On 31 March 2016 the Prudential Regulation Authority (PRA) published a discussion paper asking for views from firms and market participants on equity release mortgage (ERM) valuation, capital treatment, risk management and matters connected with the restructuring of ERMs under Solvency II.
In particular, the PRA is seeking views on good practices for managing risks which may be unique to ERMs as an asset class.
ERMs are loans secured by way of a mortgage on a residential property where the loan is repayable upon the death of the borrower or the borrower permanently moving into long-term care. ERMs allow borrowers to realise “residual value” in their property without having to sell the property.
The questions posed by the PRA in the discussion paper are likely to be of interest to a number of life insurance companies and reinsurers in the UK, as over recent years ERMs have proved to be a popular asset class with such firms. This is due to the fact that ERMs require long term funding and as such they are likely to closely match the liabilities of life insurers who have issued products such as annuities, which also have a long duration.
It is thought that the introduction of Solvency II may result in an increase in firms investing in ERMs. This is because Solvency II includes the ability for firms, subject to supervisory approval from the PRA, to apply a Matching Adjustment in the calculation of their technical provisions. The Matching Adjustment allows liability cashflows (the cashflows associated with a firm’s insurance liabilities) to be discounted at a rate in excess of the risk-free rate where the firm also holds assets which are closely matched to the cashflows on its liabilities. This can result in a lower total value of liabilities for the firm.
The discussion paper asks firms to respond to a number of questions covering the following topics:
- valuation and the use of market inputs;
- the framework of valuation models and how these models are calibrated;
- risk management issues connected with investing in ERMs, including the impact on a firm’s capital requirements; and
- the restructuring of ERMs for compliance with the requirements of the Matching Adjustment under Solvency II.
It is likely that the PRA will use the responses to these questions to re-assess, in the context of ERMs, the extent to which firms are complying with the requirements of risk management, asset valuation, the prudent person principle and the Matching Adjustment which have been implemented by Solvency II with effect from 1 January 2016.
The discussion process closes on Friday 27 May 2016.