Dowd Report On Cost Of Guarantees Linked To Equity Release Mortgages

Press Release 105 – Joint Press Release from UKSA and ShareSoc
on behalf of individual investors

Dowd Report On Cost Of Guarantees Linked To Equity Release Mortgages

UKSA-ShareSoc welcome the publication of Professor Kevin Dowd’s report on the valuation of embedded guarantees in equity release mortgages, which raises troubling questions about the quality and transparency of corporate reporting. It also raises concerns about the opaque relationship between regulators and regulated firms.

Equity release mortgages allow people over the age of 55 to borrow a proportion of the value of their own home. Usually, they don’t have to make any repayments before they go into long time care or die, so interest ‘rolls up’ and is added to the loan.

Although the debt can increase quite quickly over a period of time, crucially, equity release products have a no negative equity guarantee, which means that neither the homeowner nor their estate will be liable to pay any more than the net proceeds after the property is sold, even if that amount left is not enough to repay the outstanding rolled up loan amount.

Professor Dowd’s report questions the valuation of the ‘no negative equity guarantee’ by providers. He claims that the providers (typically insurance companies who want to back their pension liabilities) have significantly underestimated the value of this guarantee, and have made ‘a major intellectual error that can make a material difference to the valuation’. The error consists in using the wrong forward house price in the Black option pricing formula, which dramatically underestimates the cost of the guarantee. This under-estimation has created ‘a ticking time bomb’ that could do serious damage to the financial health of the Equity Release sector. The issue could have a major impact across the Equity Release sector and is likely to provide a new wave of pain for the shareholders.

UKSA-ShareSoc have the following concerns:

  • Prof Dowd has claimed that the current valuation of the guarantee involves a major intellectual error and that the PRA has known about the mis-valuation for a number of years. If this is the case, then the PRA has been irresponsible in not informing the market.
  • Any serious mis-valuation will directly affect the shareholders of these insurers. The PRA must have known the corrected valuation would lead to huge losses for shareholders, yet they have done nothing for nearly four years.
  • Perhaps the PRA was concerned about ‘fairness’ to the firms affected by the valuation issue. However, there is an equally important issue of fairness to the investors who have continued to buy shares, or to lend to the affected companies throughout the investigation.
  • If current valuation practice involves a major error, the auditors and actuaries of affected firms should explain why they did not pick this up earlier.
  • Equity release mortgages are an asset used by insurers to back pension liabilities, yet no assurance has so far been given by the PRA or FCA that no pension assets are at risk.

The stability of the financial system, and faith in the pension system, depends on investors willingly taking on risk on the basis that they understand what is going on. A proper understanding in this case relies on the assumption that statutory and regulatory reports such as the Solvency II capital adequacy calculation quantifying the risk of insolvency at 1 in 200 years, are accurate. If investors lose confidence in such reports, the stability of the financial system will be compromised.