14. Interest income and expense

Interest income and expenses comprise interest, including premiums and discounts in respect of financial instruments measured at amortized cost and instruments measured at fair value. Interest income includes interest income on hedging derivatives. Interest income and expenses also include fees and commissions received and paid, which are deferred using the effective interest rate and which are taken into account in the measurement of the financial instrument, including the costs of employee bonuses to the extent that relate directly to selling credit products.

Interest income and expense is recognized on an accruals basis using the effective interest rate which discounts the estimated future cash flows throughout the life of the financial asset or financial liability to the carrying amount in respect of assets and to amortized cost in respect of financial liabilities, with the following exception:

• purchased or originated assets impaired due to credit risk (POCI). Interest income on POCI assets is calculated on the net carrying amount using the effective interest rate adjusted by credit risk recognized over the life cycle of the asset;
• financial assets which were not POCI assets, impaired due to credit risk, which then became credit impaired financial assets. Interest income on POCI assets is calculated on the net carrying amount using the original effective interest rate from the moment of recognizing premises for impairment of the asset.

The calculation of the effective interest rate covers all commissions, transaction costs paid and received by the parties to the contract, and all other premiums and discounts constituting an integral part of the effective interest rate.

Interest income also includes the effect of the settlement of the fair value measurement of financial assets acquired as part of a merger of subsidiaries and the impact of the ruling of the Court of Justice of the European Union on the consumer’s right to lower the cost of the loan in the event of repayment of the loan before the date specified in the loan agreement (note „Litigation”) by reducing interest income, as the estimated difference between the value of the unsettled commission according to the effective interest rate as at the date of the expected early repayment of the loan and the and the settlement of the commission according to which the Bankreimburses the commission. The estimate is based on historical prepayment dates and probabilities.

Due to the fact that the Group offers insurance products along with loans, advances and lease products and there is no possibility of purchasing an insurance product from the Group that is identical with regard to the legal form, conditions and economic content without purchasing a loan, an advance or a lease product, the payments received by the Group for the insurance products sold are treated as an integral part of the remuneration for the financial instruments offered.

Remuneration received and receivable by the Group for offering insurance products for the products directly associated with the financial instruments is settled using the effective interest rate method and recognized in interest income and in the part corresponding to the performance of the agency service, if the insurer is a Group company, it is accounted for using the straight line method during the term of the insurance product and is recognized as commission income.

Remuneration is divided into the commission portion and the interest portion based on the proportion of the fair value of the financial instrument and the fair value of the intermediation service to the sum of these two values, in accordance with the relative fair value model comprising a range of different parameters, including the average effective interest rate on the financial instrument, the average contractual and economic (actual) lending or lease period, the average insurance premium amount, the term of the insurance policy, the independent insurance agent’s commission.

Measurement of the fair value of a financial instrument is based on the income-based approach, involving the conversion of future cash flows to their present value using a discount rate consisting of a risk-free rate determined in relation to the average yield on 5-year and 10-year bonds in the past year, the risk premium determined in relation to the annual costs of credit risk and exceeding the credit risk premium, which reflects all other factors that the market participants would take into account in the fair value measurement under the current circumstances.

On the other hand, measurement of the fair value of the insurance intermediation service is based on the market approach, which consists in referring to prices and other information on identical or similar comparable market transactions.

Costs directly attributable to selling insurance products are accounted for in the same manner as the revenue, i.e. as a component of the amortized cost of a financial instrument or on a one-off basis.

The Group makes periodical estimations of the remuneration amount that will be recoverable in the future due to the early termination of the insurance contract based on historical data on premiums collected and refunds made. The provision for future refunds is allocated to the financial instrument and insurance service in accordance with the relative fair value model.

The Group reviews the correctness of the adopted parameters used in the relative fair value model and the ratio of provisions for refunds whenever the Bank becomes aware of the changes in this respect, at least once a year.

The Group may use during the day the funds on the required reserve accounts for current cash settlements on the basis of an instruction submitted to the National Bank of Poland, however, it must ensure that the average monthly balance on this account is maintained in the appropriate amount as specified in the mandatory reserve declaration.