Kevin Dowd and Dean Buckner, 29 November 2018
Our new report, “Equity Release: Another Equitable in the Making” has just been released in the Studies in Applied Economics series edited by Steve Hanke. Steve is professor of applied economics and co-director of the prestigious Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, Maryland. We are very grateful to Steve for publishing it.
This report is a follow-up to Kevin’s earlier report Asleep at the Wheel: The Prudential Regulation Authority and the Equity Release Sector published by the Adam Smith Institute in August this year.
Here are the salient points from our new report:
A major problem emerging in the UK equity release sector is the under-valuation by firms of their No-Negative Equity Guarantees (NNEGs), which cap borrowers’ repayments to the maximum of the rolled-up loan amount and the value of their property at the time of repayment. Under-valuations of NNEGs imply over-valuations of ERM portfolios and indicate that equity release firms are carrying hidden losses on their books.
This under-valuation arises from the common use by firms of an incorrect valuation methodology, the Real World (RW) or Discounted Projection approach, in which NNEG valuation is based on projected future house prices. This approach is a misapplication of basic option pricing theory, because projected or expected future house prices do not belong in the option pricing formula.
The correct, Market Consistent (MC), approach uses forward house prices as the underlying variable in the relevant put option pricing equation.
The RW approach leads to NNEG valuations that are about an order of magnitude lower than reliable valuations based on the MC approach.
The RW approach violates the Technical Actuarial Standards mandated by the Institute and Faculty of Actuaries (IFoA). These require that any approaches used should be “fit for purpose both in theory and practice” and that users should be able to “rely on the resulting actuarial information.”
The RW approach has been promoted for the wrong reasons, i.e., it has been promoted on the grounds that it produces lower NNEG valuations than the MC approach. However, actuarial standards require that firms produce accurate, reliable and unbiased valuations, not valuations that reflect desired outcomes by parties with a commercial interest in obtaining low valuations.
This NNEG under-valuation story is not dependent on the validity of any particular option pricing model such as Black ’76, because the PRA’s Good Practice Principles (set out, e.g., in Supervisory Statement SS 3/17) impose an unbreachable lower bound on NNEG valuation, and because one still gets large NNEG under-valuations if one uses these lower bounds instead of an option pricing model. Therefore, even if one does not have an option pricing model or rejects Black ’76, the NNEG under-valuation problem story still goes through.
The PRA’s Good Practice Principles have been widely misunderstood by practising actuaries, commentators and even by the IFoA itself. Yet these Principles are based on elementary economics and the challenges that have been made to them are flawed in ways that should be obvious to any competent professional.
This NNEG under-valuation story bears a number of similarities to the Equitable Life scandal of almost two decades ago and suggests that some of the problems that contributed to the Equitable fiasco – especially the under-valuation of opaque long-term guarantees and the undermining of actuarial practice by commercial interests – have still to be resolved. The subsequent Morris Report of 2005 was scathing about these problems and major reforms were made to ensure that another Equitable never happened again.
Yet the IFoA’s submission to the ongoing Kingman Review on governance and accountability shows no hint of any awareness of under-valued guarantee or conflict of interest problems in actuarial practice today.
The IFoA has an obligation to promote the public interest and avoid even the appearance of conflict of interest
According to the IFoA, the problems identified by Morris have been fixed and the current model of actuarial self-regulation is doing just fine. To quote its submission, “The IFoA believes that the model of professional self-regulation subject to effective independent oversight remains the most appropriate arrangement for the regulation of actuaries in the UK. … There is no evidence to suggest that current arrangements are not serving to protect the public interest.”
Actually, there is quite a lot of evidence.
Welcome to Equitable 2.0.