We expect to finalise these proposals by the end of September so that firms can start applying the Test on their base balance sheets from the end of this year. Firms will need longer to review their internal model methodologies and make any necessary changes. We have proposed that this should take place by the end of 2021 at the latest. A key point to draw out is that lenders of equity release mortgages are exposed to the risk of individual property prices. This is because insurers provide a no-negative-equity guarantee to every borrower. Modelling approaches focused on house price indices do not capture all the risks – a portfolio of options is a very different thing to an option on a diversified index. Indeed UK insurers have experienced a number of these guarantees crystallising in recent years despite the rapid rise in UK house price indices over the past decades. One reason is that different localities of the United Kingdom have seen widely varying house price inflation – a national index masks the range of outcomes (Chart 7). Another is that some properties may become dilapidated if elderly borrowers are unable to maintain the property. Willingness to maintain may be lower where borrowers have limited or no equity remaining in their properties. Equity release contracts generally require properties to be maintained. But, in practice, losses do occur and cannot necessarily be recovered.
Unscrupulous owners and managers might therefore have an opportunity to take excessive risks or misuse policyholder funds: for example, by using them to finance their other business ventures. They might also seek to mask the true financial position of an insurer using opaque models, optimistic assumptions and impenetrable mumbo jumbo. The misalignment of incentives might be particularly extreme when an insurer is close to insolvency, with owners and managers tempted to take more risk in a ‘gamble for resurrection’. In my view, these risks are common to any profit-seeking financial institution in the business of investment in order to pay annuities. That is why, for example, our response to the recent Department of Work and Pensions consultation on superfunds said: “The risks faced by DB consolidators are similar to those managed by insurance companies providing annuities. And insurance companies may want to enter the defined benefit consolidation market. There may be unintended consequences if the two types of business are regulated differently.”4 4  https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/pra-response-to-dwp-consultation-paper-definedbenefit-pension-scheme-consolidation  3  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  3  Overall, I think the PRA’s implementation of the Solvency II regime addresses these risks well. I would emphasise in particular the following features of the regime: 1. It strongly encourages UK insurers to invest in assets with fixed cashflows that closely match those of their annuity liabilities. This limits exposure to market risk. 2.