.

Withdrawal
The withdrawal assumptions are based on the most recent withdrawal investigations taking into account past as well as expected future trends. The withdrawal rates are analysed by product type and policy duration. These withdrawal rates vary considerably by duration, policy term and company. Typically the rates are higher for risk type products versus investment type products, and are higher at early durations.

Investment return
Future investment returns are set for the main asset classes as follows:

  • Gilt rate – Effective 10 year rate at the balance sheet date off the yield curve rounded to nearest 0,25 percentage point (2005: 7,5%);
  • Equity rate – Gilt rate plus 2 percentage points as an adjustment for risk (2005: 9,5%);
  • Property rate – Gilt rate plus 1 percentage point as an adjustment for risk (2005: 8,5%); and
  • Cash rate – Gilt rate less 1,5 percentage points (2005: 6,0%).

The overall investment return for a block of business is based on the investment return assumption allowing for the current mix of assets supporting the liabilities.

The pre-taxation discount rate is set at the same rate. For the major classes of business the rate used is 9,0% per annum in 2005 (2004: 9,7% per annum). Where appropriate the investment return assumption will be adjusted to make allowance for investment expenses, taxation and the relevant prescribed margins as per PGN 104.

For annuity and guaranteed capital bond business, discount rates are set at the rate of return yielded by the assets matching the respective business, reduced by an allowance for investment expenses and the relevant prescribed margin.

Expenses
An expense analysis is performed on the actual expenses incurred in the calendar year preceding the balance sheet date. The expenses are split between acquisition, maintenance and non-recurring expenses. The individual annual maintenance cost per policy, which forms the base for future projections, are as follows:
  2005 2004
  Rands Rands
Liberty Life 258 248
Liberty Active 139 154
CAHL – complex 221 2171
CAHL– simple 98 801

The expenses derived from this analysis are adjusted accordingly by an expense inflation assumption to obtain an appropriate expense base assumption to be used in the calculation of the insurance liabilities.

1These figures have been provided for comparative purposes only as Liberty acquired CAHL on 1 April 2005 and the numbers are applicable at 31 March 2005.
 

Expense inflation
 The inflation rate is set at 3,5 percentage points lower than the gilt rate investment return assumption prevailing at the balance sheet date, resulting in a best estimate expense inflation of 4,0% at 31 December 2005.

Taxation
 Future taxation and taxation relief are allowed for at the rates and on the bases applicable to Section 29A of the Income Tax Act at the balance sheet date. Each company's current tax position is taken into account, and the taxation rates, consistent with that position and the likely future changes in that position are allowed for. In respect of capital gains taxation (CGT), taxation is allowed for at the full CGT rate. Provision is made for CGT on unrealised gains/(losses), at the valuation date, at the full undiscounted value.

Correlations
 No correlations between assumptions are allowed for.

Contribution increases
 In the valuation of the liabilities, voluntary premium increases that give rise to expected profits are not allowed for. However, compulsory increases and increases that give rise to expected losses are allowed for. This is consistent with requirements of PGN 104.

Embedded investment derivative assumptions
The assumptions used to value embedded investment derivatives, in respect of policyholder contracts, are set in accordance with PGN 110. The expected investment return assumptions are set to be consistent with the Financial Soundness Valuations, while also taking account of the yield curve at the valuation date. Both implied market volatility and historical volatility are taken into account when setting volatility assumptions. Correlations between asset classes are set based on historical evidence.

Changes in assumptions
 Modelling and other changes were made to the valuation to realign valuation assumptions with expected future experience. These changes resulted in a net increase in policyholders’ liabilities of R14 million in 2005.

The primary items were:

  • a reduction in the inflation gap from 4,0 percentage points to 3,5 percentage points, increasing the liability by R131 million;
  • setting up a liability in anticipation of the move from a real world model to a market consistent model for the calculation of the liabilities in respect of minimum investment guarantees, increasing the liability by R340 million;
  • an adjustment to policyholders’ liabilities in respect of prepaid commission, which was previously recognised as a current asset. This resulted in a decrease of the policyholders’ liability in respect of insurance contracts of R1 013 million (2004: R1 096 million). The basis change is offset by a reduction in the current asset;
  • a change in the economic valuation assumptions to re-align the economic assumptions with expected future experience, resulting in an increase of R653 million. It should be noted that the majority of this change is offset by a corresponding change in the value of the relevant matching assets;
  • the demographic experience assumptions were adjusted to reflect expected future experience, amounting to a decrease in the liability of R37 million; and
  • the balance of other modelling changes amounted to a decrease in liability of R60 million.

In addition, an allowance has been made for the adjustment to early termination values in terms of the Statement of Intent.

On 12 December 2005 a Statement of Intent was agreed between the Minister of Finance and the long-term insurance industry. In terms of the statement, minimum standards will be implemented on early termination values of retirement annuity contracts, as well as certain other contracts. Full provision has been made for the cost of these adjustments. The following adjustments amounting to R359 million are included as a basis change in the liabilities under insurance contracts:

  • an amount of R172 million in respect of the retrospective cost over the period 1 January 2001 to 31 December 2005.
  • an amount of R187 million in respect of the prospective cost of the adjustment to termination values and rates on in-force policies.

Sensitivity analysis
 Shown in the table below are the sensitivities of the value of insurance liabilities disclosed in this note to various changes in assumptions used in the estimation of the insurance liabilities. Each value is shown with only the indicated assumption being changed and holding all other assumptions constant. In practice, this is unlikely to occur, and changes in some of the assumptions may be correlated.

It should be noted that the sensitivities ignore any changes in matched assets. This is particularly relevant to the sensitivity changes in future investment returns.

Change in policyholders’ liabilities
under insurance contracts
                  2005
  Rm
Variable  
Future investment returns reduce by a 15% relative reduction in the valuation rate, with bonus rate changing commensurately 2 265
Assurance mortality and morbidity increase by 10%, annuity mortality decrease by 10% 1 900
Withdrawal rates increase by 10% 172
Maintenance expenses (other than commission) increase by 10% 339
    Expense inflation rate increase by 1% 268