Ch 27: Financial products and benefit scheme risks

Question 1

What are the two key risks to a beneficiary?

Answer 1

The two key risks are:

1. The benefits may be less valuable than required (or expected), or
2. They may not be received at the required time.

Question 2

What is the key risk to the State in relation to benefit provision?

Answer 2

The risk is that the State is expected to put right any losses that the public incurs, especially if the State provides means-tested benefits such as a minimum income level in retirement.

(For example, if the public does not make adequate retirement provision but instead spends money on their immediate lifestyle, there may be more pensioners eligible for the means-tested benefits than expected)

Question 3

What are the 4 key areas of benefit risk when the benefits are known in advance?

Answer 3

1. Inadequate funds to provide the benefits
2. Illiquid assets
3. Benefit changes
4. Not meeting beneficiaries’ needs

Question 4

What are the four key areas of benefit risk when the benefits are not known in advance?

Answer 4

1. Lower than expected benefits due to lower than expected investment returns or higher than expected expense returns.
2. Lower than expected benefits due to worse than expected purchase terms for any investment vehicles
3. Not meeting beneficiaries’ needs
4. Higher than expected claim payments on non-life insurance policies (e.g. due to high property or court-award inflation) = risk to provider

Question 5

Lifestyling

Answer 5

In the five plus years approaching retirement, the investments in the defined contribution pension scheme could be switched into the type of assets that are likely to underlie the annuity, i.e. bonds.

This way, if bond yields fall, causing annuity rates to reduce, then this is offset by a corresponding increase in the market value of the bonds in the pension scheme fund.

Question 6

Whether benefits are defined or not, how might sponsor / provider actions contribute to the uncertainty surrounding the benefits?

Answer 6

The sponsor/provider may:
- default at the time when funds held are insufficient or when the funds held include loans to the sponsor/provider

• fail to pay contributions in a timely manner
• be taken over by an organization that is unwilling to contribute to meet benefit promisis
• decide to reduce future benefits
• communicate poorly to beneficiaries on issues such as benefit guarantees, leading to complaints / need for compensation
• generally mismanage the scheme / business, leading to a benefit shortfall

Question 7

In a defined benefit scheme, what are the 6 key contribution risks?

Answer 7

1. Unknown future level of contributions. Contributions depend on the promised benefits, the eligibility of members to accrue / receive benefits, inflation, and investment returns net of tax and expenses.
2. Unknown timing of future contributions if not funded in advance.
3. The requirement to put in extra funds if there is a shortfall in the scheme - the amount and timing of which is unknown.
4. Insufficient liquid assets with which to make the contributions.
5. Insolvency risk due to excessive contributions.
6. Take-over by a third party who is unwilling to make the contributions.

(In a defined ambition scheme, such as a defined benefit promise with a defined contribution underpin, there is also the risk that contributions have to increase due to the guarantee costing more than expected)

Question 8

In a DC scheme, what are the 4 contribution risks?

Answer 8

1. Contributions are unaffordable to sponsor (because in poor financial circumstances)
2. Insufficient liquid assets with which to make the contributions
3. If contributions are linked to inflation or a salary index, that index may increase faster than expected.
4. If contributions are fixed, benefits may be less than expected / unable to provide for an expected standard of living.

Question 9

List 7 operational or external risks that may lead to uncertainty in the contributions required for a benefit scheme.

Answer 9

1. Loss of funds due to fraud or misappropriation of assets
2. Incorrect benefit payments
3. Inappropriate advice
4. Administrative costs, especially compliance with changes in legislation.
5. Wrong decisions by those to whom power has been delegated.
6. Fines or removal of tax status resulting from non-compliance
7. Changes to tax rates or status

Question 10

List six possible causes of inappropriate advice in relation to the provision of benefits

Answer 10

CRIMES

• Complicated products
• Rubbish (incompetent) adviser
• Integrity of adviser lacking
• Model of parameters unsuitable
• Errors in data relating to beneficiaries
• State-encourages 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.

Question 11

List 10 investment risks associated with a financial product

Answer 11

1. Uncertainty over the level and timing of investment returns (both income and capital)
2. Mismatching of assets and liabilities
3. Reinvestment risk
4. Default risk
5. Investment returns being lower than expected, increasing provider cost
6. Lack of appreciation of benefits by recipients due to poor returns
7. Higher than expected investment expenses
8. Liquidity risk
9. Lack of diversification
10. Changes in taxation of investment income and gains

Question 12

What is meant by ‘sponsor covenant’

Answer 12

This refers to the ability and the willingness of the sponsor to pay sufficient contributions to meet benefits as they fall due. Sponsor covenant is a source of credit risk.

Question 13

List the typical business risks faced by life insurance companies

Answer 13

1. Mortality and longevity
2. Morbidity
3. Pandemics
4. Expenses
5. Withdrawals
6. New business volumes
7. New business mix
8. Option take-up
9. Reinsurance
10. Anti-selection and moral hazard
11. Loose policy wording
12. Lack of data
13. Poor underwriting

Question 14

List the typical business risks faced by general insurance companies

Answer 14

1. Claim amounts, including claim inflation/court awards
2. Claim frequencies
3. Accumulations and catastrophes
4. Expenses
5. Renewals and lapses
6. New business mix
7. Anti-selection and moral hazard
8. Loose policy wording
9. Lack of data
10. Poor underwriting
11. Changes in the cover provided or in the characteristics of policyholders
12. Reinsurance, e.g. inappropriate reinsurance chosen

Question 15

Explain how expense, persistency and new business volume risks are inter-related

Answer 15

A product provider’s expenses can be expressed in terms of unit costs, e.g. the cost per new policy written or per in-force policy.

Unit costs comprise expenses as the numerator and volume measure as the denominator.

Lapses and new business volumes directly affect the denominator. However, the numerator will partly be fixed and will not vary exactly in line with the volume measure.

Lower than expected new business volume and/or higher than expected withdrawals will mean a lower than expected overall contribution to overheads.

Question 16

What are the risks arising from new business volumes not being as expected?

Answer 16

Greater than expected:
- Writing new business requires capital to support the additional risks taken on. If too much new business is written, the company will incur greater than expected new business strain and might face solvency issues.

• Also, the administration department might struggle to deal with very high new business volumes, leading to potential operational and reputational issues.

Less than expected:
- The company may not cover its fixed overhead expenses.`

Question 17

What are the key risks arising from the new business mix not being as expected?

Answer 17

If there are cross-subsidies in the pricing basis, there is a risk that fixed expenses will not be covered and/or that profits will not be as expected if the mix of business differs from that expected.

For example, larger policies may contribute more to fixed expenses and profits than smaller policies. There is a risk that fixed expenses are not met and/or profits are lower than expected if fewer larger policies and more small policies are written than expected.

Not all products or policies may have been priced to generate the same level if profit. There is therefore a risk that the actual mix of new business sold is weighted more towards those products or rating factors with lower profit margins than had originally been expected.