Solvency II seeks to value assets and liabilities at the amounts for which they could be exchanged or settled between knowledgeable, willing parties in an arm’s length transaction. However, when it comes to capturing equity release mortgages (“ERMs”) in regulatory capital calculations, applying that broad principle is undoubtedly “easier said than done”. That no doubt explains why, in its latest consultation in this area, the PRA has adopted a notably cautious approach. In sum, this represents a sharp tightening of the PRA’s policy position on ERMs, and one that extends, rather unusually, to specifying the quantum of particular assumptions that the PRA expects should underlie ERMs’ effective regulatory value.
Building on our earlier blogs on this subject, we explore below the scale of this tightening, how it will operate in practice, and the implications for firms.
The valuation and capital complexities that equity release, uniquely, raises
As a hypothetical scenario, imagine buying a house that you cannot move into for 25 years or more. Nor is there a certain date on which you will be able to move in, although you can make a reasonable broad prediction. When you do eventually move in, however, there is likely to have been some material deterioration in its condition; and you cannot occupy it or use it for any purpose until this future date. How much do you pay for that house, as a knowledgeable, willing party, in an arm’s length transaction?
Now, imagine that, on possession in 25 years’ time, that house will fund your pension. Getting the price right will allow you to retire securely; paying too much will leave you funding the shortfall. Now how much do you pay for the house?
With so much at stake, one can see the rationale for erring on the side of caution, and this is exactly what the PRA has done in its latest CP13/18 on equity release mortgages (ERMs)1 . In a recent blog we discussed remarks made by the PRA’s Executive Director of Insurance, David Rule. These expressed significant concerns about UK insurers’ increasing exposure to UK housing; and, further, whether insurers’ Matching Adjustment (MA) calculations for portfolios of illiquid assets, in particular ERMs, were capturing returns in excess of an appropriate risk premium. CP13/18 provides the PRA’s response to those concerns, in the form of a methodology and assumptions for valuing the no-negative equity guarantee (NNEG).
Constrains on the valuation of the no-negative equity guarantee
The PRA’s CP13/18 in fact addresses both of the questions in our hypothetical scenario. The PRA expects firms to apply a methodology for valuing NNEG risk that is consistent with a Black-Scholes option pricing formula. Importantly, to that end, the PRA has specified that firms should adopt the following key assumptions:
- House price growth is assumed to follow the Solvency II risk free discount curve.
- The deferment rate2 is at least 1%. Notably, the PRA states in CP13/18 that its best view of the deferment rate is 2%, and that it would consider anything below 1% to be difficult to justify.
- The property volatility3 parameter is 13%.
CP13/18 summarises the studies carried out by the PRA to justify its calculated deferment rate and volatility parameter. However, its approach to house price growth is clear cut and straightforward:
“Firms may in due course benefit from growth in house prices in excess of the risk-free rate, but they should not reflect this expectation in the form of an ‘upfront’ higher MA.”
Reflecting the concerns expressed by David Rule on the risks that stagnating house prices would pose to insurers holding ERM assets, CP13/18 proposes a clear policy intent that insurers should not benefit from capital relief today based on expected growth in house prices in the future above risk-free interest rates.
We expect this limit, if progressed into policy, to act as a major binding constraint on the MA for some providers. In our experience, many ERM providers use a “real-world” rather than a “risk-neutral” approach to determine property growth rate assumptions, producing an expected rate of growth in excess of the risk-free rate. Most importantly, with risk free rates at current levels, both the valuation and level of MA will be based on an assumption of negative real interest rates throughout the life of the ERM contract; whereas post-war UK house prices have, over the long term, generally tracked the trend in nominal GDP growth and so have risen consistently in real terms. The impact on the MA of limiting the growth assumption to risk-free could thus well be very significant, as the PRA explicitly recognises in CP13/18.
Importantly, the PRA also expects firms (both those that have restructured their ERM portfolios and those that have not) to take account of these assumption changes in the valuation of the ICAS illiquidity premium used to calculate the transitional measure on technical provisions (TMTP). This means that any change in technical provisions relating to the MA would not be softened by the transitional adjustment, and firms may indeed see an absolute decline in the value of the transitional deduction, reflecting the effect of the changes in assumptions on the ICAS illiquidity premium.
The PRA suggests that a phase-in period of up to three years specifically for the new calibrations may be available. This relatively unusual step indicates quite how substantial the PRA expects the change may be for some firms. By the same token, it indicates quite how far in excess of a reasonable risk premium the PRA apparently considers some calculated MAs to be at present.
Implications for firms
The PRA has invited firms to provide estimates of the change in their Solvency II technical provisions (including the transitional measure) and Solvency Capital Requirement (SCR). For affected firms, the overall impact will need to be assessed in the round. For example:
- Firms will need to consider whether complying with the PRA’s proposed assumptions should also lead them to adjust the fair value of ERM assets on the accounting and/or Solvency II balance sheets. (As a component of the PRA’s effective value test, any changes to accounting fair value would flow through the overall cap on the MA.) We expect that firms may not see a clear rationale for altering IFRS valuations, which are generally based on “real-world” assumptions. However, it remains to be seen whether the PRA will expect adjustments to be made to the value assigned to ERM assets on the Solvency II balance sheet.
- As an offsetting factor, a more stringent regulatory balance sheet valuation of ERM assets may, in turn, lower the SCR capital that needs to be held against them as the base balance sheet moves closer to the stressed position. Nevertheless, whilst this has the potential to mitigate the effect of the PRA’s required assumptions on the net solvency position, any such relief will be dampened by diversification in the SCR.
Depending on where the PRA’s proposals ultimately land, we expect that firms may consider structural action on their ERM portfolios to reduce the adverse solvency effect. For example, a structured ERM note could, in theory, be re-optimised through unwinding and restructuring. Steps such as this would, however, be quite substantial and potentially disruptive to undertake. Given the Treasury Committee’s ongoing dialogue with the PRA on the need for insurers to restructure ERM assets to include them in MA portfolios, firms may see advantages in holding off any costly restructuring work pending further clarity as to the PRA’s settled position.
1CP13/18 is also accompanied by a “Dear CEO” letter.
2The deferment rate reflects the annual discount to the current property price that would be agreed and settled today to take ownership of the property at some point in the future. It is used to determine the deferment price. The deferment price differs from the forward price of an asset in that the forward price is also agreed today, but is settled in the future. A higher deferment rate puts a lower price on the property to be acquired. Therefore, it increases the cost of the NNEG.
3Property volatility is a measure of the spread of potential paths of future house prices. A larger property volatility will lead to a greater spread of future paths. Therefore, it increases the cost of the NNEG.