Here is a part transcript of the BBC wireless programme broadcast on Tuesday August 7. Howard Mustoe (journalist) makes a clever segue from the bookie (‘Neil’) at Leicester racecourse, who doesn’t see why he should pay out winnings on a racing cert before the race has actually occurred, to the idea of matching adjustment. I forget who Chris and Anne were.
Transcript
25:40 H: And guess what, something annuity companies have started investing in is equity release. Remember Chris and Anne, and their extension? The equity release provider they used to get their loan is funded by the company that Keith used to buy his annuity. So in short, annuity pensioners like Keith, are providing the cash to lend to equity release customers like Chris and Anne. Overseeing all of this is the Prudential Regulation Authority, which is part of the Bank of England. Its job is to ensure the stability of the companies connecting Keith’s money with Chris and Anne. One person who has worked for the PRA is Dr Dean Buckner, and until May, he worked at the Bank of England, as one of the Authority’s senior technical specialists in the Life Insurance Department. There, he looked at the valuation of products like equity release. Professor Dowd told me I should speak to Dr Buckner because he too was concerned about the way companies were accounting for their equity release products. What worries him is an accounting rule called the Matching Adjustment.
26:40 DB: The purpose of the matching adjustment is effectively to reduce the amount of pension liabilities or debt you have on your balance sheet. So, you know, if it’s ten billion of debt you have valued in a market consistent way, with the matching adjustment you can lower the current value of that debt to something like 8 billion. You have saved 2 billion and by the same token you have created 2 billion pounds worth of equity on your balance sheet.
27:05 H: There are two ways to treat the risky investment on the balance sheet of an insurance company. The cautious approach is to say that risky investments, which are those with high returns, may not yield the expected return, and a company with lots of them on the balance sheet should have more capital to set against the risk. The other is to assume that the predicted returns will come good, and to count some of those returns as capital itself. Known as the Matching Adjustment, it’s the approach regulators have taken with some equity release investments.
27:35 DB: A good analogy might be this. Suppose I go to my bank manager and I want to borrow some money to buy a house and I say, well, I want to borrow at 100% loan to value. I borrow what the house is currently worth. So I’ve got a London house worth £500,000. I say I have no equity, no money, can I just borrow £500,000… what is the bank manager going to say? He’s not going to look upon that too favourably, you would imagine. He wants a bit of equity, some loss absorption which consists of what I put up, my equity. But then I say, well look, house prices have always gone up – everyone knows they’ve always gone up – that house will have gone up 30%, 40% in 10 years’ time, when I repay the mortgage, than it is now, so can we regard that 100% loan to value mortgage as 60 to 70% LTV. You can imagine, you can imagine what the bank manager is going to say to that. But Matching Adjustment is exactly like that. If it’s absurd in the one case it’s got to be absurd in the second case, don’t you think?
H: Under Matching Adjustment the risky investments create capital for themselves, making the balance sheet look healthy. Unrealistically healthy, according to Dr Buckner.
28:40 DB: If you then go on to sell your insurance company, you have then made two billion pounds out of nothing, effectively, via the matching adjustment. If the customer questions that and says, well hang on are all these books correct you say well, you know, look here it’s got a PRA kitemark of approval. The PRA has approved our model.
29:00 H: [racecourse sounds] I tried this idea out at Leicester racecourse with Neil our bookie. He didn’t like it. [To N] ‘What would happen if the rules changed so that the people who make the rules decided that you could pay out for me and a few of my friends if we have this level of certainty’?
N: Well you can’t possibly know it’s really going to win. So there’s absolutely no point in me giving your money before the race, because it might not win. There’s no such thing as a racing certainty. Despite any rules [laughs].
29:25 H: We asked the body which represents the insurance industry, the [ABI] whether they think the Matching Adjustment rules suggest companies are in better financial shape than they actually are. This was their response.
29:40 ABI: Insurance is one of the most highly regulated sectors there is, and has to comply with stringent UK and EU rules. These are specifically designed to safeguard consumers against extreme financial shocks of the type only expected once in 200 years. This means insurers have to hold back funds to ensure they can pay out even in the most extreme scenarios.
H: Dr Buckner, who was a regulator for 8 years, doesn’t share the industry’s confidence.
DB: I think the industry were very keen to get equity release onto the balance sheet in a way that they could apply Matching Adjustment. Clearly they were. And I think the regulator bought into that. I think we can safely say that equity release and Matching Adjustment in general is a method of forward booking profits. I think that’s a fact.
H: So why did you leave the PRA?
DB: Well I was approaching the end of my career. I am older than I seem. That said, I had gone through a long period of some frustration with the slow progress of what seemed to me like elementary financial theory.
H: And that relates to this?
DB: That relates precisely to this. It related to the valuation of equity release mortgages and more generally to matching adjustment.
30:45 H: Matching Adjustment was introduced with new insurance industry rules known as Solvency II, in 2016. Dr Buckner says the main problem is with the way it has been over generously applied here in the UK. He believes that is because the PRA is too prone to lobbying from the industry it regulates, and too compromised by its mission to maintain an industry in good financial health. We put these points to the PRA, but they refused us an interview, merely sending us a statement on the Matching Adjustment.
PRA: The PRA’s approach regarding its application to equity release mortgages has developed significantly. This has been guided exclusively by our statutory objectives of promoting the safety and soundness of firms, policyholder protection and effective competition. Following a review announced in 2015, more robust expectations of firms were published in 2016 and confirmed in 2017. Clearer and more precise tools to determine whether firms are meeting these prudent expectations have been out for public consultation since July 2018. They benefit from experience of Solvency II in practice and the collective expertise within the PRA, in which a plurality of views is actively encouraged when determining policy”.
32:05 H: We contacted all the lenders in the equity release council about Matching Adjustment. Not all of them apply it. It tends to be the bigger ones that do, and all denied they were taking risky financial decisions. Some cited this Prudential Regulation Authority consultation currently under way as a reason for not commenting on air. All said they were abiding by PRA rules. But I asked former insider Dean Buckner, who was an official inside the organisation which drew up the rules, how he felt about his involvement.
DB: Erm. … I feel somewhat ashamed to have been part of this frankly. It’s clearly an instance of regulatory failure. The regulator is there both to protect firms and to protect the general public. The BoE has part of its mission statement to protect the good of the people or something like that. I think it’s a horrible failure of regulation and I’m very sorry about that.