Category: ERM

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Just makes no sense

There was an RMS announcement yesterday for the sale of a portfolio of equity release mortgages from Just Group to Rothesay Life. The sale was hinted at in the Interim results released last week.

The announcement is confused partly because the sale is the first of two tranches, with the numbers referring sometimes to the total amount, sometimes to the amount in the first tranche. As far as I can make sense of it, the total imputed value of the loans being transferred is £475m, and the total amount paid by Rothesay is £334m (see also their announcement here), resulting in a theoretical loss of £141m for both tranches. Just Group say that the loss will be only £125m, but they also refer to ‘IFRS value’ as being different from the imputed value.

The stated reason for the loss is “the insurance liabilities impact due to the lower investment yield on the replacement bonds” which does make a kind of sense.

Welcome back to the weird world of Matching Adjustment accounting.

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The Hedging Fallacy

In our discussions with equity release actuaries, Dean and I have often come across some recurring arguments.

An example is what we might call the ‘hedging fallacy’ – the argument that we can’t apply B76 (or BS) to value equity release NNEGs because these option price formulas are derived under the assumption that the underlying variable, in this case, forward contracts on residential property, can be hedged. This assumption is obviously empirically invalid, so the argument goes, therefore we shouldn’t use B76/BS. And the argument (often) continues, we should then throw away B76/BS and use the discounted projection approach instead. And thankfully, the discounted projection approach delivers much lower NNEG values. So there is nothing to worry about – all that undervalued NNEG stuff is overhyped.

This argument is false, but it is false in a number of interesting ways.

Continue reading “The Hedging Fallacy”

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The Market Consistent Approach, Updated

Dean and I have updated our work on the MC approach and have just issued a new Discussion Paper on the subject, ‘A Market Consistent Approach to the Valuation of No Negative Equity Guarantees and Equity Release Mortgages’.

To quote the abstract:

This paper provides a new market consistent approach to the valuation of No Negative Equity Guarantees and Equity Release Mortgages. The paper innovates in two respects. First, it provides a new treatment of net rental yields and deferment rates and a proof that the two are equal. Second, the paper provides a new approach to the estimation of the volatility inputs. The proposed approach to volatility produces a volatility term structure that is dependent on the age and gender of the borrower. Illustrative valuations are provided based on the Black ’76 put pricing formula and mortality projections based on the M5 Cairns-Blake-Dowd (CBD) mortality model. Results have interesting ramifications for industry practice and prudential regulation.

The word ‘interesting’ does a lot of the heavy lifting here.

We will be presenting the paper to David Blake’s Sixteenth International Longevity Risk and Capital Markets Solutions conference in Copenhagen in August.

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In Praise of the PRA’s Principles

Dean and I have had a fair bit of behind the scenes back and forth on equity release valuation, and especially on the PRA’s Equity Release Valuation Principles, which continue to be as misunderstood as ever. As someone once said, it can be extremely difficult to persuade people of something that they do not wish to be true, and especially so where their living depends on their not understanding it.

Here is the link to our new Discussion Paper on the subject.

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More equity release trap

The Mail on Sunday worries about the high rates paid by some customers on older mortgages. Age Partnership, a broker, has ‘pledged’ to look at existing equity release loans “to see whether borrowers can be switched to a better deal”.

Steve Baker is the Conservative MP for Wycombe and sits on the influential Treasury Select Committee. He says it is time the equity release industry tackled these toxic loans.

‘This is a welcome step that could bring peace of mind to many elderly individuals who have found themselves, through no fault of their own, as equity release mortgage prisoners in this ultra-low interest rate environment,’ he says.

Kevin Dowd is also quoted.

The article mentions a couple who took out a loan at 6.45% four years ago. However rates have plunged so far that “it became worth paying the exit charges and switching to a lower rate”, and the couple switched to a 3.04 per cent deal.

That leaves a few questions in our minds.

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Actuarial fallacy again

Actuary predicting the future

The fallacy is very clearly articulated here.

The author correctly states that “the historical evidence can soundly reject the hypothesis that the expected rate of house price inflation is equal to the risk free rate,” then incorrectly states that “the Black Scholes priced put option gives you that expected value if and only if the expected value of house price inflation equals the risk free rate”.

Kevin and I address the fallacy in a forthcoming paper, but I will briefly discuss it here.

Continue reading “Actuarial fallacy again”

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Clever Doggie

Smarter than your average equity release actuary

Our friend Golden Retriever at golden.retriever@dogs.gov writes in about our last post on the profitability of equity release mortgage loans:

My first thought was that, surely with any investment, you know the profitability only once the asset has been redeemed, sold, or otherwise disposed of. At this point, you don’t need Black 76, or any other model, to work out profitability: you just look at actual cash inflows and outflows. Do I therefore take it that what you are looking at is actually expected profitability?

To quote Churchill:

The trouble with the ex post measure of profitability is precisely that you don’t know it until the loan has been repaid. We are interested in assessing expected profitability because we want to work out the valuations of the NNEG and ERM ex ante, so that firms have solid valuations at the time the loans are taken out. The only alternative ex ante I can think of is a crystal ball that works.

Of course, we recognise that NNEG valuation is a bit of a dog’s dinner.

Continue reading “Clever Doggie”