Accounting for lifetime mortgages, which are repaid only from the sale proceeds of the underlying property, is a complex area that involves considerable judgement dependent upon the specific facts and circumstances. In particular, these mortgages will typically contain an insurance element required to be accounted for under IFRS 4 where the level of insurance risk is significant. This paper sets out background on how lifetime mortgages typically work and guidance on the key accounting considerations.
This paper only considers current accounting standards, IFRS 4 and IAS 39. Future accounting changes could significantly impact the accounting for lifetime mortgages. In particular, where contracts are determined to be insurance contracts they will be within the scope of the IASB’s ‘Phase II’ insurance contracts project. The finalisation of a new insurance contract standard is likely to require significant changes to the accounting and in particular may not permit unbundling of non-distinct investment components (such as the loan) from insurance contracts). IFRS 9 will also change the accounting for financial instruments when it replaces IAS 39.
Lifetime mortgages (also sometimes known as ‘equity release mortgages’ or ‘reverse mortgages’) are loans secured against a property where interest is accrued but not paid until the end of the mortgage. This is usually when the borrower dies or moves into long term care. The property is then sold and the proceeds used to repay the mortgage balance (including the accrued interest). If the property is sold for more than the mortgage balance, the excess is paid to the customer. However if there is a shortfall, the loss is borne by the lender due to these contracts including a ‘no negative equity guarantee’ clause.
In a lifetime mortgage, the lender is effectively providing a guarantee to the borrower or his/her estate against negative equity exposures such that if house prices drop in the future (or increase at a lower rate than the interest rate charged), the lender may be exposed to losses when the borrower dies or moves into long term care. Further, this risk increases as the period to when the borrower dies or moves into long term case increases, as this increases the likelihood that the house prices will be below the loan balance when the loan ends.
The interest rate on a lifetime mortgage is generally higher than a normal repayment mortgage; this is because economically the rate charged includes both the cost of borrowing and the embedded insurance premium. The borrower typically has a prepayment option but, due to the nature of these contracts, this is seldom exercised. This paper does not consider the accounting impact of any embedded derivatives.
Many repayment mortgages may also be expected to be repaid through the sale of the underlying property. However unlike lifetime mortgages, repayment mortgages do not generally contain a ‘no negative equity guarantee’ and therefore are not insurance contracts.
1. Is a lifetime mortgage an insurance contract?
A lifetime mortgage is generally considered to be an insurance contract under IFRS 4 unless there is no scenario with commercial substance that could result in the insurer paying significant additional benefits. [IFRS 4 para B23]. Even if the insured event is extremely unlikely it can still give rise to an insurance contract if it has commercial substance and can result in significant additional benefits being paid. [See also IFRS Manual of Accounting paragraph 8.10].
As part of the analysis as to whether the insurance risk is significant at inception, the following factors could be considered:
- Loan to value (LTV) ratio at inception.
- Age of owners at inception (and hence mortality expectations).
- General trend and expectations in house prices at inception compared to the interest rate.
- The insurance premium embedded in the interest rate (that is, what would the rate have been without the guarantee).
Where lifetime mortgages are insurance contracts the accounting requirements of IFRS 4 apply.
Lifetime mortgages typically contain both an insurance component (the no negative equity guarantee) and a loan component (the mortgage). Depending on the issuer’s other accounting policies, IFRS 4 may either require or permit the lender to ‘unbundle’ the contract into its component parts, that is, a mortgage loan (accounted for under IAS 39) and an embedded insurance contract (accounted for under IFRS 4).
For lifetime mortgages which fall within the definition of insurance contracts, we think that generally the lender will have a choice under IFRS 4 to either unbundle as described above, or to account for the entire contract as an insurance contract under IFRS 4.
3. Accounting treatment if not unbundled
IFRS 4 allows insurers to continue to use their existing local GAAP accounting policies to measure insurance contracts. However, the amount of the insurance liability is subject to a liability adequacy test.
If an insurer applies a liability adequacy test that meets specified minimum requirements, IFRS 4 does not impose further requirements. [IFRS 4 para 16]. The minimum requirement for a liability adequacy test to comply with IFRS 4 is that it should consider current estimates of all contractual cash flows and of related cash flows such as claims handling costs, as well as cash flows resulting from embedded options and guarantees. If the recognised liability is inadequate in light of the estimated future cash flows, the entire deficiency must be recognised in profit or loss.
If an insurer's accounting policies do not require a liability adequacy test that meets the minimum requirements described above, then paragraph 17 of IFRS 4 requires a liability adequacy test to be performed based on the amount which would be calculated under IAS 37.
