The highly regarded North American Actuarial Journal has just published our article of the same title. The article can be obtained here.
The story will be a familiar one to our regular readers.
To quote the abstract:
UK equity release actuaries are using a flawed approach to value the no-negative equity guarantees [NNEGs] in their equity release mortgages. The approach they use, the Discounted Projection approach, incorrectly uses projected future house prices as the underlying prices in their put option pricing equations. The correct approach uses forward house prices. The Discounted Projection approach entails significant under-valuations of no negative equity guarantees and over-valuations of equity release mortgages and can produce valuations that violate rational pricing principles. The Discounted Projection approach is also inconsistent with both actuarial and accounting standards. Our results have significant ramifications for equity release industry practice and prudential regulation.
So there is a correct approach promoted by the Market Consistent school of thought, which produces relatively high NNEG valuations; and there is the incorrect Discounted Projection approach that the UK equity release industry is using, which produces much lower NNEG valuations.
Why does the NNEG valuation approach matter?
It matters because if we are right, then the industry has been (grossly) over-estimating the value and hence the profitability of ERM loans to lenders, and then been making distributions based on reported profits that have been (grossly) over-estimated.
And this means, in turn, that lenders and investors in those lenders will not see the realised future profits that they had been anticipating.
If only someone had warned them!
To quote the paper’s conclusion:
The Discounted Projection approach: (i) has never been explained let alone convincingly justified by those who advocate it; (ii) is based on an elementary error about the underlying price, namely, the confusion between a future price (i.e., a price in the future) and a forward price (i.e., the price of a forward contract now); (iii) violates the principle that options be calibrated using inputs that are currently known or calibratable, as opposed to using inputs that are unknown future variables or projections of unknown future variables; (iv) has not been endorsed by a single recognised independent expert; (v) does not appear in the corpus of recognised scientific research journals that are subject to rigorous peer-review;1 and (vi) is contradicted by alternative approaches such as Black ’76 that are used and taught all over the world and have been published in top tier refereed academic journals. Thus, to use the DP approach is to defy modern finance theory. In addition, the DP approach: (vii) entails significant under-valuations of no negative equity guarantees and over-valuations of equity release mortgages; (viii) can produce valuations that are known to be indefensible; (ix) is open to abuse in that it allows practitioners to obtain low NNEG valuations by inputting arbitrarily high hpi assumptions; and (x) is being promoted by practitioners with a vested commercial interest who are dismissive of the only approach that is scientifically respectable because they do not like the valuations it produces. Last but not least, there is a prima facie case that the DP approach is inconsistent with both (xi) actuarial and (xii) accounting standards.
It’s not as though there were any red flags either.
- Admittedly, Hosty et alia (2007) was later published in the British Actuarial Journal, but it is not clear whether BAJ articles (or for that matter, any articles and reports published by the IFoA, e.g., such as Tunaru and Quaye, 2019) are subject to “rigorous peer review” and the only thing that is clear about the review process, whatever that might be, is that it is unclear. To quote from the BAJ’s website, “British Actuarial Journal contains the sessional research programme of the Institute and Faculty of Actuaries along with transcripts of the discussions and debates. It also contains Presidential addresses; memoirs and papers of interest to practitioners.” There is nothing about rigorous scientific peer review.