Since Just Group’s trading update last week, there has been much speculation about the ‘pioneering no negative equity guarantee (NNEG) hedging transaction’ announced by the firm. It is not clear whether the firm has put the hedge in place, or whether they are still waiting to establish ‘appropriate regulatory treatment’ with PRA. The current thinking is that the hedge will be transacted through a major reinsurer, and that it will be a purchase of some form of long dated put option on the housing index.
Real Risk-Free Rate or Deferment Rate?
The PRA’s Consultation Paper CP 7/19 makes some sensible points on a number of issues, but one proposal is a bit bonkers. We refer to S2.4 where it proposed “to take account of movements in real risk-free rates when setting the deferment rate,”’ in order to prevent variability in the real risk-free rate causing variability in the forward rate:
The PRA would increase (reduce) the deferment rate if the review shows there has been a material increase (reduction) in long-term real risk-free interest rates since the last update.
In an earlier post, however, we showed that the deferment rate is equal to the current net rental yield, i.e. the nominal net rental payment divided by the current nominal house price. The real risk-free rate does not even enter into it!
Net Rental Rate or Deferment Rate?
These two rates are frequently run together, so which is to be preferred?
A trick question!
The answer is that they are mathematically identical, but they are defined differently.
The Eumaeus Guide to Equity Release Valuation
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.
On the Actuarial Treatment of Equity Release Mortgages
Craig Turnbull (Author, A History of British Actuarial Thought with day job as Investment Director at Aberdeen Standard Investments) has just published this piece on the valuation of equity release mortgages.
Continue reading “On the Actuarial Treatment of Equity Release Mortgages”
Present and future
The presentation yesterday went well, although there was the usual puzzlement about whether expectations about house price growth enter into the calculation of the forward price.
The best trick I can think of, although this doesn’t always work, doesn’t require any mathematics, just logic.
The forward paradox
Jeffery and Smith (Equity Release Mortgages: Irish & UK Experience, p.30) discuss the apparent paradox that when we use a ‘real world’ model to project a forward price, then calculate the expected value of put and call options at different strikes, the internal rate of return of those options is considerably different from that obtained using the Black formula. See their table which I have copied below. Put options even have negative discount rates.
Taking the case of the put options, how can we rationalise these negative discount rates? Why would an investor even consider an asset that is expected to lose money, let alone one as risky as a put option which has a chance of expiring worthless, losing everything?
They continue.
The answer is that few rational investors hold a portfolio 100% in a put option. Rather, a put option is a form of insurance held in connection with other assets. An investor in shares can, sometimes with a modest outlay, acquire a put option that substantially mitigates losses in a market crash. The willingness to accept a negative expected return on the put option reflects the reduction of risk to the portfolio as a whole. This is the same reason that buyers of household or motor insurance would not expect (or hope) to make a profit on that insurance.
Are they right? Does the ‘willingness to accept a negative expected return’ really reflect the need to reduce the risk?
Houses as an investment asset
Tunaru writes (p.30):
… it can be argued that the buyer of a house is not the equivalent to an investor buying a house as an investment asset. For the majority of buyers, houses play the role of a consumption asset and not that of an investment asset. There is no evidence that rental yields are driving future house prices so the expected house prices at various future long horizons cannot be determined with growth models in the same way expected share prices may be determined with growth models linked to dividends.
Just out
The ABI-IFoA-Tunaru paper was published this morning. It is 90 pages and fairly mathematically complex and we will be commenting next week.
There is some rather strange stuff on p.33 that defies comprehension so far, hopefully the weekend will make a difference. Comments (via our contact page) gratefully received as ever.
Have a good weekend.
Libor flat
I mentioned David Land’s bemused question to the Equity Release working party yesterday. If the working party hasn’t yet fixed the right method of calculating the forward, isn’t that a pretty major source of possible error?
No coherent answer emerged, but Land raised an interesting point. If we can’t lower the value of the no negative equity guarantee by putting in an optimistic growth forecast, perhaps we can tweak the funding rate instead? He drops a hint when he suggests that there’s a large range of possible funding rates that you could think about, and that ‘The PRA thinks that you could possibly fund a house at Libor flat, which seems remarkably difficult’.
Nice try, but there is a problem with that idea too.