27. Financial products and benefit scheme risks Flashcards
1
Q
What are two key risks to a beneficiary?
A
- Benefits may be less valuable than required
- Benefits may not be received on time
2
Q
What is the key risk to the state in benefit provision?
2
A
- State expected to put right any losses that the public incurs, especially if
- State provides ‘top up’ to minimum income level in retirement (means-tested benefits)
3
Q
What are the key areas of benefit risk when the benefits are known in advance?
4
A
- Inadequate funds to provide the benefits (e.g. undefunding, insolvency, mismatch)
- Illiquid assets (e.g. funds have been set aside but are not available when they are required)
- Benefit changes (e.g. Future state benefits or insured event definition change (CI))
- Not meeting beneficiaries needs (e.g. due to inflation)
4
Q
What are the key areas for benefit risk when the benefit is not known in advance?
A
- Lower than expected benefit payments=> due to lower than expected investment returns+ higher than expected expense charges
- Lower than expected benefits=> worse than expected purchase terms for any investment vehicle
- Not meeting beneficiaries needs- inflation or failure to recognise beneficiaries needs when they were promised
- Higher than expected claim payments on non-life insurance policies (e.g. due to high court-award inflation) - risk to provider
5
Q
How can a DC scheme use its investment strategy to mitigate the risk of worse than expected annuity rates?
A
- Lifestyling=>5 + years approaching retirement
- i.e. Investment switch to assets likely to underlie the annuity=> bonds
- This way if yields fall causing annuity rates reduce then this will
- Offset by corresponding increase in the MV of the bonds in the pension scheme fund
6
Q
Whether benefits are defined or not, How might a sponsor or provider contribute to the uncertainty around benefits?
6
A
The sponsor may:
- Default at a time when funds held are insufficient or when the funds held include loans to the sponsor.
- Fail to pay contribution in a timely manner
- Be taken over by an organisation unwilling to meet the benefit promises
- Decide to reduce future benefits
- Communicate poorly to beneficiaries on issues such as benefit guarantees=> Leading to complaints+ need for compensation
- Mismanage the scheme/business=> benefit shortfall
7
Q
In a DB what are the key contribution risks?
6
A
- Unknown future level of contributions. Contributions depend on promised benefits, eligibility of members to accrue/receive benefits, inflation returns, investment returns
- Unknown timing of future contributions if not funded in advance
- Requirement to put in extra funds if there is a shortfall=> Amount + timing unknown
- Insufficient liquid assets with which to make the contributions
- Insolvency due to excessive contributions
- Take over by a 3rd party who is unwilling to make contributions
8
Q
In a DC what are the contribution risks?
A
- Contributions are unaffordable to the sponsor
- Insufficient liquid assets to make the contributions
- If contributions are linked to an inflation or salary index=> index may increase faster than expected
- Fixed contribution=> Benefits < E[Benefits]
9
Q
What operational or external risks may lead to uncertainty in the contribution required for a benefit scheme?
7
A
- Loss of funds due to fraud or misappropriation of assets
- Incorrect benefit payments
- Inappropriate advice
- Admin costs=> compliances with changes in legislation
- Wrong decisions by those to whom power has been delegated
- Fines or removal of tax status resulting from non-compliance
- Changes to tax rates or status
10
Q
What are the causes of inappropriate advice given in relation to the provision of benefits?
6
A
CRIMES
- Complicated products
- Rubbish adviser
- Integrity of adviser lacking
- Model or parameters unsuitable
- Errors in data relating to beneficiaries
- State-encouraged but inappropriate actions e.g. Encouraging people to save for retirement when this might reduce the level of state benefits they are entitled to and reduce their overall standard of living in retirement
11
Q
What are the investments risks associated with a financial product?
10
A
- Uncertainty over the timing and level of investment returns
- Mismatching A and L
- Reinvestment risk
- Default risk
- Investment returns being lower than expected
- Lack of appreciation of benefits by recipients
- Higher than expected investment expenses
- Liquidity risk
- Lack of diversification
- Changes in the taxation of investment income and gains
12
Q
What is a sponsor’s covenant?
A
- Ability+ willingness of Sponsor to pay benefits as they fall due
- Source of credit risk
13
Q
What typical business risks are life insurance companies faced by?
A
- Mortality and longevity risk
- Morbidity
- Pandemic
- Expenses
- Withdrawals
- New business volumes
- New business mix
- Options take up
- Reinsurance
- Anti-selection+ moral hazard
- Loose policy wording
- Lack of data
- Poor underwriting
14
Q
What business risks are typically faced by general insurance companies?
A
- Claim amounts
- Claim frequencies
- Accumulations+ catastrophises
- Expenses
- Renewals + lapses
- New business volumes
- New business mix
- Anti-selection and moral hazard
- Loose policy wording
- Lack of data
- Poor underwriting
- Changes in the cover provided or in the characteristics of policyholders
- Reinsurance inappropriate reinsurance chosen
15
Q
How are expense, persistency and new business volume risks inter-linked?
A
- Expense expressed as unit costs e.g. cost per policy
- Unit costs=expenses/volume
- Lapses and new business volumes directly affect Volume
- Expenses will be fixed and not vary in line with Lapses and new business volume
- Lower than expected NB volume + higher than expected lapse rate=> greater unit cost
16
Q
What are the risks of new business volume not being as expected?
A
Greater than expected:
- Writing new business requires capital to support additional risks taken on
- If too many NB, greater than expected NB strain incured
- Could lead to solvency issues
- Also, adminstration might struggled with increased NB volumes
- Leading to operational and reputational issues
Less than expected:
- Company may not cover its fixed overhead expenses
17
Q
What are the risks arising from the new business mix not being as expected?
A
- If there are cross subsidies=> risk of fixed expenses not being as covered+ profits not being as expected if mix is not as expected
- E.g. larger policies may contribute more to fixed expenses and profits than smaller policies
- IF fewer larger policies and more smaller policies than expected=> fixed expenses not met
- Not all products have been priced to give the same level of profit
- Risk actual policies sold are weighted more towards the lower level profit generators than that expected
