Geeks only. The chart above shows why Equity Release Mortgages are both fascinating and toxic. We have discussed ERM valuation in a number of earlier posts, but ERMs are used as assets to back conventional annuity books under what’s called ‘matching adjustment’, but we need to consider both sides of the balance sheet, because the insurance industry has weird ways of valuing liabilities too.
The PRA (and IFRS) allows firms to discount insurance liabilities at the estimated rate of return on the assets, which is absolutely bonkers but the industry lobbied hard in 2012 for it and here we are. Thus there is a ‘matching adjustment benefit’ arising from the higher discount rate, which effectively creates equity on the books of an MA firm.