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Accessible Unlicensed Requires Authentication Published by De Gruyter January 30, 2015

Risk Analysis for Reverse Mortgages with Different Payout Designs

Daniel Cho, Katja Hanewald and Michael Sherris

Abstract

We analyze the risk and profitability of reverse mortgages with lump-sum or income stream payments from the lender’s perspective. Reverse mortgage cash flows and loan balances are modeled in a multi-period stochastic framework that allows for house price risk, interest rate risk and risk of delayed loan termination. A vector autoregressive (VAR) model is used to simulate economic scenarios and to derive stochastic discount factors for pricing the no negative equity guarantee embedded in reverse mortgage contracts. Our results show that lump-sum reverse mortgages are more profitable and require less risk-based capital than income stream reverse mortgages, which explains why this product design dominates in most markets. The loan-to-value ratio, the borrower’s age, mortality improvements and the lender’s financing structure are shown to be important drivers of the profitability and riskiness of reverse mortgages, but changes in these parameters do not change the main conclusions.

JEL Classification: G12; G21; G32

Funding statement: Funding: Australian Research Council, (Grant / Award Number: ‘Centre of Excellence in Population Ageing Research’, ‘Linkage Grant Project LP0883398’).

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Published Online: 2015-1-30
Published in Print: 2015-1-1

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