Risk Management and Payout Design of Reverse Mortgages

Abstract

We analyze the risk and protability of reverse mortgages with lump-sum or income stream payments from the lender’s perspective. Reverse mortgage cash ows 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 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 protable 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 nancing structure are shown to be important drivers of the protability and riskiness of reverse mortgages, but changes in these parameters do not change the main conclusions.