Category: accounting

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The Mysterious Mystery Shop

Dean’s article “Just one in the Eye for Age UK?” (22 Aug 2019) tells an interesting story from the latest issue of Private Eye about a mystery shopper who contacted Hub financial via the Age UK website, enquiring about an equity release mortgage (ERM). When he took Age UK’s advice to “dip his toe” into equity release, his enquiry was channelled through Hub’s independent panel of lenders and he was offered an ERM loan from one particular firm. This offer came as a bit of a surprise to the toe tipper, however, because he had already been offered an ERM loan from another firm that was also on Hub’s panel, and in his opinion, this previous offer from the other firm was a better one. So one wonders what is going on.

These articles got me thinking: how would one go about establishing the potential loss to an ERM borrower from going with one lender, when an alternative lender would have given them better terms?

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Quids in

Kevin writes here

It also gets interesting if the firms use different valuation approaches from each other. In that case it would be theoretically possible for both parties to post a profit on the transaction or for both parties to post a loss on it.

He is referring to the approaches used to value the embedded put option in the ERM, and the actual put option used to hedge the ERM.

There is a troubling reminder here of what happened to AIG Financial Products in the run-up to the last financial crisis.

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Just published

Just out, the Just Group financial report for 2018. The reconciliation of regulatory to statutory capital is on p.28, copied below (with added difference column).

As you see the fictive regulatory asset (TMTP) decreases by £372m over the year. This is mainly offset (1) by the increase in sub-debt, consisting of the Tier 3 subordinated debt issued in February 2018. Next year there will be a further increase of solvency II capital because of the £300m Tier 1 qualifying regulatory capital instrument issued in March this year.

There is also (2) the mysterious increase due to ‘other valuation differences’ but I have never been able to locate where this comes from.

31 December 2018 £m 31 December 2017 £m Difference
Shareholders’ net equity on IFRS basis 1,664 1,741 (77)
Goodwill (34) (33) (1)
Intangibles (137) (160) 23
Solvency II risk margin (851) (902) 51
Solvency II TMTP 1,738 2,110 (372)
Other valuation differences and impact on deferred tax (813) (1,009) 196
Ineligible items (7) (6) (1)
Subordinated debt 615 394 221
Group adjustments 1 0 1
Solvency II own funds 2,176 2,135 41
Solvency II SCR (1,597) (1,539) (58)
Solvency II excess own funds 579 596 (17)
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The Red Queen effect

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

According to Wikipedia, the Red Queen effect, i.e. the need to run in order to stand still, has been used to explain all sorts of scientific and philosophical ideas.  No one, as far as I know, has used it to explain equity release mortgage valuation.

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Rebel rebel

There is a very fine article in InsuranceERM just published. Behind a paywall I am afraid, but it explains the idea of Eumaeus very well, although I would say that. For those without a subscription, an interesting part is here

As InsuranceERM went to press in December, the PRA published its policy statement (PS31/18), which Buckner largely welcomed. “For the first time it settles, with great authority and a wealth of cogent reasoning, how life insurers should correctly value a portfolio of simple European put options,” he says.

But he is scathing of the PRA’s change of heart on applying the rules for valuing guarantees to business written before Solvency II came into effect. Insurers can now apply different treatment to the same type of loans, depending on whether they were written before or after 1 January 2016. “It makes no sense to me,” he says.

Indeed it made so little sense to me that I queried it with the PRA after the interview.

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Asleep at the wheel again

I have so far dwelt on the positive aspects of PS 31/18. It is a landmark paper by the PRA in that for the first time it settles, with great authority and a wealth of cogent reasoning, how life insurers should correctly value a portfolio of simple European put options. Other non-insurance institutions have valued them correctly for a long time, but never mind that, it is an important breakthrough notwithstanding. In his letter of 10 December, David Rule stresses the importance of not valuing options in a way that assumes future house price growth (and by implication any asset growth) in excess of the risk-free rate.

But all is not well.

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