Equity release providers have come under the spotlight of the Prudential Regulation Authority as it launches an investigation into lifetime mortgage valuations, capital treatment and risk management.
In a discussion paper published yesterday (31 March), the Bank of England’s regulatory arm said it was seeking a range of views on good practice for managing the risks introduced into the wider market by large financial institutions investing in this asset class.
It flagged the difficulty of valuing equity release deals using estimates about when the occupant of the property may die and release it for sale, estimating drawdown rates and setting property-related assumptions.
Lifetime mortgages restricted to older customers, which do not have a fixed term, generally have a no negative equity guarantee and have no obligation to make regular interest payments on the capital, are a particular focus of the PRA’s exploratory probe.
The no negative equity guarantee (NNEG) - an assurance on certain forms of repayment that any excess of the accrued loan amount above the value of the property will be written off by the lender - was seized upon by the regulator as a potential risk to lenders, despite being one of the product standards required by the Equity Release Council.
From the provider’s point of view, the future value of the equity release mortgage at any given exit date depends on whether or not the NNEG is in play. If it is, the loan plus accrued interest is repaid to the provider in full, but if it not, the repayment is restricted to the value of the property.
The paper pointed out that responsibility for the sale of the property upon exit may, in some circumstances, rest with the lender who, for risk management purposes, may be willing to reduce the sale price in order to reflect a ‘quick sale discount’ on a vacant property.
“If so, this will further increase the value of the NNEG. There may be a relationship between the desirability of offering a quick sale discount and market-wide movements in house prices,” it stated.
Assumptions about exit dates affect the valuation of repayments, charges and expenses, as well as the valuation of the NNEG, according to the paper.
The exit date is “highly uncertain”, depending on the mortality, entry into long-term care or early repayment decisions of the borrower. Pooling a substantial number of equity release mortgages leads to greater confidence around the proportion of the portfolio that might exit in each future period, although some uncertainty remains.
The paper also focused on equity release mortgages’ lack of active trading, which means fair valuation is usually on a ‘mark-to-model’ basis, with a requirement to maximise the use of observable market inputs.
“The PRA has observed that firms writing equity release mortgages typically restrict the initial valuation to the amount lent, for example by including a spread of appropriate size when discounting cashflows, and updating the valuation to allow for new information affecting the valuation as it emerges,” read the document.
Good equity release risk management is central to demonstrating an overall system of control over investments, the paper warned, suggesting valuation uncertainty, the monitoring of LTVs over time and ensuring the liquidity of the overall asset portfolio as some of the relevant aspects.
Providers need to explain how they are identifying and monitor emerging risks, the paper said, “such as changes in flood risk and other environmental issues, legal changes, changes to the taxation of residential property or associated mortgages, changes to political or social attitudes to long-term care, or changes in the market for ordinary mortgages”.
Dean Mirfin, technical director at Key Retirement, said the existing UK treatment of equity release mortgage lending, in terms of capital requirements under Solvency II, was “very harsh” and was putting off many new providers entering the market.
“Part of the challenge is the ‘unknown unknowns’ with equity release mortgages, which puts them at risk of over-regulation. This seems to be a positive step, the PRA are genuinely looking for feedback on the regulatory approach to the treatment of assets.”
The process closes on 27 May, at which point the PRA may invite some respondents to participate in further discussions and could also launch a full consultation where it considers that policy or supervisory proposals are warranted.
peter.walker@ft.com
