Reverse mortgages provide an alternative source of funding for retirement income and health care costs. The two main risks that reverse mortgage providers face are house price risk and longevity risk. Recent real estate literature has shown that the idiosyncratic component of house price risk is large. We analyze the combined impact of house price risk and longevity risk on the pricing and risk profile of reverse mortgage loans in a stochastic multi-period model. The model incorporates a new hybrid hedonic repeat-sales pricing model for houses with specific characteristics, as well as a stochastic mortality model for mortality improvements along the cohort direction (the Wills Sherris model). Our results show that pricing based on an aggregate house price index does not accurately assess the risks underwritten by reverse mortgage lenders, and that failing to take into account cohort trends in mortality improvements substantially underestimates the longevity risk involved in reverse mortgage loans.

A growing literature addresses the pricing and risk management of reverse mortgages and other equity release products. More and more sophisticated pricing techniques are being used and a range of different models have been developed for the health-related termination of equity release products. Several studies including Wang et al. (2008), Li et al. (2010) and Yang (2011) assess the impact of longevity risk on the pricing and risk management of reverse mortgages. A key risk factor -house price risk -has received relatively less research attention. Previous studies have typically assessed house price risk based on market-wide house price indices. For example, Chen et al. (2010), Yang (2011) and Lee et al. (2012) model house price risk using a nationwide house price index for the United States, whereas Hosty et al. (2008) and Li et al. (2010) use a nationwide index for the UK. Wang et al. (2008) average house prices in eight capital cities in Australia. Sherris and Sun (2010), Alai et al. (2013) and Cho et al. (2013) use city-level data for Sydney, Australia. Reverse mortgage loans implicitly include no-negative equity guarantees that are basically a portfolio of options on individual properties, instead of an option on a portfolio of properties.