Although we have often criticised it, the Discounted Projection aka ‘Real World’ Approach used by the equity release industry to value their NNEGs and ERMs has two significant things going for it. The first is fantastic marketing. Who could be against a ‘real world’ approach, especially when the alternative is a Market Consistent or ‘Risk Neutral’ approach? Everyone knows that most people are not risk-neutral. ‘Real world’ or ‘risk neutral? It’s a no-brainer.
The other thing that the DP/’Real World’ approach has going for it is that it produces much lower valuations. Hosty et alia (2007) hit the nail right on the head:
7.3.3 Market consistent or real world?
On our proxy market consistent approach we have derived a cost for the NNEG which would render the product non-profitable, whilst real world modelling has produced a significantly lower cost.
The importance of commercial considerations as a reason for preferring this approach was confirmed by Tom Kenny at the 28 February 2019 Staple Inn launch event for the Tunaru report. Mr Kenny was the chair of the event, and is Director of Actuarial & Underwriting, Retirement Lending at Just Group plc in his day job: “clearly if we move down a purely market consistent route … it’s going to be extremely expensive,” he said.
Darn right it’s going to be expensive.
However, the issue is not whether the firms’ NNEG valuations would go up if they used another approach. The real issue is whether firms are using the right approach in the first place. If firms are using a valuation approach that greatly undervalues their NNEGs, then they have greatly under-estimated their costs and those costs are already being borne by firms and their investors, regardless of whether firms acknowledge that fact. We would respectfully suggest that firms should be facing up to this problem instead of trying to avoid it. For their part, analysts should be wondering how big this problem might be and asking themselves about the potential impact on firms’ financial conditions. Under-valued costs mean past profits have been overstated. They also imply hidden losses and over-estimated capital, potentially on a large scale.
Imagine if Bosch are under-valuing the guarantees they issue with their washing machines. Their management then discover that the costs of replacing or repairing their washing machines are going to be higher than they had expected, but they don’t yet know how much higher. The problem might only be a small problem but then again it might not. So what is the most appropriate response from the management when they are informed of it? Should they deny it on the grounds that they wouldn’t like it if their guarantees turned out to be more costly than they had thought or should they look into the issue with a view to fixing the problem before it gets any worse? We would have thought that the answer to that question was obvious, but then why would the answer be any different if it was ERMs rather than washing machines whose guarantees were being under-valued? And if the losses involved might potentially be on a large scale, then doesn’t that reinforce the need to address the problem as a matter of some urgency, lest a potentially large problem grow into a larger problem down the road if nothing is done about it?
All of which makes us wonder who is really operating in the real world and who is not.