The potential for falling house prices after Brexit threatens the stability of lifetime mortgage returns. Firms are modelling worst case scenarios and testing the limits of an otherwise attractive asset. Callum Tanner reports.
With only four months since the UK voted to leave the EU, the observable impact of Brexit on financial markets is still short-term. But given insurers invest heavily in long-term illiquid assets, they now have to start thinking about Brexit's long-term impact. One such illiquid at risk is a lifetime, or equity release, mortgage.
Although uncertain, many economists are predicting stagnated growth in the UK as a result of Brexit. One asset at the centre of this trend is UK property, and the potential for prolonged falling house prices or a short, sharp drop in values followed by limited long-term recovery.
If this happens it poses a problem for insurers invested heavily in lifetime mortgages because of their exposure to negative equity. Legal & General, Just Retirement Partnership (JRP), LV=, Aviva and Retirement Advantage, among others, promise customers they will not claim back more than the value of their home, known as a no negative equity guarantee (NNEG).
"The real challenge is for companies to adequately cover the longevity risk and NNEG risk in their creation of the fixed note." - Gareth Mee, EY
For insurers, that means if house prices fall beyond a certain point, when the NNEG starts to bite, yields will be lower than expected.
Actuaries understand this problem best. By considering an extreme longevity, extreme negative equity scenario, it is possible to show that insurers could eventually earn nothing from a lifetime mortgage asset.
"As longevity increases, unless we have a large amount of property growth, there will be products for which the NNEG starts to bite at older ages. This wouldn't be a problem we would experience for a while, but if this happens, returns would be dampened," says Gareth Mee, executive director at EY.
Insurers consider long term negative equity unlikely, but nonetheless risk teams and regulators are not taking any chances. While some question the future attractiveness of the asset class, others remain enthusiastic.
Safe as houses?
To show just how far house prices would need to fall before equity release returns turned negative, JRP argued in October that even if values fell by 10% and then another 1% every year for 30 years, with the policyholder living until 100, the firm would still yield 4.5%.
The firm has 38% of its asset portfolio invested in equity release mortgages, averaging a yield of about 5.5%.
Although JRP is confident is can ride out any potential house price volatility, others are less sure about their own firm's ability to. A paper by the Institute and Faculty of Actuaries from 2014 describes the nature of the NNEG, saying that it can be thought of as providing the customer with a put option to sell their property on repayment of the loan with a price equal to the value of the loan at that point.
Out of reach
At InsuranceERM's Insurance Risk and Capital event on 19 October, the head of ALM at LV=, Emily Penn, argued that matching adjustment approvals were not equal across the industry, with some firms gaining the go ahead for structures unknown to, or disallowed, for others.
For smaller firms lifetime mortgages therefore appear out of reach, because if they cannot gain MA approval their LTV or interest rates would likely be less competitive than other offerings in the market.
Even firms that have already restructured equity release are hoping for more of a level playing field in the future.
"What I am afraid of is the PRA continuing to set policy internally as they take individual companies through applications with no public discussion," says a senior risk manager at a UK insurer.
Firms are still waiting for the PRA to publish a paper on equity release mortgages following its consultation in May this year. Firms have now submitted answers to PRA questions surrounding the risk of exit rates triggered by long-term care and the NNEG.
Some firms say the paper is likely to have been delayed as a result of Brexit.
This is not a problem for insurers if the house price exceeds the loan because this would mean the put option is hugely out of the money, but if the house value falls lower than the loan balance, taking into account accrued interest, this results in a reduction in loan repayment terms for the borrower. For some insurers, the increased threat of falling house prices has made this type of guarantee look unattractive.
"Having guarantees and flexibility on assets creates difficulties from an insurance company perspective, especially when looking at getting matching adjustment (MA) approval, although there are a number of ways that this can be managed," says a senior actuary at a UK insurer.
Some firms are also more vulnerable to this risk than others, depending on how large the initial loan is relative to the value of a home, known as loan-to-value (LTV), and age of the borrower. Comparing a 20% LTV lifetime mortgage for a 70-year-old at a 5% interest rate to a 30% LTV at 7%, assuming a house never grows in value, the NNEG starts to bite at year 33 for the former and year 18 for the latter, according to EY's Mee.
NNEG also hits firms with more legacy business given these were set at higher interest rates than today. In October, JRP said it was comfortable with an average LTV portfolio at 29% across all ages.
