5.2 Amendments to the applied IFRS

5.2.1. Standards, interpretations and amended standards effective from 1 January 2017

The following changes in standards were applied to the consolidated financial statements.

5.2.2. Standards, interpretations and amended standards not yet effective

5.2.2.1. IFRS 9 – Financial Instruments

IFRS 9 Financial Instruments, published by the IASB in July 2014 and approved by the European Commission in November 2016, replaces IAS 39 Financial Instruments: Recognition and Measurement. IFRS 9 is effective for annual periods beginning on or after 1 January 2018. Earlier application is permitted.

In October 2017, the IASB published amendments to IFRS 9 entitled Prepayment features with negative compensation.

The amendment is effective for annual periods beginning on or after 1 January 2019. Earlier application is permitted.

The PZU Group will apply IFRS 9 as of 1 January 2018, in the version published in July 2014 and it will take advantage of the possibility of earlier application of the above amendments to IFRS 9.

IFRS 9 sets out new requirements for the classification and measurement of financial instruments, impairment of financial assets and hedge accounting.

Estimated impact of the application of the new standard

The PZU Group is still analyzing the practical aspects of applying the IFRS 9 requirements in the context of the consolidation of receivables from loans taken over in the Pekao and Alior Bank acquisitions, including the initial fair value measurement under IFRS 3 and, in particular, the allocation of impairment losses to stages as at the date of obtaining control over Pekao and Alior Bank. In addition, the final purchase price allocation of the Pekao acquisition will be important for the assessment of the cumulative effect of the application of IFRS 9 on the PZU Group’s consolidated equity.

Accordingly, the calculation of cumulative effect of the application of IFRS 9 on the PZU Group’s consolidated equity has not yet been completed.

Below we present an estimate, prepared as at 1 January 2018, of the effect that the application of IFRS 9 would have on the selected components of the PZU Group, i.e. mainly on the insurance companies and on the banks – the Pekao Group and the Alior Bank Group (their data were presented based on their consolidated financial statements). The effect of changes in impairment losses under IAS 39 on credit risk losses under IFRS 9, as shown below, will be partially offset by expected credit losses already recognized in the consolidated financial statements as a decrease in the value of loan receivables of the Pekao Group and the Alior Bank Group, in the part in which they constitute an element of fair value measurement recognized at the moment PZU obtained control over the banks.

Classification and measurement of financial assets

This standard introduces a new approach to the classification of financial assets, which depends on:

• the entity’s business model for managing the financial assets and
• the contractual cash flow characteristics of the financial asset.

According to IFRS 9 financial assets are classified for valuation at:

• amortized cost;
• fair value through profit or loss;
• fair value through other comprehensive income.

The instruments are classified as at the time of application of IFRS 9 for the first time or at the time of recognition of the instrument. The classification may only be changed in very rare cases when the business model changes.

Business models

The PZU Group has evaluated the business models in which financial assets are managed and management information is provided. This analysis included, among others:

• how the performance of the business model and the financial assets held within that business model are evaluated and reported to the entity's key management personnel;
• the risks that affect the performance of the business model (and the financial assets held within that business model) and, in particular, the way in which those risks are managed.

Financial assets held for trading and those that are managed and evaluated at fair value will be measured at fair value through profit or loss because they are not held for the purpose of obtaining only contractual cash flows, or for both the purpose of obtaining contractual cash flows and selling financial assets.

SPPI test

In order to evaluate whether contractual cash flows consist of solely payments of principal and interest (so called the SPPI test), a special test is performed. The principal amount is defined as the fair value of the financial asset at initial recognition. Interest consists of consideration for the time value of money, for the credit risk associated with the principal amount outstanding during a particular period of time and for other basic lending risks and costs, as well as a profit margin.

The SPPI test examines whether a financial asset contains contractual terms that could change the timing or amounts of contractual cash flows so that the condition of obtaining solely payments of principal and interest would not be met. In making its evaluation, the PZU Group takes the following into account:

• conditional events that could change the amounts and timing of cash flows;
• factors increasing interest;
• terms of prepayment and extension;
• terms limiting the right to obtain cash flows;
• factors that modify the time value of money, e.g. periodic resets of the interest rate.

Financial assets measured at amortized cost

A financial asset is classified as financial asset measured at amortized cost if both of the following conditions are met:

• the financial asset is held within a business model whose objective is achieved by holding financial assets in order to collect contractual cash flows,
• it passes the SPPI test – the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

These conditions are met by the financial assets classified according to the current IAS 39 as loans and receivables (of which most credit receivables from clients) and financial assets held to maturity, except for the financial assets, for which it was resolved after an analysis that their terms may result in cash flows that are not solely payments of principal and interest on the principal amount outstanding.

Financial assets measured at amortized cost also include purchased financial assets impaired due to credit risk. Such financial assets were acquired in connection with the merger with a separate part of Bank BPH in 2016 and Bank Meritum in 2015. As a result, loans and debt securities (treasury bonds) of an investment nature were classified as measured at amortized cost. Under IAS 39 provisions, which were applied until 31 December 2017, the items were classified respectively as loans and receivables, financial assets available for sale and financial assets held to maturity.

