C26 Financial products and benefit scheme risks Flashcards
Outline the main uncertainty that exists for the parties involved when there is a delay between a benefit being promised and that benefit being provided.
Uncertainty may relate to the level or the incidence of:
- the benefits (DC, Unit linked, or with profit LI)
- the contributions / premiums required to pay for those benefits (DB or w/o profit LI)
Risks to the beneficiary
There is a risk that the beneficiary’s circumstances will have changed and that:
- the benefits will be less valuable than required, or
- they will not be received at the required time.
Risks to the provider
- benefit payments will be greater than expected
- payments will be required at an inopportune time.
Risks to the State
- Expected to put right any losses that the public incurs.
Give possible reasons why the benefits might be less valuable than expected in relation to a:
defined contribution scheme
Defined contribution scheme
Benefits may be less valuable than expected due to:
lower than expected investment returns or higher than expected expense charges
poorer than expected annuity rates at retirement (if an annuity is purchased)
higher than expected inflation, eroding the real value of the benefits (if a fixed income annuity is purchased)
sponsor default on contributions or failure to pay contributions in a timely manner
inappropriate advice and/or poor communication with beneficiaries
fraud or mismanagement
tax or regulatory changes.
Give possible reasons why the benefits might be less valuable than expected in relation to a:
defined benefit scheme.
Defined benefit scheme
Benefits may be less valuable than expected due to:
a change in benefits, eg by the State
higher than expected inflation, eroding the real value of the benefits (if they are not inflation-linked)
a shortfall in the fund, which results in the sponsor reducing benefits
sponsor default on benefits or failure to pay benefits at the times required
takeover of the sponsor by an organisation that won’t meet the promised benefits
sponsor insolvency
inappropriate advice and/or poor communication with beneficiaries
fraud or mismanagement
tax or regulatory changes.
Describe the main risks related to benefits that are known in advance
Affects DB, w/o Profit LI, fixed GI
- Inadequate funds
insufficient funds having been set aside, ie underfunding
insolvency of a sponsor or provider of the benefits
the holding of investments which are not matched to the liabilities
a combination of these events. - Illiquid assets
- Benefit changes
- Failing to meet the beneficiaries’ needs
Explain the Risk of failing to meet the beneficiaries’ nee
Risk of failing to meet the beneficiaries’ needs
Where funds are sufficient and liquid, and the level and incidence of benefits is exactly as promised, the beneficiaries are still exposed to the risk that these promised benefits do not meet their needs.
This may be as a result of:
a failure to recognise this when the benefit promise was made
inflation eroding the value of the benefits
beneficiaries’ circumstances changing.
Describe the main risks related to benefits that are NOT known in advance
Affects DC, with profit and unit linked LI and most GI
Investment and expense risk
Annuity risk
Risk of inadequate benefits
Inflation risk
Describe the additional factors that could affect the uncertainty of the benefits, irrespective of whether benefits are defined or not
These are:
default by sponsor / provider at a time when the funds held are insufficient
default by sponsor / provider when funds held include loans to the sponsor /provider
failure by sponsor / provider to pay contributions / premiums in a timely manner
takeover of the sponsor / provider by an organisation unwilling to continue to meet benefit promises
decision by the sponsor / provider that future benefits will be reduced
inadequate communication by the sponsor / provider with beneficiaries, for example relating to the strength of the sponsor / provider, guarantees etc, giving rise to
complaints and possible compensation to some beneficiaries and shortfall for others
general economic mismanagement by a sponsor / provider of assets and liabilities may also lead to a risk of a benefit shortfall.
- Fraud
- Tax and regulatory changes
Describe the main risks related to the Contributions / premiums that are known in advance
affects DC
- Risk of unaffordable contributions / premiums
- Inflation risk, if cont/premium linked to inflation
- Inadequate benefits
List the factors that affect the level of contribution in a DB scheme.
The overall level of the contributions required will depend on:
the amount of the promised benefit
the probability of individuals being eligible to accrue the benefits
the probability of individuals being eligible to receive the benefits
the effect of inflation on the level, or the real level, of the benefits
the investment return achieved on the contributions (net of tax and expenses, if appropriate).
