Are the risks associated with equity-release schemes fully understood by those selling the schemes?
Equity-release products have a hangover from their reputation in the late 1980s. Potential customers are being reassured that the equity-release products being sold now are far better as they offer a “no negative equity” guarantee, giving the consumer the protection they desire.
However, for any guarantee to be worthwhile, there must be a risk to the guarantor. The questions being faced by the providers of equity-release products are how great is this risk, how should it be accounted for and whether insurance should be bought to transfer this risk away from the banks?
Two key risks which providers of equity release face are house price inflation and mortality risk.
For a lifetime mortgage, if HPI is low, then there is a risk that the value of the rolled-up mortgage becomes greater than the value of the property.
Mortality risk exists because the longer the householder lives, the greater the likelihood that the value of the loan will increase beyond the value of the property.
Let us look at the example of a 60-year-old taking out a lifetime mortgage on a property with an initial property value of £100,000 and a loan to value of 25 per cent and an increase in the value of the property 3 per cent a year against the increase in the value of the loan 7 per cent a year. They would have to live until the age of 97 before there is a loss to the provider on death.
What are the chances of a 60-year-old living until the age of 97? Probably not as low as you might think. People who are likely to enter into an equity-release mortgage are likely to be the more affluent in society and to have greater expected longevity. People are also living longer in the UK in general, which adds to the risk.
Mortality tables which allow for the improvements in mortality suggest that a 60-yearold single male would have a 7 per cent probability of living to the age of 97 while a female has an 11 per cent chance.
In practice, it is likely that it would be a couple living in the property. Assuming they are both 60 years old, the probability of at least one of them living for another 37 years is 17 per cent.
For every year that an individual lives beyond the age of 97, the greater the gap between the rolled-up mortgage and the value of the house.
Performing some actuarial calculations using the above assumptions gives an expected loss for the bank of £4,000 for an individual male but £10,000 for a couple.
However, if one of the householders lives until the age of 100 then the loss is almost £50,000. As can be seen, the variance around this expectation is substantial.
Of course, this is based on assumptions about HPI and mortality, as well as future interest rates. If HPI were 4 per cent a year in the long term, rather then 3 per cent, then the expected loss falls to zero and the householder would have to live to the age of 109 before a loss were made.
If HPI were 0 per cent, then the expected loss for a couple would be £129,000 and the householders would have to live to the age of 81 before a loss would be made. The probability of a couple aged 60 both dying before the age of 81 is a mere 6 per cent.
House prices are at an all-time high and it depends on which economist you ask as to whether HPI will continue to be high, or whether there will be a correction equivalent to a 20 per cent or 30 per cent fall.
Given the uncertainty surrounding HPI, the only way to model it realistically is by using complex scenario modelling methods known as Monte Carlo simulations. HPI is not constant over time, it is cyclical with periods of significant inflation and deflation and models must allow for this. A further advantage of such modelling is that it can allow for unusual events. The Japanese housing market has seen more than a decade of house price deflation. Could this happen in the UK?
In the UK, there has historically been a causal link between interest rates and HPI so that as interest rates rise, HPI falls. It is not difficult to imagine a scenario where loan values increase rapidly while the asset providing the security decreases in value.
This is not intended to be doom-mongering, it is simply to demonstrate that in order to assess any risk you must understand where the risk may come from.
That these scenarios are possible, if unlikely, would suggest that banks offering these products should account for the risk on their balance sheet or alternatively take out insurance to cover their risks. This is important for the sellers of equity-release products as well as for consumers.