The Just Group 2019 interim statement is out today. It has already received coverage in mainstream financial media, and we don’t normally repeat what is already said.
What caught our eye, however, was the mention on p.50 of the put option on property index, the NNEG hedge we discussed earlier. We speculated whether the firm has put the hedge in place, or whether they are still waiting to establish ‘appropriate regulatory treatment’ with PRA. Turns out (and we should have spotted this from the 2018 financial statement – 2018 p.72, section 25 ) that it was already in place by 2018, so it is merely the regulatory treatment they are waiting for .
But here’s the interesting thing.
The notional value of the hedge was £80m at year end 2018, and remains at that level, so nothing in the nature of the contract has changed. But the fair value reported at the end of 2018 was £3.3m, whereas it has risen to £10m.
That is a large increase, assuming that the option is long dated. A long dated option will have a low gamma, i.e. the delta or sensitivity will not change much as the underlying asset price rises or falls. The change of £7m is therefore caused either by changes in the underlying asset, or by volatility.
Just don’t state their volatility assumptions, so we can’t speculate. But if on the other hand the change was caused by the underlying, then what factors are causing it? If the option is priced correctly, then the inputs are risk free rate, imputed net rental (deferment rate) and property index value. If incorrectly, then the inputs are forecast growth rate and property index value.
Who can say. However, their statement on p.5 is interesting.
The Group is considering the regulatory treatment for its no negative equity guarantee (“NNEG”) hedging transaction, designed to reduce exposure to fluctuations in property growth rates in light of CP7/19.
My emphasis. Correctly priced, the option will be unaffected by future expected property growth rates, so could it be that the put option employs the same incorrect pricing method as the NNEG itself? If so, as we commented in our earlier post (link above), that’s a wonderful way to correct a significant mispricing on your own balance sheet. You merely transfer it to other insurers, so that the industry as a whole absorbs the error. And if it all goes horribly wrong, then FSCS bails the firms out, insurance premiums go up, so the public at large absorbs the error.
Problem solved.