The problem also becomes more acute if annuity payments grow out of line with equity release returns.
"Some think that because equity release is a longevity-related product, that it must be a good fit for annuity business.
While this may be true at sufficient volumes, there is a potential basis risk where the lives underlying these different retirement options differ that firms should take into account," says the senior actuary.
Matching adjustment repacks
Instead of giving up on the asset, larger firms have relied on restructuring cashflows to keep them matched to annuity payments and gain MA approval. The question is whether firms have done enough to ensure the NNEG does not threaten MA compliance.
In February 2015, the Prudential Regulation Authority (PRA) made clear to firms that if they wanted to include lifetime mortgages in MA portfolios, they would need to restructure the asset cashflows using securitisation. This works by splitting cashflows into a fixed and a floating note, with the fixed note only paying stable cashflows into the MA portfolio and the potentially volatile floating note paid into another part of the business.
The repacks include removing projected cashflows, which are uncertain because of the threat of prolonged negative equity, according to Mee.
"The real challenge is for companies to adequately cover the longevity risk and NNEG risk in their creation of the fixed note," he says. "Firms tend to chop off cashflows to make sure the NNEG does not threaten MA compliance, so they tend to be prudent in case negative equity materialises."
Using the example illustrated by the graph, Mee explains that firms restructuring equity release mortgages with an SPV cut off the cashflows that exist between the green line and the red line, where they believe the NNEG could start to bite.
The green line shows the fixed note under expected house price inflation and the red line shows cashflows simulating a 25% house price drop.
A senior risk manager at a UK insurer says his restructuring approach, and the amount of capital held, is more robust than the statistics would tell you is required for a 1-in-200-year event. He says the problem, though, is that the past may not be a great indicator for the future of the asset.
"Brexit is a great case in point, where the dynamics that drive the property market may be changing: how willing are foreign investors to support UK property prices, what will happen to house prices if immigration patterns change? Then future GDP growth versus inflation, how fast will real wages rise and what does that mean for the affordability of house prices?" he says.
"If house prices were to fall to 50% and recover, this wouldn't be an issue. If they fell to 50%, and stayed there indefinitely, this would very quickly become a challenge. The interest accrual would quite quickly exceed the property values.
Nevertheless, we consider this a very extreme scenario which would profoundly impact other areas of the UK economy before equity release mortgages."
Scott Eason, head of insurance consulting at Barnett Waddingham, says firms are comfortable with the idea of restructuring or replacing a NNEG impacted equity release mortgage, just like firms plan to replace corporate bonds if they default.
"Almost everyone I know in the market has kept the equity tranches of these structures. This enables firms to amend the structures and vary these exposures in the future," he says. "If the modelling suggests that the structure can't pay the fixed note, then the insurer has control over the whole asset, so they can restructure the notes to ensure they maintain the required credit quality for MA purposes."
The question then becomes about liquidity, he says, given that corporate bonds are a relatively liquid market compared to self-originated lifetime mortgages, so firms must ensure they have enough cash being generated in the structure to meet note payments.
"Problems can occur if policyholders live longer or don't redeem mortgages as expected, and so many structures include liquidity facilities or stockpile cash in the early years by not paying coupons," he says.
Still attractive
Despite the complexity of these issues insurers are particularly drawn to illiquids like equity release mortgages, because yields in fixed income markets are next to nothing while firms have struggled to source other liability-matching assets like infrastructure projects.
The threat of falling house prices may therefore have little impact on a firm's appetite for lifetime mortgage assets. It is also part of a wider trend of the necessity to take on more risk in a lower-for-longer interest rate environment, with 5% returns of lifetime mortgages more attractive than many other assets in the market.
"If house prices were to fall to 50% and recover, this wouldn't be an issue. If they fell to 50%, and stayed there indefinitely, this would very quickly become a challenge." - Senior risk manager, UK insurer
"A one-off event, such as Brexit or the outcome of the US elections, doesn't really change our view on a particular investment. In terms of house prices falling the LTV is low enough to mean we are not concerned," says one insurance investment manager.
Furthermore, both Eason and Mee say they are seeing clients entering or considering entering the lifetime mortgage market. Mee says one insurer has as much as 75% of its asset portfolio invested in equity release.
The worry for some risk officers and actuaries is that an extreme form of negative equity would come as a profound shock to firms heavily invested in lifetime mortgages. For now, though, most firms think that is a risk worth taking.