Posted on by db

The ermpire strikes back

The equity release lobby has begun to respond to the Adam Smith Institute report. All the indications are they haven’t actually read it. Robert Sinclair of the Association of Mortgage Intermediaries has dismissed the parallel drawn between equity release and the Equitable Life affair, saying that Equitable Life was based on two different scenarios: they were invested badly and there were guaranteed annuities which they couldn’t afford to repay’. Did you say ‘guarantee’, Robert? The summary of the ASI report, i.e. the bit you don’t have to read very far to get to, says ‘This scandal is similar in nature to the Equitable Life scandal of nearly two decades ago – it involves the under-estimation of opaque long-term guarantees’.

Sinclair adds: ‘The risk is the gap between the current valuation and the longevity risk which is a judgement on how much house prices rise.’ He clearly hasn’t read either the ASI report, or the PRA’s own consultation document on equity release, CP 13/18, for neither is about risk management, but read on.

Value versus risk
The Equity Release Council also mentions the issue of risk management, saying that media-reports-about-the-report raise the question whether there are enough precautions about people living longer or house prices falling. ‘Managing risk is fundamental to what the equity release and insurance industries do’. Possibly, but the problem of equity release is not inadequate risk management, but incorrect valuation.

An analogy may help. I used to manage investments for clients, so if I invested all their money in the FTSE index, I was taking a risk on their behalf. I needed to ensure that managing risk was fundamental to my position, that it matched their risk appetite, that I had made some quantitative study of how much the FTSE was likely to draw down over their investment horizon and all that good stuff. I would also give clients some kind of best efforts estimate of how much the position might perform over the risk free rate. Not promise, mind you, for there always have been strict rules about that, but give some indication. Investment salesmanship is all about the tricky art of giving indications or suggestions without promises or guarantees. But suppose I was so confident in my investment ability that I decided to value client positions on the basis that my predictions had already been achieved? Suppose I was selling the investment portfolio at a FTSE value corresponding to 16,000 or 20,000? I think you would say that was illegal, and in the world of investment management you would be correct. There are strict rules around how client money is managed.

But what the ASI report is saying (and as it happens also the PRA consultation), is not that equity release guarantees have been risk managed badly. They are saying unequivocally that they have been incorrectly valued. The valuation of the put option which models the guarantee depends on the deferment price of the residential property, i.e. the price you would pay now to receive the property in the future. That price must be lower than what you would pay to receive it now. Yet the PRA says (CP 13/18 p.8) that it has ‘seen approaches’ equivalent to assuming a negative deferment rate, i.e. where you would pay more to receive the property later, which is obviously wrong. Imagine paying a tenant money to live in your house for 20 years!

The ERC also mentions how the Solvency II regime is ‘regarded by many as having the most rigorous and sophisticated regulatory requirements in the world’, and quotes Sam Woods at the 11 July 2018 Treasury Select Committee hearing, saying that equity release mortgages ‘play an important role and will play an increasingly important role’. Clearly so, but this suggestion insinuates that the PRA and the ASI are somehow on different sides of the valuation question. There is likely no other point of comparison between the two organisations, but the option formulas given on p.27 of the ASI report, and on p.20 of the PRA consultation paper are mathematically identical. To spell it out, both organisations are saying the valuation is wrong, and both give identical versions of what the right valuation should be.

Cheeky!
It is also somewhat cheeky of the ERC to selectively quote Woods, given the rest of what he and David Belsham have to say about equity release. The full transcript is linked below, but Woods says ‘there’s a variety of practice in the industry’, i.e. some firms are valuing the guarantee wrongly, and ‘there will be some people with different positions’, i.e. some firms are really valuing it wrongly. He adds ‘This needs to be properly recognised by firms, and effectively all firms brought up to a suitable minimum level’, i.e. all firms need to value it correctly. David Belsham adds ominously ‘I would refer you back to the Equitable’.

Did you say ‘Equitable’, @Robert Sinclair?

References