The question arises as to how this test should be applied to lifetime mortgages. If the valuation basis applied already incorporates the valuation of the no negative equity guarantee into the carrying value of the asset, then it may be that this valuation basis meets IFRS 4’s minimum requirements for a liability adequacy test (although this would need to be assessed on a case-by-case basis). However, where the valuation basis applied does not otherwise value the no negative equity guarantee an acceptable approach to the liability adequacy test is described below. However, as IFRS 4 contains limited guidance, there may be other acceptable approaches.
Applying the liability adequacy test
The liability adequacy test could be performed by comparing the amount of the mortgage including all accrued coupons on expected maturity with the expected market value of the property held as collateral. If the expected value of the property is lower, then this should be reflected in the accounts by reducing the carrying value of the of the lifetime mortgage asset. This could be achieved by using a paragraph AG8 of IAS 39 type methodology.
Under this approach an effective income rate (the ‘original EIR’) is determined at inception of the contract. Any subsequent changes in assumptions around mortality and house prices are applied to update the expected amount of the mortgage and the expected market value of the property at the updated expected maturity of the mortgage. If the expected value of the property is lower, this is discounted at the original EIR and becomes the new carrying amount of the lifetime mortgage asset, with any difference from the previous carrying amount recognised in the income statement. Note that this will be different to an IAS 39 impairment methodology as it takes into account current estimates of all contractual cash flows (as required by IFRS 4), whereas under IAS 39 an impairment would only be recognised after an incurred loss event.
In practice an AG8 methodology is likely to be the most commonly applied method by banks as it is close to the accounting for changes in expected cash flows for loans held at amortised cost under IAS 39. While this method is consistent with amortised cost accounting it arguable might result in overly prudent provisions being recognised as it does not take into consideration the additional component of future interest charges to cover the insurance risk (the embedded insurance premiums)which could be used to offset any expected shortfalls under insurance accounting. An alternative acceptable approach may be to perform the liability adequacy test in the way described above but with the roll up of the value of the mortgage to exclude these ‘embedded insurance premiums’ not yet recognised.
The operation of the liability adequacy test described above is based on the assumption that the lender is seeking to apply an amortised cost basis of valuation. In practice where lifetime mortgages are issued by insurance groups they are often valued using fair value type approaches where the value changes in response to changes in interest rates (this is in order to match the movements in the insurance liabilities, such as annuities, that these loans are held to back). Where a fair value type approach is adopted, a liability adequacy test appropriate for this valuation basis will need to be developed unless the valuation approach already incorporates a liability adequacy test meeting the minimum requirements set out in paragraph 16 of IFRS 4.
4. Accounting treatment if unbundled
If the contract is unbundled, then the insurance component would only be in relation to the ‘no negative equity guarantee’. The total income expected over the life of the contract would need to be split between the interest on the mortgage loan and the insurance premium, with an appropriate revenue recognition methodology selected for each component. The mortgage loan component would be accounted for under IAS 39.
The insurance component would be accounted for as a standalone insurance contract under IFRS 4. Whilst IFRS 4 does not specify a pattern for revenue recognition, one approach would be for revenue to be recognised over the terms of the contact based on the allocation of the total cash flows to the insurance premium component. For example, the allocation of revenue over time could be done on either a straight line or effective interest rate (EIR) basis (to match the revenue recognition profile on the mortgage component).
An accounting policy would need to be developed for the insurance component which would be accounted for as a standalone insurance contract (and so be subject to a liability adequacy test).
IFRS 4 does not specify how insurance contracts should be presented in the primary statements. Therefore an appropriate accounting policy for the disclosure of insurance contracts will need to be developed.
In certain situations the presentation of lifetime mortgages will be similar to ordinary repayment mortgages for example if the insurance contract is not unbundled and an accounting policy choice is taken to account for the contract under IAS 39, subject to a liability adequacy test. In other situations revenue from the insurance component will be presented separately as a stand-alone insurance contract.
If amounts relating to an insurance contract are included within other line items, this should be made clear, if material, for example through adapting the title of the line item.
In many cases the accounting and presentation of lifetime mortgages may be similar to ordinary repayment mortgages. While the IFRS 7 financial risk management disclosures scope out insurance contracts, IFRS 4 does require certain IFRS 7 disclosures to be provided as if they were in the scope of IFRS 7. In addition users of the accounts would expect certain common mortgage related disclosures to be made (for example LTV disclosures).
In addition IFRS 4 contains specific disclosure requirements for insurance contracts, which will also need to be disclosed. This includes qualitative disclosures such a description of the objectives, policies and processes for managing insurance risk, and quantitative disclosures for the sensitivity to insurance risk.
Careful consideration will therefore need to be given to both the IFRS 4 and IFRS 7 disclosure requirements for lifetime mortgages.
Given that IFRS 4 allows various methods for accounting for insurance contracts it is important that the accounting policy adopted is appropriate described in the accounting policies notes. This should include details of any policy choices made, how the asset and revenue is measured and presentation within the financial statements.