Kevin Dowd 13 August 2018
I welcome the Equity Release Council’s response to my report, “Asleep at the Wheel: The Prudential Regulation Authority and the Equity Release Sector,” which the Adam Smith Institute published last Tuesday, 8 August. The ERC’s response confirms (I presumably, inadvertently) my central point that the industry are not valuing the No-Negative Equity Guarantees (NNEGs)1 in their Equity Release Mortgages (ERMs) properly, and their response does not dispute my second claim that the degree of under-valuation is material. Their response also suggests a remarkable degree of misunderstanding about the regulatory system – one suspects that they are a victim of industry propaganda.
To quote from their response:
Media reports of a publication from the Adam Smith Institute this week have raised questions about the growing equity release market and whether lenders are taking enough precautions to fulfil the NNEG, for example, if people live longer than expected or if economic circumstances change and house prices fall.
Managing risk is fundamental to what the equity release and insurance industries do.
Misleading!
My report does not discuss whether lenders are “taking enough precautions to fulfil the NNEG” nor does it suggest that managing risk is unimportant to what the equity release and insurance industries do.
Instead, my report claims that the approach used by firms to value their NNEGs is not correct and it provides quotes from the firms’ own reports as evidence to support this claim.
While the detail of pricing decisions are [sic] commercially sensitive, common factors in offering [KD: the term “offering” must presumably mean “pricing”] a No Negative Equity Guarantee include three fundamental lines of security:
The first of these is the problematic one:
a prudent view of house price trends with allowances for future uncertainty
I can only interpret this statement as suggesting that companies use a prudent view of house price trends when pricing their NNEGs. This statement sounds reassuring at first sight but the problem with it is that price trends are irrelevant for pricing or valuing the NNEG. The reason is that the NNEG is an option and expected prices/price trends do not appear as inputs into the option pricing equation. So the ERC confirms that firms are pricing their NNEGs using a variable that is irrelevant to correct option pricing and are therefore not pricing their options properly.
Under-valuing the NNEG could make a difference to those who invest in ER firms. If a firm’s NNEG is under-valued by, say, £1 billion, then the firm is carrying £1 billion in unrealized losses and its capital is over-valued by the same amount.
So those who stand to lose from an under-valued NNEG are the investors, such as pension funds – an important point that the ERC fails to challenge or even to mention. Potential losers from an under-valued NNEGs also include the annuitants, i.e., actual or prospective pensioners, whose pension funds have invested in ERMs.
Note, too, that this unrealized loss of £1 billion is already borne and is not some hypothetical future loss that can be avoided. The best the firm can do is acknowledge the loss by revaluing its NNEGs properly.
Nor should this already-borne loss be confused with the potential losses firms might suffer from a house market downturn. Should the house market go down, firms would suffer additional losses on top of those from their under-valued NNEGs.
Then there is the regulation:
Equity release lenders are regulated firms that operate within strict UK and EU rules. For example, the UK insurance sector is subject to the Solvency II regime, which is regarded by many as having the most rigorous and sophisticated regulatory requirements in the world.
I grant that the UK insurance industry has often complained about the “strictness” of the rules and frequently tells us that the Solvency II regime has the most rigorous and sophisticated regulatory requirements in the world. But this picture of the regulatory system is a little misleading in two respects:
First, it fails to point out that the rules are to a large extent the product of lobbying by the industry itself, such as on the subject of Matching Adjustment regulatory concessions that allow firms to create fake capital with regulatory approval.
Second, it fails to point out that the “strict”, “rigorous” and “sophisticated” UK regulatory requirements have failed to deliver what they set out to deliver.
Case in point: the core purpose of Solvency II was to prevent another Equitable Life type disaster, in which the firm concerned had under-valued opaque long-term guarantees to the point where it could no longer take in new business. That the purpose of Solvency II was to avoid another Equitable Life fiasco was clear from the start, as a European Commission memo from July 10th 2007 makes clear:
The proposed new solvency regime addresses in particular a number of problems which have appeared in the Equitable Life situation. … It is therefore less likely that situations such as that experienced in the case of Equitable Life will reoccur in the future.
Now we find that Equity Release firms are also under-valuing opaque long-term guarantees and apparently on a bigger scale than Equitable Life.
And so two years into operation, Solvency II has already failed to deliver on its central purpose, i.e., Solvency II has proven that it is not fit for purpose.
Solvency II is about as effective as Monty Python’s dead parrot.
I hope I am not the only one to have noticed this.
- This guarantee means that the maximum repayment on their loan will never exceed the value of their home. Thus, if the loan amount has exceeded the home price by the time that the loan is repaid, the borrower (or their estate, if they have died by that point) would only be required to pay back the value of their home.