An assessment was also made of the business model for investment securities, which are mostly held to obtain cash flows and for sale, as a result of which it was concluded that it was common practice in some of these securities to hold them to obtain cash flows and the intentions with respect to them had not changed. Therefore, it was concluded that the appropriate business model for these securities is a model whose objective is achieved by holding financial assets to collect contractual cash flows and accordingly they were reclassified to assets measured at amortized cost. Previously, these securities were classified as available for sale and measured at fair value through equity.

Financial assets measured at fair value through other comprehensive income

Financial assets are measured at fair value through other comprehensive income if both of the following conditions are met:

• the financial asset is held within a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets,
• it passes the SPPI test – the contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

These conditions are satisfied in particular by the debt instruments, which under IAS 39 were classified as financial assets available for sale.

Since some receivables from clients on account of loans and corporate and municipal securities were classified into a business model whose objective is achieved by both collecting contractual cash flows and selling financial assets, these loans will be measured at fair value through equity. Before applying IFRS 9, these items were measured at amortized cost in accordance with IAS 39.

In connection with the possible sale of some assets from the portfolio of securities previously held to maturity, they were reclassified to fair value through equity, because the relevant business model for these securities is a model whose objective is achieved by both collecting cash flows and selling financial assets. Before applying IFRS 9, these items were measured at amortized cost in accordance with IAS 39.

This category of financial assets also includes equity instruments, for which an irrevocable designation has been made to be measured at fair value, with subsequent changes in fair value recognized in other comprehensive income.

Financial assets at fair value through profit or loss

This category includes other financial instruments that do not meet the conditions for being classified as financial assets measured at amortized cost or fair value through other comprehensive income. This pertains in particular to the following financial assets:

• financial assets designated at fair value through profit or loss,
• financial assets classified under IAS 39 as held for trading,
• derivatives,
• participation units that are not equity instruments and to which the SPPI condition does not apply, which solely payment of principal and interest, classified under IAS 39 as financial assets available for sale,
• financial assets that have not passed the SPPI test - for which contractual terms result in cash flows not being solely payments of principal and interest,
• financial assets held within a business model other than the one whose objective is to hold financial assets in order to collect contractual cash flows or both to collect contractual cash flows and to sell financial assets,
• equity instruments that, in accordance with IAS 39, were classified as available for sale and measured at fair value through equity but not irrevocably designated as at fair value through equity,
• loan receivables from customers for loans under which contractual cash flows are not solely payments of principal and interest due to financial leverage increasing the variability of contractual cash flows. This applies mainly to student loans, loans with subsidies from the Agency for Restructuring and Modernization of Agriculture and some corporate exposures. Before applying IFRS 9, these items were measured at amortized cost in accordance with IAS 39.

Classification and measurement of financial liabilities

Financial liabilities measured at fair value through profit or loss

Financial liabilities measured at fair value through profit or loss include those instruments that were classified in the same category under IAS 39, in particular:

• derivatives,
• liabilities on borrowed securities (short sale),
• investment contracts for the client’s account and risk (unit-linked),
• liabilities to members of consolidated mutual funds.

Financial liabilities measured at amortized cost

Financial liabilities measured at amortized cost include those instruments that were classified in the same category under IAS 39, in particular:

• deposit obtained by PZU Group’s banks,
• securities issued by banks,
• loans received,
• liabilities on the issue of own debt securities,
• subordinated liabilities
• liabilities under repurchase transactions.

Impairment

IFRS 9 introduces an obligation to recognize not only incurred losses, as in the case of IAS 39, but also expected credit loss (ECL). This means a significant increase in the probability weighted estimates of expected credit loss.

The new impairment model is applied to the following financial assets that are not measured at fair value through profit or loss:

• loan receivables from clients
• debt securities
• lease receivables
• lending commitments and issued financial guarantees (previously impairment losses were recognized in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets).

For debt assets measured at amortized cost and at fair value through other comprehensive income, impairment is measured as:

Lifetime ECL are the expected credit losses that result from all possible default events over the expected life of a financial instrument.

12-month ECL is the portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.

The Group measures the loss allowance at an amount equal to lifetime ECL, except for the following instruments, for which 12-month ECL is recognized instead:

• debt securities that have low credit risk at the reporting date. Low-risk debt securities are those securities that have been assigned an external investment-grade rating,
• other financial instruments for which credit risk has not increased significantly since initial recognition.

Change of the approach to calculation of impairment losses will have significant consequences in the case of modelling of the credit risk parameters and final amount of the charges made. The loss identification period and IBNR charge will no longer be used. The charge will be calculated in three categories:

• stage 1 – stage with low credit risk – 12-month ECL will be recognized;
• stage 2 – the portfolio in which a significant increase of credit risk occurs – lifetime ECL will be recognized;
• stage 3 – impaired loans – lifetime ECL will be recognized.