Describe the uncertainties/Risks related to the incidence of contributions in a DB scheme
- Uncertain level of future contributions / premiums
- Funds not set aside ( unfunded scheme)
- Funding deficit
- Insufficient liquid funds
- insolvency risk due to excessive contributions
- Takeover risk
- Cost of guarantees
Outline the risk to the sponsor associated requirement to make good any shortfall in DB scheme by payment of extra contributions
- Insufficient liquid funds
- insolvency risk due to excessive contributions
Describe the additional factors that could affect the uncertainty of the contributions/premium, irrespective of whether they are defined or not
loss of funds due to fraud or misappropriation
incorrect benefit payments
inappropriate advice
administrative costs, especially resulting from compliance with changes in legislation
decisions by parties to whom power has been delegated
fines or removal of tax status resulting from non-compliance with legislative requirements
changes to tax rates or status.
List the six factors that could lead to inappropriate advice being given
Inappropriate advice may result from:
incompetence or insufficient experience of the advisor
lack of integrity of the advisor, perhaps due to sales related payments
the use of an unsuitable model or parameters
errors in the data relating to the beneficiaries
State-encouraged but inappropriate actions
over-complicated products.
Describe the factors that could affect the uncertainty/security of benefits, contributions and investment returns.
- all of the factors that affect the uncertainty of
benefits, contributions and investment returns. - Investment risk
- Liquidity risk: need for extra contributions, for whatever reason, is not met immediately.
- Model, parameter and data risk: Errors in determining contribution/premium requirement
- Strength of the sponsor / provider promise
List the investment risks associated with a financial product.
Investment risks for a financial product include:
uncertainty over the level and incidence of investment income
uncertainty over the level and incidence of capital gains
reinvestment risk arising from mismatching assets and liabilities
default risk
investment returns being lower than expected
benefits not being appreciated due to poor investment returns
liquidity risk
lack of diversification
changes in the taxation of investment income and gains
investment expenses.
List business risk for a financial provider/benefit scheme
These risks relate to:
claims: mortality / longevity, morbidity, general insurance claim rates and amounts
expenses
withdrawals / renewals
new business volume and mix
options and guarantees
use of reinsurance (insurance company) or insurance (benefit scheme).
List Business risks for financial product providers
- Mortality and longevity risks
- Morbidity risk
- General insurance claim risks
- Expense risk
- Persistency or renewal risk
- Volume and mix of business risks
- Option and guarantee risks
- Reinsurance risk
Describe Mortality and longevity risks for a financial risk provider
Experience worse than assumption due to :
- a change in the long-term mortality rate,
- a change in the rate of mortality improvement,
- a one-off shock such as a pandemic,
- random variation.
Describe morbidity risk for a financial risk provider
Experience worse than assumption due to :
- changes such as the duration of illness,
- the rate of incidence of illness
- a one-off pandemic shock.
Describe General insurance claim risks
There is a risk that claim volumes or claim amounts may be significantly different to those expected due to
- climate change,
- exceptional natural events,
- changes in customer behaviour
- unexpected increases in court award inflation etc.
Outline the main causes of expense risk.
Expense risks include:
higher than expected base expenses (eg due to budget over-runs, lack of expense control or poor estimation)
unexpected one-off or exceptional costs (eg due to dealing with unexpected regulatory change)
higher than expected levels of expense inflation
mismatching between the timing and level of expense outgo and charge income
inadequate spreading of fixed expenses.
Explain how expense risk is interlinked with other risks
A product provider’s expenses can be expressed in terms of unit costs: the cost per new plan written, the cost per in-force policy and the cost of each claim paid. Unit costs comprise expenses as the numerator and a volume measure as the denominator. Lapses and business volumes written affect the denominator and so expense, persistency and new business volume risks are interlinked.
Describe lapse, Persistency or renewal risk
Whether lapses are a source of surplus or deficit depends on the funds notionally held against a particular policy compared to any surrender value paid. If the lapse rate is different from that assumed, surplus or deficit will result.
Increased lapses will always adversely affect expense unit costs.
Selective withdrawal- > worse experience
Liquidity issues
Describe Volume of business risks
- Limited capital -> cap on new business
- higher than expected volumes of business are sold, the company might face solvency issues arising from new business strain.
- Volumes of new policies directly affect expense unit costs, and so link to expense risk.
Explain how mix of business risk arises for an insurance company.
- Cross subsidies
- More volume on low profit margin products
List each type of risks in LI and benefit scheme
refer to ppt for examples of risks for each risk types
