Transcript of the Treasury Select Committee hearing, 11 July 2018, on Equity Release, 15:19:50.
Witnesses: Sam Woods, Deputy Governor for Prudential Regulation and Chief Executive Officer of the Prudential Regulation Authority , Sarah Breeden, Executive Director, International Banks Supervision, Bank of England, and David Belsham, External member of the Prudential Regulation Committee.
15:19:50 Hosie: ‘Let me move on to equity release and the Solvency II consultation paper published 2 weeks ago. We have received correspondence from the Equity Release Council and they say that the proposals, quote ‘lead to excessive prudence for insurers holding Equity Release Mortgages and allowance for risk equivalent to a 25 to 30% immediate fall in property prices and no recovery’. How would you respond to that?
Woods: So, first thing I would say is, this is a consultation, so we have put some views out there we are going to take views on it and I am sure the equity release council will not be shy in giving us those views itself. But as a starting point I don’t consider that what we have put out to be overly prudent and at the heart of what we are saying is that for this product which we think plays an important role and will play an increasingly important role and is a suitable investment for annuity writers as part of a diverse portfolio, but for this product there is a particular challenge in valuing this thing called the no negative equity guarantee which is the thing that says to a customer ‘you can put back the house on us’ or your descendants do it, [and] if it turns out that the rolled up value of the loan is higher than the value of the house at that point, you can immediately see that this is an enormously complicated financial instrument and therefore there are a variety of views about how you should value it. [15:21:19] Our particular focus is on making sure that the valuation of that does not leave out risks to which the insurance company is exposed, such as house price inflation is above [below?] the risk free rate which we regard as a risk to which an insurance company is exposed. Because if those things are left out, the risk is that the Matching Adjustment on the other side of the balance sheet is too big, and therefore firms don’t have enough capital, and that is what we are trying to get a handle on, and there is going to be a vigorous debate.
[15:21:48] Hosie: You say ‘get a handle on it’, but again I know we’ve been told the Matching Adjustment is not market consistent, so it’s incompatible with the principles and formula proposed by yourselves in CP 13/18. It’s a technical error that I know has been explained, but the frustration that we are told is ‘we know this, we’ve been told this, but nothing seems to have been done’. So where are we with the industry saying, you’ve got the Matching Adjustment wrong, where are we with this?
[15:22:23] Woods: Well, we simply don’t agree that it’s wrong. The problem we’ve got on equity release is that the position is insufficiently clear about how you should deal with this stuff in the Solvency II framework, and as a result there’s a variety of practice in the industry. Another motivation for our consultation is the competition one in that we see that variety of practice and we are not sure there is a level playing field. What I can tell you is, the calibration we’ve put forward is well within the span of current industry practice. So I think that the more prudent end of current industry practice is not different from what we are suggesting, but inevitably there will be some people with different positions, and those with a different one are likely to give us some quite forthright evidence in our consultation.
[15:23:07] Belsham: The key thing is this no negative equity guarantee which is effectively a put option on residential housing. In fact, on the customer’s individual house. And so you have firms effectively writing put options. Some of them are very good at it. They have recognised it’s a put option, they value it as a put option, so they will use Monte Carlo techniques and stochastic models, they will use a variation on the Black Scholes formula with some market consistent assumptions. The difference between that and the Matching Adjustment is that the Matching Adjustment is available as a way firms can earn a liquidity premium on fixed interest assets, and it’s reasonable to capitalise that liquidity premium, because on a corporate bond the coupons are fixed, the maturity value is fixed, so you can anticipate in advance exactly what cashflows you can get, and insofar as you are being paid for the liquidity premium it’s reasonable to capitalise that up front. It’s how the industry has worked, and we have accepted that approach. Where you have a property, you are fully exposed to a fall in property value. If the residential market drops, there’s not a ‘pull to par’ that automatically says that by the time you reach the maturity date there will be a redemption. So they are fundamentally different. A corporate bond with cashflows, where the Matching Adjustment was designed to be available and an Equity Release Mortgage with the no negative equity guarantee. If the loan to value is very low then the no negative equity guarantee is not onerous and it very much resembles a fixed interest asset. If it’s on mortgages where the loan to value is material, it will then roll up throughout the life of the loan at maybe 5-6-7% interest rate that’s been charged to the customer, and so you have an option that’s closer to the money throughout its life. And that’s the concern really. This needs to be properly recognised by firms, and effectively all firms brought up to a suitable minimum level. What we are doing is not moving them all, it’s within the range of what firms decide to do.
Hosie: So your argument fundamentally would be that the regulations you have put in place are not dreadfully onerous, they are simply recognising the risks that exist, and that some of the firms are downplaying.
[15:25:30] Belsham: Yes, I would refer you back to the Equitable. They gave onerous guarantees, they valued them on a realistic assumption, and if you value onerous guarantees on a realistic assumption, they won’t cost much. If you value guarantees properly, where you recognise you are giving an option, then you hold a market consistent cost of that guarantee. If Equitable had had a market consistent cost of their guarantee there would not have been a problem with that firm.