Research on equity release mortgage risk diversification with financial innovation: reinsurance usage

Kuo-Shing Chen

Journal of Risk Model Validation

Abstract: ABSTRACT In many developed countries, equity release mortgages (ERMs) have been promoted as a scheme for accessing the equity locked up in a residence, particularly after the property owner has retired. However, ERMs include certain risk factors: crossover risk, housing price depreciation risk and interest rate risk. In this paper, I derive a new closed-form approximation for European option prices and an actuarially fair pricing of mortgage insurance based on the Brownian motion process assumption and a reverse mortgage insurer's risk with a reinsurance policy. The simulation method considers the stochastic processes of housing prices, and I analyze the insurer's risk of government-insured reverse mortgages after developing the insurance pricing model that applies the framework of European put options. The numerical results confirm that the reverse mortgages with proportional reinsurance contracts were highly sensitive to the housing price jump-diffusion process. To address the longevity risk for the elderly, I evaluate the Black-Scholes model option to project future mortality to determine the values of expected losses. To the best of my knowledge, this paper is the first study to examine the risk diversification of ERMs via the reinsurance strategy.

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