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Asleep at the Wheel: The UK Equity Release Industry is Sitting on a Big Problem

Asleep at the Wheel

The UK Equity Release Industry is Sitting on a Big Problem

By Professor Kevin Dowd

Most UK equity release mortgages involve a no-negative equity guarantee by which the lender guarantees that the borrower or their estate will never need to pay back more than the value of their house when the loan is repaid.
The valuation of these guarantees became a hot issue this summer with the publication of Howard Mustoe’s BBC story and my report Asleep at the Wheel in August. This is a big issue because investors in the sector stand to lose billions.

Yet the reaction to these reports shows that there is considerable confusion about the valuation of these guarantees.

There shouldn’t be!

The truth is that we have known how to do these valuations properly since the seminal option pricing work of Black, Scholes and Merton in the 1970s. The problem is that equity release companies are using the wrong approach.

The correct approach uses the forward house price in the option pricing formula, but firms are using the expected future house price in the formula instead. This practice has no scientific foundation and constitutes a major error. It also produces large under-valuations in the guarantees.

My research lends support to the Prudential Regulation Authority, which has been telling the equity release industry for years that it was using the wrong approach. The industry is still in a state of denial, however, because the wrong approach is also highly profitable, at least in the short term, and firms do not wish to acknowledge that they are sitting on large hidden losses. Unfortunately, this approach may not be sustainable in the long run.

My report produced gratifyingly negative reactions from industry bodies like the Equity Release Council and analysts such as Baroness Altmann, David Cameron’s former pensions minister, but these responses merely reconfirm the central message that they still don’t understand the underlying issues.

The actuarial profession is divided, and their professional body, the Institute and Faculty of Actuaries, is on record as having endorsed some of the misconceptions of industry practitioners. However, the better actuaries understand the issues all too well.

In many ways this equity release problem is reminiscent of the Equitable Life fiasco of nearly two decades ago. That mess has taken nearly twenty years to sort out, and hundreds of thousands of investors have lost large sums of money. It has many of the same ingredients – opaque undervalued long term guarantees, incompetent practitioners, inadequate regulation and the actuarial profession. In the aftermath of the Equitable, we were assured that these problems have been fixed, but it is now clear that the ‘fixes’ haven’t worked.

Further results from this research project were presented to a seminar at the London School of Economics on 1 October. The seminar could best be described as a punchup and many industry people still refuse to accept that anything is wrong.

In the meantime, it looks like this issue is going to run and run, for a while at least. But the underlying problems will not go away, and at some point the industry will have to come to terms with them.

The article was first published in IMPACT Magazine in January 2019.

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