RBS 2003 Annual Report Download - page 60

Operating and financial review continued
58
Operating and financial review
Fair value
Securities and derivatives held for trading purposes are
recognised in the financial statements at fair value. In the
balance sheet, trading securities are included within Treasury
and other eligible bills, Debt securities and Equity shares as
appropriate. Positive fair values (assets) of trading derivatives
are included in Other assets and negative fair values (liabilities)
in Other liabilities. Positive and negative fair values of trading
derivatives are offset where the contracts have been entered
into under master netting agreements or other agreements that
give a legally enforceable right of set-off. Gains or losses
arising from changes in fair value are included in Dealing
profits in the profit and loss account.
Fair value is the value at which a position could be closed out
or sold in a transaction to a willing and knowledgeable
counterparty over a reasonable period of time under current
market conditions. Fair values are determined by reference to
observable market prices where available and reliable. Where
representative market prices for an instrument are not available
or are unreliable because of poor liquidity, the fair value is
derived from prices for its components using appropriate
pricing or valuation models that are based on independently
sourced market parameters, including interest rate yield
curves, option volatilities and currency rates.
Securities carried at fair value include government, asset-
backed and corporate debt obligations and corporate equity
shares. Fair value for a substantial proportion of these
instruments is based on observable market prices or derived
from observable market parameters. Determining fair value for
such instruments does not involve significant judgement.
Where observable prices are not available or if a position
could be liquidated only at an unfavourable price or over an
extended period, fair value is based on appropriate valuation
techniques or management estimates.
The Group’s derivative products include swaps, forwards, futures
and options. Exchange traded instruments are valued using
quoted prices. The fair value of over-the-counter instruments is
derived from pricing models which take account of contract
terms, including maturity, as well as quoted market parameters
such as interest rates and volatilities. Most of the Group’s
pricing models do not entail material subjectivity because the
methodologies utilised do not incorporate significant judgement
and the parameters included in the models can be calibrated
to actively quoted market prices. Values established from pricing
models are adjusted for credit risk, liquidity risk and future
operational costs.
The table below analyses the Group’s assets and liabilities carried at
fair value according to the basis on which fair value is determined.
Assets carried at fair value Liabilities carried at fair value
Fair value at 31 Securities Securities
December 2003 purchased Derivatives sold Derivatives
is based on: %%%%
Quoted market prices 99 1 99 1
Internal models 1 99 1 99
100 100 100 100
General insurance claims
The Group makes provision for the full cost of settling
outstanding claims arising from its general insurance business
at the balance sheet date, including claims estimated to have
been incurred but not yet reported at that date and claims
handling expenses. Claims are recognised in the accounting
period in which the loss occurs.
Provisions are determined by management based on
experience of claims settled and on statistical models which
require certain assumptions to be made regarding the
incidence, timing and amount of claims and any specific
factors such as adverse weather conditions. In order to
calculate the total provision required, the historical
development of claims is analysed using statistical
methodology to extrapolate, within acceptable probability
parameters, the value of outstanding claims at the balance
sheet date. Also included in the estimation of outstanding
claims are other assumptions such as the inflationary factor
used for bodily injury claims which is based on historical
trends and, therefore, allows for some increase due to changes
in common law and statute. Costs for both direct and indirect
claims handling expenses are also included. Outward
reinsurance recoveries are accounted for in the same
accounting period as the direct claims to which they relate.
The outstanding claims provision is based on information
available to management and the eventual outcome may vary
from the original assessment. Actual claims experience may
differ from the historical pattern on which the estimate is based
and the cost of settling individual claims may exceed that assumed.
Goodwill
The Group capitalises goodwill arising on the acquisition of
businesses, as disclosed in the Accounting policies. Under UK
GAAP goodwill is amortised and there is a rebuttable
presumption that the useful economic life of purchased
goodwill does not exceed 20 years from the date of
acquisition. The useful economic life of acquired goodwill is
assessed on the basis of the type and diversity of the
business, its location and the markets in which it operates.
Under US GAAP goodwill is not amortised but is subject to
annual review for impairment.
An impairment test is designed to assess the recoverable
amount of an asset or, in the case of goodwill, an operating
segment, by comparing its carrying value with the discounted
value of future cash flows that it will generate. Impairment
testing inherently involves a number of judgmental areas: the
preparation of cash flow forecasts for periods that are beyond
the normal requirements of management reporting, the
valuation of the separable assets of each business whose
goodwill is being reviewed and an assessment of the discount
rate appropriate to the business. Under UK GAAP, impairment
tests are only undertaken in the year following an acquisition or
when there is evidence that impairment might have occurred.
US GAAP requires annual impairment tests that are different
from any UK tests and accordingly they may support a different
carrying value for the asset being tested.