Most UK Equity Release mortgages1 involve a no-negative equity guarantee (NNEG) by which the lender guarantees that the borrower (or their estate, if they have passed away by then) will never need to pay back more than the value of their house when the loan is repaid.
The valuation of these NNEGs has become an issue in light of recent reports – Howard Mustoe’s BBC story “Home equity release may cost pension firms billions” and my Adam Smith Institute report, “Asleep at the Wheel: the Prudential Regulation Authority and the Equity Release Sector.”
In particular, our reports claimed that Equity Release firms are undervaluing their NNEG guarantees – and to a considerable extent.
So how big is the NNEG valuation ‘problem’ across the Equity Release sector?
No one can give an exact number because no-one has access to the detailed books of all the firms involved.
But we do have some information and we can use that to produce a back-of-the-envelope estimate.
Taking account of the total amount loaned (around £19.8 billion by my estimate) and the estimated under-valuation per £ loaned (which I estimate to be in the region of 59%), I get a ballpark estimate for the total NNEG valuation across the sector that is in the region of £11.7 billion.
I would suggest that back-of-the-envelope or not, this estimate is large enough to be a cause for concern. Any hidden NNEG losses would come straight off the bottom line, and hidden losses on this scale, if I am right, would be a concern to investors.
Please don’t take my word for it. The number I have suggested (or, strictly speaking, the approach used to obtain it) should be scrutinised and challenged, and I am happy to make the basis of my calculations clear.2 I am also well aware that my approach could be improved, and I made that clear in my report. I doubt that a more sophisticated analysis would arrive at results that are much different from mine, however.
So there you have the basis of my model, warts and all.3 If anyone feels like taking a swipe at it, be my guest.
Alternatively, if the equity release industry don’t like this number, then all they need to do is to disclose their own valuations and the basis for them, and so submit them to independent verification.
- An Equity Release mortgage is a loan made to a home-owning customer late in life that is collateralised by their home. The loan is made at some fraction of the home value and is repaid when the customer leaves the house by dying or going into a care home.
- Basis of calculations as follows: Black ’76 model for put option, calibrated on male borrower aged 70, loan-to-value ratio = 35%, risk-free interest rate = 1.5%, net rental rate = 2.5%, loan rate = 5%, volatility = 13%. The LTV is a little low in my opinion, and a higher LTV would produce a higher NNEG, but I wanted to err on the side of conservatism. Wouldn’t want to go to press with alarmist numbers, you see. See also note 3.
- I say “my model”, but that is little misleading. “My” model is almost identical to the PRA model. Both use Black ’76, the only difference is that I use Continuous Mortality Investigation male death rate projections to obtain the house exit probabilities, and I don’t know how the PRA obtain their exit probs because they do not (appear to) disclose how they obtained them.