InsuranceERM covered our paper on Equity Release and the Institute yesterday. They are also advertising a conference in February, where I will be speaking on whether arbitrary discount rates are consistent with IFRS principles.
On other matters, the Institute have now published this presentation at Life Conference by the Equity Release Working Party, the one which actuaries voted on, as we reported last week. Note the whacking great disclaimer on the second page stating that ‘The IFoA and our employers do not endorse any of the views stated … in this presentation’, a standard boilerplate that normally appears at the end of presentations bearing the Institute’s logo. What is the Institute worried about?
The Working Party needs an ear trumpet. Slide 8 states (correctly) that house prices exhibit autocorrelation, mean reversion, conditional heteroscedasticity, volatility that varies by property groups, momentum effects, jumps etc, but as we have already showed, these effects do not necessarily impact Black Scholes valuation. For example, the formula prices the hedging of this mean reverting price series perfectly well, also this autocorrelated (also heteroscedastic) series. Note that autocorrelation is not really your friend.
Slide 12 states that Black Scholes and variants assume a random walk with drift and constant volatility. Correct, these are sufficient conditions, but the presentation clearly assumes that they are necessary conditions. Wrong.
Slide 9 suggests a high correlation between house price inflation against the base rate. It’s not clear why the Working Group picked this slide. You would expect a correlation given the connection (1) between house prices and rentals (2) between change in rentals, which are a component of RPI, and RPI itself and (3) between anticipated RPI and the base rate.
Thus the historical growth in HP used as an input to the faulty ‘real world’ valuation model is a result of the high interest rates between the 1970s and early 1990s, and we should not necessarily expect it to continue. Furthermore, if base rates rise in anticipation of future expected inflation by the Bank, you have to wonder about the effect. Do high interest rates cause the inflation, or do they anticipate the future? The biggest risk to an ERM portfolio is a shock rise in interest rates made by the Bank in order to achieve its stated objective of controlling inflation, the second biggest risk is a protracted decline of the kind seen in Japan from the early 1990s to the present.
Have a good weekend!