Equity ReleaseSep 5 2018

Equity release – with caution

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Equity release – with caution

The financial services industry has done very well out of equity release.

As of last year, more than £20bn of equity release loans were outstanding to consumers, and £3bn was lent last year to individuals, all keen to make the best use of what was likely to be their most valuable asset: their home.

The motivators are obvious: declining gilt yields suppressing annuity rates, forcing pensioners to turn to other assets to support their lifestyle; baby boomers supporting cash-strapped offspring struggling to get onto the property market.

And while business seems to be booming, even The Pensions Advice Service has acknowledged that equity release might become more mainstream as people run down their pensions.

But this has not always been the case.

Back in the 1990s the equity release industry was rocked by scandal when plummeting house prices found many equity release borrowers and their descendants unable to pay off the full extent of their loan when they came to leave their property.

 

So the industry came up with a marketing brainwave: the no negative equity guarantee (NNEG). This states that whatever happens to house prices, borrowers will no longer be in the position of having to find extra money if their property price falls below the value of the loan.

As a marketing strategy, it did much to clean up the industry and bring money back into the sector. And while house prices continued their seemingly endless rise upwards, it all seemed a bit academic.

But now house prices seem to be stagnating, the Bank of England – specifically the Prudential Regulation Authority (PRA) – is becoming somewhat concerned. The reason is largely because of equity release products’ increasing popularity among the life offices.

Key Points

  • The no negative equity guarantee was designed by equity release lenders to reassure borrowers
  • The Bank of England is getting concerned about property prices
  • Lenders may have to set aside more capital to match their liabilities

The problem is much less to do with lending to pensioners, and relates much more to the issue of how to fund annuities, and increasingly defined benefit schemes that have been transferred to life offices.

Seeking higher yields

Robert Bugg, senior consultant at actuarial consultancy Milliman, said: “There’s a growing market for defined benefit derisking and final salary schemes transferring their liabilities to the insurance market.

“Gilt yields are now so much less than they used to be and corporate bonds are not yielding so much, so other types of alternative assets are being used to find that higher yield.

“This allows insurers to offer competitive prices to pension schemes and retail annuity customers. Equity release is a big part of the strategy for finding higher-yielding assets to allow insurers to take on those liabilities at a competitive price.”

The process is looked on favourably by the actuaries.

Henry Jupe, associate director in Deloitte’s Emea Centre for Regulatory Strategy, said: “Insurers are writing a very substantial proportion of new business in the equity release market, which is quite an appropriate risk to be writing on the balance sheet because it is a long-term, very illiquid risk.”

Equity release loans pay a high rate of interest, typically 4 to 4.5 per cent, which is rolled up and usually paid back at the end of loan.

It is considered a relatively stable asset, being illiquid and relatively immune to the short-term fluctuations of investment markets. As a result, many life companies use equity release as assets to match the liabilities further down the line from annuity payments – one is a long-term asset that pays out after a certain number of years, and the other is a long-term liability.

The PRA estimated that last year, as much as 25 per cent of life offices’ annuity portfolios were backed by long-term direct assets, such as equity release, commercial property and infrastructure financing. However, by 2020, it is expected that this figure could rise to 40 per cent.

Stagnant market concern

The trouble for the PRA is that there is no external agency to measure the value of these assets, and so the insurers take a view as to how ‘risky’ they are and what value to attribute to them. 

And here is where the difference lies: the PRA has been getting concerned about the impending stagnation of the housing market, and the commitment to a no negative equity guarantee made by the loan issuers.

The insurers on the other hand, are more than comfortable with the risks they are assuming over the NNEG; nonetheless, the PRA, in a series of papers published over the past year, is asking for these companies to account for the increased risks.

Mr Bugg said: “Insurers have taken on these assets with a particular internal view as to how risky this NNEG genuinely is. The PRA has said you need to hold more capital against that risk.

“It’s not different from what the PRA has reportedly been saying in private to companies over the past six months. Many companies will already have made adjustments to their models to reflect the PRA’s view on the riskiness of NNEG.

“The PRA has been criticised by some for its apparent lack of concern for a competitive and vibrant equity release industry, and good customer outcomes.

“For them, it’s about the [security] for the policyholder – it’s to make sure they can pay these annuities.”

The issue is largely a matter of managing the insurers’ balance sheets. Under Solvency II, insurers are able to make what is called a ‘matching adjustment’, when matching long-term assets against long-term liabilities.

This means that it takes account of the fact that when trying to determine the value of the asset when it comes to maturity, to ensure it can pay the liability when it arises, insurers can be more generous in their assumptions in terms of how valuable it will be in the future.

This is because, as a long-term illiquid asset, equity release is not affected by the same risks as shorter-term assets, such as daily trading and market sentiment. Instead, the main risk with a long-term asset is default risk.

The PRA is saying that the NNEG is a riskier notion than the insurers have been accounting for, and is itself a potential default risk.

This means it will have an impact on the matching adjustments, the matching adjustment will be reduced and so the insurers have to hold more capital to cater for the impending liabilities of annuity payments some time in the future.

What this means in terms of actual impact on lenders is impossible to forecast, but Dean Mirfin, chief product officer at Key, said much of it depends on where lenders sit with regard to their capital position already.

He said: “For some providers it will have no impact; if the outcome is that more capital has to be set aside it will depend on what their means are to facilitate that. There are a number of ways lenders can deal with that, but if they don’t want to change the structure of their product in terms of LTVs, one straightforward outcome is that interest rates could go up, but there are other levers they can play with.”

Lenders could either change the LTV they offer, change the interest rate they charge, or implement a combination of both. A recent report from the Adam Smith Institute written by Durham University professor Kevin Dowd, claimed that the PRA was not doing enough to plan for the housing market imploding.

Mr Mirfin said: “What we do know is that House Price Index risk – the downside risk that lenders assume – is [already] pretty severe. If you do have a big fall in house prices, the regulators will be looking at mainstream mortgages – lifetime mortgages are a fraction of all lending.”

Perhaps it is all a storm in a teacup. But it is clear the PRA is attempting to fulfil its function as a regulator, spotting warning signs on the horizon before it is too late to do anything.

Melanie Tringham is deputy features editor of Financial Adviser and FTAdviser.com