5.4 Acquisition method

The acquisition of subsidiaries by PZU Group is settled for using the acquisition method.

In the case of every acquisition transaction, an acquirer is determined as well as the acquisition date being the day on which it obtains control of the acquiree. On the acquisition date, identifiable assets acquired, liabilities assumed and non-controlling interest in the acquiree are recognized separately from goodwill.

All identifiable assets acquired and liabilities assumed are measured at acquisition-date fair value.

In the case of every acquisition, all non-controlling interest in an acquiree are measured at value of a proportional share in fair value of identifiable net assets of the acquiree.

Determining goodwill or gain from a bargain purchase

Goodwill is measured and recognized as at the acquisition date as the difference between:

• the consideration transferred measured at their acquisition-date fair value;
• non-controlling interest in the acquiree, measured as described above;
• fair value of share in capital of the acquired entity owned by PZU Group prior to the acquisition date;
• over the net of the acquisition-date fair value of the identifiable assets acquired and the liabilities assumed.

If the net fair values of identifiable assets acquired and the liabilities assumed exceeds the fair value of payment received, the gain from bargain purchase is recognized in the consolidated statement of profit or loss. Before the gain from bargain purchase is recognized, the reassessment is made to verify if all of the acquired assets and all of the liabilities assumed were correctly identified.

In the period of maximum 1 year from taking the control, PZU Group may retrospectively adjust provisional fair values of assets and liabilities recognized as at the acquisition date, so as to reflect new information obtained concerning the facts and circumstances at the acquisition date, which, if known, could have an effect on measurement of these assets and liabilities. Such adjustments are charged directly to the recognized goodwill or profit from one-off acquisition.

Intangible assets

Intangible assets acquired on business combination transactions are recognized at fair value as at the acquisition date. Fair value of intangible assets reflects expectations as to the probability that the entity achieves economic benefits from a given asset. Fair value of intangible assets is determined in the following manner:

• trademark – using the relief-from-royalty method, based on potential savings on the license fees the entity will not be charged with being the owner of the trademark (i.e. the present value of future license fees). Determining the market rate of license fees involves an analysis of license rates for using trademarks applied between unrelated parties in a comparable market segment. Then, hypothetical license payments are established, defined as the product of the adopted license fee and the value of estimated revenue from sales. In order to calculate the net income from license, license payments should be reduced by the hypothetical amount of income tax. To the calculated net cash flows the potential tax savings on tax depreciation of a trademark should be added, the so-called TAB (tax amortization benefit). Finally, the indicated cash flows are discounted using the discount rate reflecting, among others, the typical risk of a given trademark;
• broker and customer relations – using the MEEM method (multi-period excess earnings method) based on the present value of future profits generated by the respective relations. Fair value is determined based on discounted future cash flows arising from the additional revenue generated by the company owning a given intangible asset as compared to the revenue generated by the company if it did not hold such an asset. The relations are identified along with the projected period of their duration (using an appropriate churn rate and applying the so-called Weibull’s curve); revenue and costs related to individual relations are projected. The identified and calculated CAC (contributory asset charge), including retaining capital ratios at levels required by supervisory authorities, fixed assets, organized workforce, trademark and other intangible assets, is applied to cash flows after tax. Should there be any tax structures in place allowing an average market participant for tax depreciation of the relations, the TAB should be included in its measurement;
• present value of future profits (VIF, value in force) – as a potential excess of book value of technical provisions over their fair value, including deferred acquisition costs. Fair value of technical provisions is determined as the expected value of nominal cash flows projected using actuarial methods appropriate for particular provision types, including the specific nature of a given portfolio and market trends. The expected value of future cash flows is determined by discounting projected nominal cash flows using discount rates established on the basis of the risk-free rates curve. When forecasting nominal cash flows, the following factors are considered: the likelihood of occurrence and the value of future claims, claim handling costs (both direct and indirect) and – in the case of unearned premiums reserve – also administrative expenses related to insurance portfolio management. The estimates take into account reinsurer's share resulting from binding reinsurance treaties. The relevant probability of an event occurrence is estimated using statistical and actuarial methods, whereas the cash flow value results from relevant provisions of insurance contracts and actuarial analysis;
• IT systems – gross value of purchased systems was specified as the amount of financial expenditure made to purchase them. For systems developed internally, their gross value is established at the amount of capitalized expenditures made to develop them. Values specified in such a manner are adjusted by the existed horizon of operational use of the system which is determined as a percentage parameter of duration of the system’s lifecycle in relation to the projected period of its operational use. Fair value of systems under construction is adjusted to the amount of expenditures made on functions for which the development works have not been completed or which have not been tested, and thus are not ready for production delivery;
• customer relations concerning clients holding CDIs (core deposit intangible) – as a current value of the difference between the borrowing costs of CDIs and alternative borrowing costs (including interest and administrative expenses) which would be incurred by the bank if it did not have a portfolio of such accounts. The value of a CDI is measured with the favorable source of funds method, which derives from the expense and income methods. In this method, forecasts are made for the retention level of CDIs (with the application of so-called Weibull curve), average opening balance and the number of accounts which have to be included in the measurement are estimated and net balance of deposits is calculated (adjusted by the retention ratio and unstable part of the deposit base). On the basis of the requirements for the compulsory provision and interest and administration expenses less commission income from accounts the cost of acquired deposits is calculated. Next, on the basis of interest rate benchmarks, the alternative borrowing cost is estimated. In the next step, the difference between the alternative borrowing costs and the cost of acquired accounts, which is discounted using the acceptable return rate, is calculated. In the measurement of CDI no tax amortization benefit (TAB) was included.

