As noted earlier, there was a presentation at Staple Inn yesterday evening on equity release mortgages, and this appears to be the paper. The strange jumble of ideas presented in the paper is connected with a much deeper question, namely why it took so long (more than four years) for the PRA to decide how to value a simple European option.
Now PRA PS 31/18 is a finely argued piece of work and a credit to the organisation that produced it. But why did it take so long? We raised this issue in our letter of 30 Sep 2018, saying
It is a worry that the consultation as a whole has taken such a long time.
… once the decrements have been quantified using standard longevity modelling, the ERM valuation model embeds a simple European put option. Clearly the deferment rate concept has caused an intellectual challenge for some, but it is a natural consequence of modern derivative pricing theory, which dates back more than 40 years.
PRA replied
2.129 The PRA considers that the assessment of NNEG risk for the purposes of the MA is more complex than valuing a put option. The PRA also considers that it was appropriate to consult widely on the approach to follow for this assessment, given the importance of the policy to the market: this is amply evidenced by the number of responses, the breadth of issues raised by the respondents and the diversity of views expressed. [my emphasis]
Now this is simply not true. The first part of their answer begs the question. Given, as we have said, that once the decrements have been quantified (which is stuff actuaries should know), it really is a series of simple European puts. Why did the valuation of it take so long? PRA haven’t answered that.
Taking the second part, they say that respondents raised broad and diverse issues about pricing a simple European put. Very well, we all agree on that. But these respondents are presumably qualified actuaries working at firms, or have been advised by such actuaries. Why did it take them so long to price a simple option? Indeed, given that the PRA employs a large department of qualified actuaries, why did they need to take any of the respondents’ views seriously? Is the whole profession incompetent?
As of evidence of this, look at some of the things that respondents complained about, according to the PRA. According to para 2.57, a respondent argued that rental income is irrelevant because no purchase of the property has occurred at the start of the contract and the risk of shortfall only occurs at the point of mortgage redemption. This clearly shows that the respondent either hasn’t read or hasn’t understood CP 13/18, and PRA rightly replies that ‘this fails to recognise the importance of Principles II and III’.
According to 2.61, a respondent argued that foregone rent does not imply any diminution of current or future value of the property, which is correct, but we are talking about the value of a deferment contract, not the value of the property, and the PRA replies accordingly.
Turning to the strange paper, probably written by one of the respondents, this argues that ‘with residents in situ the market value of the property is diminished and that there is an economic value to the use of the property’. But no maximum future value of the property is implied in the pricing of the reversion (i.e. the deferment contract).
Common to all these objections is the failure of the respondents, presumably trained actuaries, to understand basic economics. As we point out in Equity Release: A New Equitable in the Making, Principle III states that one would pay less for the second product than for the first and follows from elementary economics. Why would we not pay less to get less? What is so difficult about that?
So the answer to the question of why it took so long to value a simple European option is not that a simple European option is complicated, far from it. Simple options are simple. And while it is true that there were diverse views on how to value a simple option, this does not address the root cause, namely a cultural failing in the actuarial profession and the body that represents it, which fought tooth and nail throughout the whole period to prevent a basic valuation question being addressed. The length of time caused a significant damage to the public interest. Shareholder confidence has been damaged, policyholders have been exposed to unnecessary risk.
Who calls who to account?