The impairment loss calculation method also impacts the method of recognizing interest income – for stages 1 and 2 interest income will be determined on the basis of gross exposures, and in stage 3 on the net basis. If credit risk increases significantly (stage 2) then the expected credit losses will be recognized earlier, which will contribute to higher impairment losses and consequently affect the financial result.

The PZU Group recognizes the cumulative changes in lifetime ECL since initial recognition as a loss allowance for ECL from purchased or originated credit-impaired financial assets (POCI).

Calculation of PD and LGD parameters

PZU Group uses the following parameters to estimate loss allowances:

• Probability of Default (PD) – probability of default of a counterparty over a specified time horizon,
• Loss given Default (LGD) – loss given default, expressed as a percentage of the total exposure in case of a counterparty’s insolvency.

For issuers and exposures that are externally rated, PDs is assigned on the basis of the average market default rate for the rating classes concerned. First, the internal rating of an entity/issue is determined in accordance with the internal rating methodology. The tables published by external rating agencies are used to estimate average PD.

The Moody’s RiskCalc model is used for issuers of corporate bonds and corporate loans, for which no external rating is available. The EDF parameter (expected default frequency) is used to estimate PD. When estimating lifetime PD for exposures with maturity above 5 years (in the RiskCalc model, the forward EDF curve refers to a 5-year period), it is assumed that in subsequent years PD is constant and corresponds to the value determined by the model for the 5th year.

For issuers of corporate bonds and corporate loans, 12-month LGD is determined based on the Moody’s RiskCalc model (LGD module). When estimating lifetime LGD for exposures with maturity above 5 years, it is assumed that in subsequent years LGD is constant and corresponds to the value determined by the module for the 5th year.

If a credit rating agency has allocated a separate recovery rate to the instrument concerned then this parameter is used. For a given RR parameter the formula: LGD = 1-RR is applicable.

Where the RiskCalc model cannot be used to estimate LGD levels and where the instrument does not have LGD awarded by an external rating agency then the average RR should be used, based on market data (properly differentiating for the corporate and sovereign debt class) from external rating agencies, i.e. Moody's, Standard&Poor's or Fitch, using the following formula: LGD = 1-RR. When lifetime LGD must be estimated, the value of this parameter is assumed to be constant. The degree of subordination of debt is taken into account when selecting data for LGD.

Change in credit risk since initial recognition

At each reporting date, the PZU Group shall assesses whether the credit risk on a financial instrument has increased significantly since initial recognition. When making the assessment, the PZU Group should use the change in the risk of a default occurring over the expected life of the financial instrument instead of the change in the amount of expected credit losses. To make that assessment, the Group compares the PD for the financial instrument as at the reporting date with the PD as at the date of initial recognition and consider reasonable and supportable information, that is available without undue cost or effort.

It is assumed that the credit risk on a financial instrument has not increased significantly since initial recognition if the financial instrument is determined to have low credit risk at the reporting date. The PZU Group assumes that financial instruments have low credit risk at the reporting date even if it has an external investment-grade rating.

For financial instruments, the PZU Group assesses whether credit risk has increased significantly by comparing:

• lifetime PD at the reporting date, with
• lifetime PD estimated at the time of initial recognition.

The PZU Group regularly monitors the effectiveness of the criteria used to identify a significant increase in credit risk, in order to confirm that:

• the criteria allow for identification of a significant increase in credit risk before the impairment of the exposure occurs,
• the criteria do not coincide with the 30-day past due period,
• the average time between identifying a significant increase in credit risk and impairment is reasonable,
• exposures are generally not transferred directly from stage 1 (12-month ECL) to stage 3 (impairment)
• there is no unreasonable volatility of allowances for expected credit losses resulting from transfers between 12- month ECL and lifetime ECL.

Hedge accounting

Upon first application of IFRS 9 it is possible to opt to continue application of the hedge accounting requirements in accordance with IAS 39 instead of section 6 of IFRS 9. The PZU Group has made a decision to continue to apply IAS 39 to hedge accounting. However, in respect to hedge accounting disclosures, the Group will apply IFRS 7 Financial Instruments: Disclosures amended by IFRS 9, because the option to choose an accounting policy does not exempt the Group from the application of the new disclosure requirements.

Disclosures

The requirements of IFRS 9 will result in a significant change in the presentation disclosures pertaining to financial instruments. The PZU Group intends to take advantage of the exemption not to restate the comparative data from prior periods in respect to the changes resulting from classification and measurement (including impairment). The differences in the carrying amount of financial assets and liabilities arising from the application of IFRS 9 will be recognized in the “Retained earnings” item.

5.2.2.2. Other standards, interpretations and amended standards issued but not effective:

• Approved by the regulation of the European Commission

• Not approved by the European Commission:

In summary, in the opinion of the PZU Group, the introduction of the above standards and interpretations (except for IFRS 9) will have no material effect on the accounting principles applied by the PZU Group.