Solvency II and Just Group’s discount to NTA
The 10foot portfolio holds shares in Just Group plc (LON: JUST), a UK-based insurer that provides defined benefit de-risking programs, and ‘lifetime mortgages’, which are equity release mortgages (ERMs) with no negative equity guarantee, for retirees.
Just has persistently traded at a discount to NTA that has puzzled me for some time and I wrote in my quarterly review that I was surprised Just’s major shareholder, Permira, sold its massive stake in the company at a substantial discount to Just’s NTA of around £1.65 per share.
Just and other businesses in the UK are affected by the implementation of Solvency II requirements as well as potential changes to the regulatory framework if Brexit goes ahead. I have historically pinned Just’s discount to NTA on these factors, combined with the business’s complexity, recent merger, and fairly well telegraphed sell-down by the major shareholder. I didn’t think that the discount was fully justified.
Each of those reasons is probably true to some extent. However after reading the Prudential Regulatory Authority’s (Just’s regulator) recent Solvency II Consultation Paper CP13/18 and Just Group’s solvency report that was released in June, I have come across a possible impact to solvency, that could explain why the stock trades at a discount.
What is deferment?
The Prudential Authority states for equity release mortgages (III) The present value of deferred possession of a property should be less than the value of immediate possession.
Imagine that you have two contracts. Contract 1 is to take possession of a property immediately for $100, while Contract 2 is to take possession of the same property one year in the future, also for $100. If all of the terms are identical, Contract 2, in which you take possession later, should be worth less.
This is due partly due to foregone income of the property, but even in circumstances where income would not be earned from the property directly (such as an equity release mortgage) the other rights (e.g. a right to use the property) also have value. As a result, in order to compare the two contracts fairly, any contract that is not taken into possession immediately, must be discounted to present value. The PRA states that an appropriate deferment rate for equity release mortgages should be “positive”, and in FY17 Just Group used a 0.5% deferment rate (i.e., a discount rate).
All else being equal, a higher deferment rate should result in a lower asset value.
Additionally, because the price in both contracts is agreed upon in present value terms (even if settlement is in the future), adjustments are not made for future growth in property values, because both contracts are already equally exposed to this. I could not determine precisely which part of the equity release mortgage the deferment rate applies to. I think it is supposed to apply to the property, but it may apply to Just’s asset (i.e., the loan it makes).
E.g. You have a $100,000 house. You borrow $28,000 in an equity release mortgage. Just Group takes the house when you die and sells it to recoup the loan. Just Group therefore has a contract to take control of your house at some point, so it has to discount the value of the house (or the loan??) to present value, presumably over the period of X years for which Just estimates you will live. Just Group provides an estimate of the impact in its reports.
The most recent deferment requirements on Just Group are from Supervisory Statement SS3/17 which was published by the Prudential Authority in July 2017. SS3/17 requires that a deferment rate should be positive, but does not appear to specify what rate should be used. Just Group used a 0.5% deferment rate in 2017, which was compliant with this requirement.
However, Consultation Paper CP3/18, which was released yesterday, concluded that a best view of the deferment rate would be 2% and that, while a range of judgments are possible, an assumption of less than 1% would be difficult to justify.
This appears to suggest that if CP3/18 goes into practice without any alterations, Just Group may in time have to increase its deferment rate from 0.5% to at least 1%. In its Solvency and Financial Condition Report from June 2018, Just Group says that every 0.25% increase in the deferment rate assumption would reduce post-tax Own Funds by £80 million. So if the deferment rate increases to 1% (a 0.5% increase), then Just Group should see its Own Funds fall by £160 million. Own Funds here refers to equity from a solvency capital perspective, not a book value perspective. Still, the likelihood of a fairly serious impact to the capital requirements could also cause the stock to trade at a lower price.
There is an adjustment called TMTP that eases the transition into Solvency II, and Just says that this adjustment (implementation of which would require regulatory approval) would ameliorate up to 70% of the impact of a higher deferment rate. I won’t go into that here.
The Prudential Regulatory Authority has a useful summary statement here:
1.5 The PRA also considers that the economic effect of the NNEG (no negative equity guarantee) is effectively to provide the borrower with a put option – to give the insurer possession of the property in settlement of their debt if it is worth less than the loan and accumulated interest. The value of this requires an assessment of the present value of obtaining possession of the property at some point in the future. The current version of SS3/17 characterises this as a deferment price and reflects the PRA’s view that a deferment price will be lower than the price for possession today. The PRA considers that the extent to which that price is higher than the deferment price does not depend on views on future house price growth, because both immediate and deferred possession give exposure to future house price growth: the only difference is the value attributed to possession during the deferment period.
Just Group NTA
Just Group had net tangible assets of around £1.5 billion as at 31 December, and a market capitalisation of around $1.3 billion currently.
Here is a rough calculation of Just’s solvency, with the NTA calculations immediately below that:
Just Group “Own Funds” calculation for solvency purposes:
Total equity: £1,740m (note this includes intangibles), plus £384m in Tier 2 capital notes (at fair value) = £2,124m in Basic Own Funds. (Audited basic own funds is £2,132m due to some small adjustments).
Just Group’s Solvency Capital Requirement (SCR) is £1,606 million.
So while Just Group does have a substantial excess of solvency capital, a potential £160m (or more) impact to solvency from a higher deferment rate is not trivial.
This analysis also does not take into account the potential for the industry to raise prices to cover the higher capital requirements and maintain ROE. On balance I would think it is likely that price rises can be passed on to the customer, as a no negative equity guarantee is a peace of mind purchase and I would think much less price sensitive than many other purchases. However, it may be difficult to raise prices on existing policies in force,
I thought this is something that was worth recording with an eye to potentially revisiting in the future. I am still in the process of researching these papers and do not intend to make any changes to my Just position at this time.
I own shares in Just Group plc. This is a disclosure and not a recommendation.
I am not an expert on UK accounting or Solvency II. I may be entirely off-base and I would welcome correction either in the comments or via email (firstname.lastname@example.org) if that is the case.
An earlier version of this post incorrectly stated that deferment rates would have an impact on Just’s asset values from an accounting perspective (I.e., it would reduce Just’s book value). That was likely incorrect – deferment only affects asset values for the purposes of solvency calculations.