Since Just Group’s trading update last week, there has been much speculation about the ‘pioneering no negative equity guarantee (NNEG) hedging transaction’ announced by the firm. It is not clear whether the firm has put the hedge in place, or whether they are still waiting to establish ‘appropriate regulatory treatment’ with PRA. The current thinking is that the hedge will be transacted through a major reinsurer, and that it will be a purchase of some form of long dated put option on the housing index.
Two things are clear. If it really is a hedge, then falls in the housing index should result in a profit on the hedge that will (basis risk aside) offset losses on the ERM trading book, so the question of appropriate regulatory treatment should be straightforward.
Two, if the hedge is correctly priced, i.e. on a using market consistent basis, then the difference between the ‘real world’ option pricing model used by Just and the market consistent option pricing model will be immediately crystallised.
What would that difference be? We know that the forward curve assumed by the real world model slopes upward with maturity, the curve given by the market consistent model slopes downwards. So a market consistent put option will be priced higher, probably significantly higher, than a real world one. We will try to put a number on this later, but it is already clear that the firm will have to take a loss on both the regulatory and statutory book, if the hedge takes place, and if it is correctly priced.
If the hedge is not correctly priced, the transaction simply transfers the NNEG problem onto another part of the insurance sector, but that is a separate story, if true.