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The Actuary The magazine of the Institute & Faculty of Actuaries

Equity release schemes

Equity release schemes enable customers to access the wealth they have in their properties while they continue to live there, usually without the require-
ment to make any repayments during their lifetime. There are two main variants:
– Mortgage schemes, under which the provider lends the customer cash and takes a mortgage charge over the consumer’s property. The fixed-interest lifetime mortgages, or ‘roll-up’ mortgages are the dominant schemes in the market today, representing over 90% of sales. Under these schemes the customer is advanced a sum of money by the provider, and interest is compounded at a fixed rate with no repayments during the customer’s lifetime. Capital and interest are repaid from the property sale proceeds when the customer dies or moves into care. A ‘no negative equity’ guarantee (NNEG) ensures that there is no further call on the estate in the event that the value of the loan has overtaken the property value.
– Reversion schemes, where the provider buys a share (or all) of the customer’s property, and the customer continues to live in the property for the rest of their life. The provider pays a discounted price for the property (eg £30,000 for a 60% share of a £100,000 house), reflecting the fact that it will be some years before the property is sold and they get a return on their investment. The customer does not pay rent in the meantime.

Working party
The purpose of the working party was to produce a report that would meet a wide range of interests, while also making a worthwhile contribution to the actuarial debate. This was achieved by separately publishing a general report and a technical supplement. We also aimed to promote the role of actuaries in the equity release market, as many providers have a traditional mortgage background and are not used to taking actuarial advice. However, the financial risks inherent in equity release products are classic actuarial problems and we believe that the profession should be making a wider contribution to this market. At present some providers are writing equity release products without detailed analysis of the inherent risks, and one of our objectives was to highlight the potential costs to encourage more rigorous review to be carried out in the future.

Potential for market growth
The report begins by analysing trends in private, occupational, and state provision of pensions to reach the inevitable conclusion that there is a significant gap between current provision and that necessary to meet consumer needs. Current government policy is to reverse the 40%/60% ratio of private to public pension provision by 2050, mainly to be achieved by linking state pensions to the Retail Prices Index instead of the National Average Earnings Index. This places an increased burden on private and occupational provision. However, in recent years employers have reduced their contributions to occupational schemes from an average of 11.1% of salary to 5.1%, and slightly less than half the population of working age have any pensions savings at all in excess of state provision.
With the aggregate housing wealth of the population aged over 65 now standing at around £1,100bn, this suggests that there should be strong demand-led growth in the equity release market.
Comparing consumers’ needs and appetite for equity release with current sales volumes, we reached the conclusion that the market is currently undersupplied. This could be because the products are not yet available that will address consumers’ needs, or because of brand or distribution issues. Either way, the market could grow to several times its current size over the next few years, perhaps to £5bn of new loans a year, if the large mortgage providers enter the market.

Product pricing
The technical supplement produced by the working party outlines the financial risks inherent in different equity release schemes for product providers, and considers the setting of assumptions for product pricing and for assessing appropriate levels of risk capital and reserves. Lack of publicly available information makes the setting of decrement assumptions difficult for both existing product providers and potential market entrants, and one of our recommendations is that the profession should carry out ongoing experience investigations. Without this, providers must charge appropriate risk premiums and have to set aside a greater amount of risk capital than if data were more widely available. Ultimately these costs must be passed on to customers, and this reduces the appeal of the market.

Risk models
The nature of equity release products and their inherent guarantees means that deterministic analysis methods cannot be used to price for risks reliably. The products expose providers to contingent economic risks overlaid with mortality and other decrements, so it is important to use stochastic techniques (or closed-form equivalents such as the Black-Scholes option pricing methodology) to cost risks accurately. With the uncertainty surrounding future mortality improvements, some practitioners are now considering stochastic mortality models to interact with the economic models thereby giving a wider range of outcomes, and larger worst loss positions.

