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A Few Loose Ends

Anyone with the intestinal fortitude to wade through our Eumaeus Guide might have noticed that in several places in the report we promised to post two spreadsheets: one giving the calculations underlying our volatility chapter, Chapter 10, and the other the hedging example discussed in the Appendix to Chapter 20.
So why didn’t we post them as promised when we published the report?
Simple: because we, er, forgot. Sorry.

So here (1) they are (2), and see also our new models page

A word of explanation about these spreadsheets.

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Turning Japanese

Turning Japanese

In a previous posting, we discussed a type of stress test in which house prices fall immediately after an ERM contract has been entered into.

However most stress tests are passage-of-time stress tests in which we posit some hypothetical stress over time and then use our model to see how that stress would effect something we are interested in, over the passage of time.

For example, we might assume a hypothetical rate of growth of hpi and show how the ERM valuation would behave over time under the posited scenario.

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Just hedging their bet

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.

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A Back of the Envelope House Price Stress Test for ERMs

by Kevin Dowd

A scenario analysis is a hypothetical ‘what if’ exercise in which we examine what might happen to some variable of interest (e.g., a NNEG or ERM valuation) if some future scenario were to occur.

For example, we might examine what would happen according to our model if future house prices were to behave in a particular way.

A stress test is a scenario analysis in which the posited scenario is an adverse one (e.g., a large drop in house prices).

One type of scenario analysis/stress test is to model the impact of an immediate one-off house price fall. We assume that house prices fall five minutes after the ERM loan has been made. This exercise is ridiculously easy to carry out and can be very revealing. It should therefore be an essential tool in every ERM risk manager’s toolkit.

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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!

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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.

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Just One More Thing

A penny for your Thoth

Kevin Dowd 3 July 2019

Or maybe a couple of things. Still working on the baffling case of the logic of the Matching Adjustment, and I wonder if even Columbo could solve this one.

Let’s sweep aside the objections of the Doubting Thomases (here, here, here etc.) that MA is theoretically flawed. Perhaps IFoA president-elect John Taylor is right when he claimed that MA is not only a Fundamental Actuarial Principle but sound too.

But then I struggle with implementation. You take your credit spread, which is known. You decompose the spread into the Fundamental Spread, the risky bit, and the Matching Adjustment, which is the non-risky bit. I still don’t quite understand the bit about some of the spread above risk-free being risk-free, but that might be me so let’s move on.

Ah yes, you say. Implementation is easy. You just apply the regulatory formula.

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