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Arbitrage opportunities

A commenter comments.

If your theories are correct, it is Eumaeus who should be
able to make unlimited arbitrage profits if the matching adjustment is mis-pricing. Why have you not done this?  The answer is that outside the university classroom, arbitrage is not possible for illiquid assets / liabilities.

Eumaeus replies

On the contrary, arbitrage is easy. (1) Borrow from pensioners at close to risk free through the buyout market, receive payment in safe assets (2) replace safe assets with higher yielding ones (3) persuade PRA that some or all of the spread on higher yielding assets is risk free (4) discount liabilities at the higher rate and create capital (5) when you have created enough capital, distribute some of it to owners.

I.e. Matching Adjustment is an effective a way of shorting the illiquid asset. You have bought the illiquid at market price, including the ‘illiquidity premium’, although it is difficult to prize away the illiquidity element from the market risky element. Then, by discounting your illiquid riskless pension liability at higher than risk free, you have beautifully captured that illiquidity spread. Arbitrage courtesy of PRA, thank you regulators!

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At Last, a Refereed Article on NNEG Valuation

… that uses the correct valuation approach. Disclosure: we are two of the co-authors, so we would say that.

The article, “The Valuation of No-Negative Equity Guarantees and Equity Release Mortgages” by Kevin Dowd, David Blake, Dean Buckner and John Fry has just been accepted by the well regarded academic economics journal, Economics Letters.

Continue reading “At Last, a Refereed Article on NNEG Valuation”

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Just one in the Eye for Age UK?


A curious piece in the Eye yesterday claimed that a mystery shopper contacted Hub financial via the Age UK website, enquiring about an equity release mortgage.

Get a copy yourself and support good investigative journalism, but briefly, the shopper was quoted 5.35% from Just Group, a provider on the Hub ‘panel’ of lenders, as being the best value.

When the same shopper contacted L&G, also supposedly on the panel, he was quoted only 5%. He complained to Sir Brian Pomeroy (Age UK chairman of trustees) saying he might publish something about the problem, but instead got ‘a stiff letter from Julian Pike of expensive “reputation management” solicitors Farrer and Co’, suggesting firmly that he should not publish.

Just fancy that.

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In the news

We learned on Friday that the High Court blocked the ‘Part VII’ transfer of a £12bn annuity portfolio from Prudential to Rothesay.  According to the judge, Justice Snowden, Rothesay was ‘a relatively new entrant without an established reputation in the business’, and that although its capital strength was as strong as that of Prudential, it ‘does not have the same capital management policies or backing of a large group with the resources . . . to support a business that carries its name’.

This decision is significant for a number of reasons, some of which we will have to leave until later. The main thing for now is that at least one part of the system is working. The PRA and the Independent Expert approved the transfer and saw no detriment to existing policyholders. But the judge saw detriment, and that was that.

Whether or not Rothesay’s capital position is as strong as Prudential is an interesting question we shall put aside for now.

In other news,  the shares of American insurer GE dropped last week after Madoff whistleblower Harry Markopolos claimed a $38bn fraud. Although whether it is fraud, or merely insurance accounting, is always difficult to say.

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The Eumaeus Guide to Equity Release Valuation

Published this morning

THE EUMAEUS GUIDE TO EQUITY RELEASE VALUATION

 Restating the Case for a Market Consistent Approach

The 180 page guide, by Dr Dean Buckner (Eumaeus) and Professor Kevin Dowd (Durham University and Eumaeus) is the most comprehensive work on the valuation of equity release mortgages to date.

The guide emphasises the team’s previous warnings about poor valuation practice in the equity release sector. “As far as we are aware, not a single equity release firm is valuing its No-Negative Equity Guarantees (NNEGs) correctly,” said Dowd.

The result is a guarantee-undervaluation problem akin to that we saw two decades ago in the Equitable Life fiasco.

Key findings include that:

  • This NNEG under-valuation problem is on a large scale and implies correspondingly large over-valuations of Equity Release Mortgages (ERMs).
  • The Discounted Projection or ‘Real World’ approach used by the equity release industry is inherently flawed and produces valuations that violate bounds that are known to be inviolable.
  • The only scientifically valid valuation approach is the Market Consistent approach, which is also the only approach compatible with accounting principles and technical actuarial standards.
  • Market consistent valuations cast doubt on the profitability of ERM loans especially to younger borrowers.

The guide develops the team’s previous work on the valuation of the guarantee embedded in equity release mortgages. There is a new mathematical derivation of the ERM “deferment rate” from first principles. “The deferment rate is important not only for the valuation of equity release mortgages, but also for the valuation of leasehold extensions,” said Buckner. “Equity release is a form of lease to the borrower, and this work shows how both can be valued in an objective and scientific way, unlike existing approaches.”

The report also contains results on the complex mathematics of the volatility used in the option formula underlying the guarantee, as well as new work on property dilapidation, mortality and long-term care, drawdown, prepayment and ERM stress-testing.