The share price of Just Group has been in freefall since 24 July following a statement by the firm about proposals by the Prudential Regulation Authority (PRA) which, if implemented, would result in a ‘reduction in its regulatory capital position’.
The proposals concern the valuation of the ‘no negative equity’ guarantee embedded in equity release mortgage assets. The PRA is fretting that firms are undervaluing them. But how much is the undervaluation, and how much would the reduction in capital be? Analysts have been scratching their heads for weeks. One estimated a loss of no more than £50m, another thought it could be as much as £500m.
Nobody seems to know. How large is the impact, and why is it so difficult to tell from regulatory reports, given the more transparent, risk-based and dynamic era of supervision ushered in by the Solvency II insurance capital regime?
Relevant, clear and useful
Let’s turn to Just’s Solvency and Financial Condition Report for 2017. This is an EU mandated report whose primary purpose is to provide relevant, clear and useful information about the solvency and financial condition of the firm. The report states, p.54:
As at 31 December 2017, the Board considers the Matching Adjustment in the Group’s balance sheet in respect of LTM notes satisfies the principles of SS3/17 giving rise to an implied property volatility of 12% and a positive deferment rate of 0.5% on a risk neutral basis.
Now this is possibly ‘relevant’ and ‘useful’, but in what way clear? What is Matching Adjustment? What is risk neutral, what is an ‘LTM note’, and what in particular is a deferment rate? I shall cover some of these topics in later posts, but, in brief, the matching adjustment is a way of creating equity on a company’s balance sheet by manipulating the discount rate for annuities and other forms of pension debt. Raising the rate above risk free reduces the value of debt, and so automatically increases the equity in the firm, on the principle that assets must equal liabilities (i.e. debt plus equity). An ‘LTM note’ is a way of securitising ERM assets into separate tranches so that the annuitants hold the senior tranche, and the annuity provider holds the junior (risky) tranch. Never mind that the annuitants are exposed to the provider as well as the senior tranche, but that is for later posts.
The item to focus on here is the deferment rate.
One rate to bind them all
The deferment rate is a discount rate that applies to the spot price of an asset, determining how much you would pay today to take possession of the asset in the future. It is the basis for calculating the forward price, namely the price you would agree now to pay in the future to take possession in the future. The forward price is the main input to the Black 76 option formula used to price the no negative equity guarantee.
In valuing the forward, the buyer would expect to be compensated for the loss of income on the property during the deferment period, and the seller would want to receive interest until the date the cash was settled. Thus the forward rate f is equal to the interest rate r minus the deferment rate q.
f = r – q
Note that both buyer and seller are indifferent to the forecast growth in the asset, although firms seem to have got this wrong. The PRA has said over and over again that HPI assumptions are irrelevant to the pricing of ERMs.
… the PRA’s view is that firms should not use assumptions about future house price growth in excess of the risk free rate as a basis for reducing value of the NNEG and inflating the MA benefit claimed … The PRA considers that the extent to which that price is higher than the deferment price does not depend on views on future house price growth, because both immediate and deferred possession give exposure to future house price growth: the only difference is the value attributed to possession during the deferment period (CP 13/18, p.5).
In plain English, firms are using the wrong method for valuing the NNEG. They are using house price inflation to compute the forward rate, the PRA says they should be using the risk free rate minus the deferment rate.
So the question is, what is the impact on Just of changing to a deferment rate assumption of 0.5%? We need to work out (1) what deferment rate they must have been using before the change and (2) the sensitivity of their balance sheet to such a change.
Implied deferment rate
The sensitivity is easy to determine, as the firm helpfully provide this, saying (ibid) that a 0.25% increase in the implied deferment rate would have an impact of negative c£80m on the balance sheet.
For the deferment rate they were using before the change, the Solvency report offers absolutely no clue, but we can make a rough guess from the firm’s annual report for 2016, p.163:
In the absence of a reliable long-term forward curve for UK residential property price inflation, the Group has made an assumption about future residential property price inflation. This has been derived by reference to the long-term expectation of the UK retail price inflation, “RPI”, (consistent with the Bank of England inflation target) plus an allowance for the expectation of house price growth above RPI (property risk premium) less a margin for a combination of risks including property dilapidation and basis risk. This results in a single rate of future house price growth of 4.25%.
This indicates they are using house price inflation of 4.25% for the forward rate. From the formula above, and assuming an interest rate of 2%, we have
f = r – q = assumed hpi
q = r – assumed hpi = 2% – 4.25% = -2.25%
The previous implied deferment rate is therefore minus 2.25%. This is a difference of 2.75% from the current rate, which is 11 steps of 0.25%, thus (multiplying by the sensitivity) the impact should be 11 x £80m or £880m.
Which is nearly a billion pounds.
Where aren’t they saying this?
According to Just Group’s own published sensitivities the impact of the change seems to be nearly one billion pounds. That’s a large number, but where does it appear on their regulatory report? Why hasn’t it come off their capital? For according to the report, its ‘own funds’, i.e. regulatory capital, actually went slightly up from 2016 to 2017, rather than down by a whopping 1£1bn.
What hasn’t happened to that capital? To be continued.
References
- EIOPA SS on Solvency and Financial Condition Report, 18 December 2017
- Just Group Solvency and Financial Condition Report 2017, published 18 June 2018.
- Just Group business update, 24 July 2018
- Just Group Results for the period ended 31 December 2016, published 10 Mar 2017
- Just notes publication of 13/18, 2 July 2018