Risk Based Capital and Pricing for Reverse Mortgages Revisited

Demographic change is happening in developed countries with an ageing of the population. Individuals are financing retirement increasingly from superannuation savings and less from government pension support. A major asset that individuals have to fund their retirement is the residential home. The reverse mortgage is a product that allows retirees to access the value of their home to provide financing of retirement. Product providers need to assess the risks in offering reverse mortgage products including the “no negative equity” guarantee as well as the risks arising from termination of loans. Risk based capital and product sensitivity to future uncertainties need consideration following the recent financial crisis where interest rate spreads increased dramatically. This paper develops and implements a methodology to assess risk, pricing and capital requirements for reverse mortgage products for providers in the Australian market. A Vector Autoregressive Model (VAR) for financial variables including interest rates, house prices and CPI based on Australian data is used to better capture the interrelationship between economic variables. These economic variables are the most important in determining the timing and severity of losses to the issuer. The VAR model is flexible and straightforward to use in simulations. A typical reverse mortgage for a 65 year old is used to demonstrate the analysis. Termination rates and the impact on risk based capital are assessed based on US experience. Risk measures are used along with sensitivity analysis to assess pricing and capital for insurers and lenders. The effect of termination, mortality, and interest rate spreads is quantified.