The discount rate applied to measure the intangible assets reflects the time value of money and risks related to expected cash flows in the future. It is calculated based on the expected return from the best alternative investment as compared with the measured investment. The rate indicates the lowest acceptable return from an asset by the investor in such a manner that the return rate achieved by the investor is at least equal to the best available investment alternative. The return from alternative investment must be comparable in terms of value, time and certainty.

Cost of equity (CE) is estimated as at the acquisition date in accordance with the CAPM (Capital Asset Pricing Model) model: CE = RF + ERP x β + SP + SR, where RF stands for risk-free rate, ERP – market risk premium, β – measure of systematical risk borne by the equity holders, including the operational and financial risks related to a given type of activity, SP – low capitalization premium, SR – specific premiums.

Credits and loans granted to clients

Fair value valuation of the loan portfolio was performed with the income method which consists in discounting future cash flows from the valuated part of the loan.

• Performing loans – (individual clients) – current value of cash flows is determined as a sum of contractual installments of principal amounts and interests (in accordance with contractual margin rates and non-payable part of principal amount), adjusted by the credit risk and pre-payments, wherever significant. The following is applied to discount cash flows:

- average basic reference rate calculated on a basis of daily quotations for appropriate basic rates (WIBOR, LIBOR) for the period of three months preceding the date, plus an effective interest rate margin. Average values weighted with the non-payable principal amount for current sales were applied as reference effective interest rates. Effective interest rates were divided by currency, product group and client scoring; or

- market interest rates obtained from the yield curve build based on the rates of the financial market, FRA contracts, and IRS rates for all currencies adjusted by liquidity margin used in the system of transfer funds (STF), margin on capital cost measured with application of the aforementioned CAPM model and margin on portfolio credit service costs estimated by business units;

In order to include in the model the prepayments for credit installments made by the clients, the model of economic life cycles was applied. The prepayment ratio was included only in the case of the loans and mortgage loans, while it was considered irrelevant with respect to other products.

• Performing loans (business clients) – the assumptions used in the measurement of business clients portfolio are the same as in the case of individual clients portfolio, with the exceptions described below:

- in determining reference effective interest rate the size of the enterprise is taken into account instead of client scoring;

- prepayment ratio is not taken into account, while it was considered irrelevant.
For the clients largest in terms of the total value of non-payable equity, an individual analysis of price conditions (taking into consideration a potential rating change) which would be offered to the same clients on the measurement day is performed. On its basis it was concluded that in the case of the business clients, the price conditions of the offered products would not significantly differ from the price conditions determined in the concluded agreements. Besides the individual assessment of the largest clients, an analysis of the effective interest rates for the whole business clients portfolio was performed. The analysis showed that the margins applied to the portfolio are stable and that the average margins of the whole portfolio do not differ from the margins achieved on the current sale.

• Credits with no determined payment schedules – it was assumed that the fair value is equal to their carrying amount. It resulted from the assumption of possible immediate repayment of such liabilities (overdrafts, credit cards of corporate clients, commercial open-end credit, factoring);
• Non-performing loans – fair value was established on the basis of expected recoverable flows of capital and interests, determined by application of the following parameters: PD – default probability of a client from the flow date, and LGD – loss in the case of default upon the flow. Calculated recoverable cash flows were discounted similarly to performing loans.

Property, plant and equipment

Property is measured using the income method, whereas other tangible assets – using market or cost method.

Technical provisions

The value of technical provisions is recognized in the carrying amount. The difference between fair value and the carrying amount of technical provisions is disclosed as intangible assets (future profits from concluded insurance contracts).

Liabilities arising from unfavorable (generating charges) lease agreements

In order to determine the fair value of the liabilities arising from unfavorable (generating charges) property lease agreements, an analysis of standard market lease rates in individual locations, as at the time of determining the fair value, was performed. Next, the rates were compared with the amounts arising from the concluded lease agreements. Due to the high number of agreements, the analysis was conducted on an agreement sample for agreements concluded in different years. Then, the differences found in the analyzed sample were extrapolated to the whole portfolio of agreements concluded in a given year. While determining the fair value, no lease agreements renegotiations or terminations performed before the date set in the agreement were assumed (especially in the cases of the agreements in which the conventional rental rate differed from the estimated market rate). Based on the lease area, localization of the property, lease period and difference between market rate and actually paid rate, cash flows, including their moment of occurrence in the projected period, were determined. The cash flows determined in such a way were discounted as at the date of the valuation at risk-free rate. The value of the discounted cash flows is the fair value of the liabilities as at the moment of the valuation.