Where a customer remortgages on a roll-up mortgage, it will usually be because term interest rates have fallen, and a cheaper rate is available elsewhere. The provider may then face a financial loss.
For example, if a customer has taken a mortgage at 7% pa interest (fixed rate for life) and term interest rates fall by 2% pa, then the customer can repay their existing loan and take out a new mortgage at 5% pa interest. The provider will usually have raised funds at a floating rate, and will enter into an interest-rate swap at the outset of the scheme, so that its assets (the customer’s mortgage) and liabilities are matched.
If the customer remortgages, the provider will have to break their swap, and their counterparty will charge them a ‘mark-to-market’ penalty, reflecting the fact that the counterparty can only obtain 2% pa less on a replacement swap. Ideally providers would like to pass this cost on to the customer by charging a mark-to-market penalty on the mortgage contract. However, the majority of existing providers feel constrained by regulations and accepted market practice, and so adopt simplified scales that can greatly understate the extent of any losses. In our example, the provider might have to pay 15% of the accumulated loan to the swap counterparty, but only have in place penalties on the mortgage contract of 5%/4%/3%/2%/1%/0% of the initial loan amount in policy years 1/2/3/4/5/6+. Effectively this gives customers a one-way bet on interest rates. This is also a feature in the wider fixed-rate mortgage market, but is more significant for equity release mortgages where interest rates are fixed for the full term of the contract.

The no negative equity guarantee
The NNEG guarantees to the customer that the loan will be capped at the property’s value, and so results in a claim if capital plus accrued interest exceeds the property sale proceeds.
The assessed value of the NNEG will depend on the provider’s pricing strategy (eg maximum loan to value ratios MLTVs) and assumptions made as to future house price inflation, and it would be wrong to produce a single figure as being ‘the value of the NNEG’. In the working party report we model NNEG outcomes using the Black-Scholes option pricing method, and a set of assumptions that are derived from first principles. On this basis the cost of the NNEG comes out in excess of 60 basis points pa. A number of factors will influence the cost of the NNEG, and should be considered when measuring its cost:
– The higher the interest rate charged, the higher the cost of the NNEG, even though the contracts will be more profitable overall.
– Higher MLTVs will increase the cost of the NNEG, but will also increase the average case size, and so the overall revenue stream from the business. In certain circumstances you can increase the MLTVs and increase overall profitability at the same time, so again the cost of the NNEG should not be viewed in isolation.
– The longer the customer’s life expectancy, the lower should be the permitted MLTV. However, current market practice is for the same MLTV to be offered to people within five-year age bands irrespective of sex and marital status. For example, Northern Rock allows a couple who are both aged 60 (life expectancy 30 years) a MLTV of 15%, and a single male age 66 (life expectancy 17 years) the same MLTV. This introduces the risk of other providers adopting more sophisticated rating methods (eg age and sex-dependent MLTVs). As the market becomes more competitive, customers may then select against providers with banded MLTVs, reducing the overall profitability of their portfolio.
Negative equity claims will arise principally on the longest surviving cases. By the time claims emerge, the profits from contracts that ran off at earlier durations may well have been booked and spent if no provision is made. It is therefore important that providers should allow for the cost of this benefit in their customer pricing, and then regularly reappraise the appropriate level of capital set aside as the portfolio evolves.
Perhaps inevitably, much of the debate at the launch of the report centred on the costing of the NNEG. A number of participants questioned whether 60 basis points pa was realistic and suggested that current market pricing is at odds with that finding. Michael Pomery noted that many actuaries would not be surprised at the high cost of long-term guarantees. The debate continued in the reception afterwards, and then in the pub after that, with no-one winning the argument. Clearly this is one area the working party will have to investigate further in the future.

Releasing potential
The equity release market is an increasingly important one, and in time will become a core part of financial services. The inherent financial risks are complex to model, and actuaries are well-placed to carry out analysis for providers. Actuaries should look for opportunities in the equity release field so that the profession can increase its influence and make an important contribution towards the secure development of the market.