CH26 - Financial product and benefit scheme risks

Question 1

Risks and uncertainties

Answer 1

Where there is a delay between a benefit being promised and that benefit being provided, there will always be some uncertainty.

This uncertainty may relate to the level or the incidence of:

1. the benefits (usually defined contribution schemes and life insurance products that are unit-linked or with-profit)
2. the contributions / premiums required to pay for those benefits (usually defined benefit schemes and without profit life insurance products)

Question 2

Risks to the beneficiary (2)

Answer 2

There is a risk that the beneficiary’s circumstances will have changed and that:

1. the benefits will be less valuable than required
2. they will not be received at the required time

Question 3

Possible reasons why the benefits might be less valuable than expected in relation to a defined contribution scheme (7)

Answer 3

1. lower than expected investment returns or higher than expected expense charges
2. poorer than expected annuity rates at retirement (if an annuity is purchased)
3. higher than expected inflation, eroding the real value of the benefits (if a fixed income annuity is purchased)
4. sponsor default on contributions or failure to pay contributions in a timely manner
5. inappropriate advice and/or poor communication with beneficiaries
6. fraud or mismanagement
7. tax or regulatory changes

Question 4

Possible reasons why the benefits might be less valuable than expected in relation to a defined benefit scheme (9)

Answer 4

1. a change in benefits, e.g. by the States
2. higher than expected inflation, eroding the real value of the benefits (if they are not inflation-linked)
3. a shortfall in the fund, which results in the sponsor reducing benefits
4. sponsor default on benefits or failure to pay benefits at the times required
5. takeover of the sponsor by an organisation that won’t meet the promised benefits
6. sponsor insolvency
7. inappropriate advice and/or poor communication with beneficiaries
8. fraud or mismanagement
9. tax or regulatory changes

Question 5

Risks to the provider

Answer 5

There is a risk to the provider (e.g. insurance company or scheme sponsor) that benefit payments will be greater than expected or that payments will be required at an appropriate time.

Question 6

Risks to the state

Answer 6

There may be a risk for the State that it is expected to put right any losses that the public incurs.

This is particularly relevant if the State provides means-tested benefits, for example a minimum income level in retirement.

Question 7

Mean-testing

Answer 7

Mean-testing is a process for establishing whether an individual is eligible to receive benefits and/or how much benefit they should receive. It is often based on an individual’s income or assets or both.

Question 8

Benefits that are known in advance - Risk of inadequate funds (4)

Answer 8

Where the benefits are pre-defined, the greatest risk for a potential beneficiary is that there are insufficient funds available to provide the promised benefit.
This may be as a result of:
1. insufficient funds having been set aside, i.e. underfunding
2. the insolvency of a sponsor or provider of the benefits
3. the holding of investments which are not matched to the liabilities
4. a combination of these events

Question 9

Give examples of how underfunding in a benefit scheme may have occured (3)

Answer 9

A funded benefit scheme, i.e. one in which money is set aside prior to paying benefits, could be underfunded because:

1. the assumptions about future experience were unduly optimistic, i.e the contributions were unrealistically low
2. the assumptions were reasonable but the experience turned out to be unfavourable, e.g. poor investment returns or regulatory changes requiring benefit improvements
3. the sponsor did not pay what was required in terms of contributions, e.g due to poor commercial performance or even insolvency

Question 10

Benefits that are known in advance - Risk of illiquid assets

Answer 10

A separate risk is that the funds, although sufficient, are not available when they are required to finance the benefit. This liquidity may arise when assets have been set aside to fund the benefits, but it is more likely to occur if no separate assets exist.

The usual way of mitigating against liquidity risk is to hold cash.However, it is not normally necessary for a funded scheme to hold significant levels of cash as the income flow from contributions and investments will usually provide sufficient liquidity for most schemes to meet benefit outgo.

Question 11

Benefits that are known in advance - Risk of benefit changes

Answer 11

There may be a further risk that a benefit promise is changed or is changeable within the terms of the contract.
In the case of non-State provision of benefits, legislation will usually prevent a worsening of benefits that relate to past periods, unless the beneficiary agrees to the change.
However, some types of contract, for example critical illness contracts, may have definitions of an insured event that are not guaranteed throughout the terms of the contract.

Question 12

Give an example of each of the State, employer (as scheme sponsor) and individual may want to change benefits

Answer 12

State:
State benefits usually change in order to reduce costs, e.g. to deal with the increased costs arising in an ageing society. They may change to meet legislative requirements too, e.g. the equalisation of State retirement ages for men and women following a European Court ruling.

Employer:
An employer-sponsored scheme may be integrated with the State scheme, i.e target an overall level of provision including the State benefits. Any change in State benefits will have an impact on net employer benefits.

Individual:
Personal arrangements need to change due to changes in an individual’s circumstances, e.g. marriage or the arrival of children.

Question 13

Benefits that are known in advance - Risk of failing to meet the beneficiaries’ needs (3)

Answer 13

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:
1. a failure to recognise this when the benefit promise was made
2. inflation eroding the value of the benefits
3. beneficiaries’ circumstances changing

Question 14

Benefits that are not known in advance - Investment and expense risk

Answer 14

Where beneficiaries are not fully defined, but are instead linked in some way to the funds available and investment conditions, there is further uncertainty, and hence risk, for the beneficiary that the level of the benefits will be lower than expected if:

1. the investment return is lower than had been anticipated
2. any expense charges deducted are higher than expected

Question 15

Benefits that are not known in advance - Annuity risk

Answer 15

The level of benefits will also be reduced if the terms of purchase for any investment vehicles are worse than had been anticipated.
For example, for a member of a defined contribution scheme, if an annuity were to be purchased to provide a retirement pension, the level of the pension would be dependent on the terms on which an annuity could be purchased at the retirement date.

Risks exist to the extent that the investments held prior to retirement differ from those underlying the basis for calculating the annuity rate.
The risk may remain with the provider of the defined contribution arrangement if there are guaranteed annuity rates that provide higher benefits than could be bought in the market.

Question 16

State the two main factors that would lead to a worsening of the terms on which an annuity can be purchased

Answer 16

1. Failing bond yields (because annuity providers tend to back annuities with bonds)
2. increasing longevity

Question 17

Benefits that are not known in advance - Risk of inadequate benefits

Answer 17

There is a risk that either inflation or a failure to recognise benefit needs when planning provision leads to benefits that do not meet the beneficiaries’ true needs, and they consequently suffer a lower than expected standard of living.

Question 18

Benefits that are not known in advance - Inflation risk

Answer 18

There is an inflation risk for the beneficiary. Inflation may mean price or earnings inflation.
For a pension scheme, the inflation risk applies both before and after retirement. Before retirement, the risk is that the value of past contributions will reduce in real terms relative to earnings if the investment return is below earnings inflation. After retirement, the risk is that the purchasing power of the pension will be reduced if it does not increase as quickly as price inflation.

There is also inflation risk for the provider. For example:
For non-life insurance policies there is the risk that the payment on an insured event occurring is much higher than was anticipated when the policy was written. This could happen when inflationary increases in the value of the insured property are higher than general inflation, or when the courts award higher than anticipated levels of compensation for insured events.

Question 19

General benefit risks (7)

Answer 19

Whether benefits are defined or not, there are some general factors that create uncertainty around the benefits to be received.
These are:
1. Default by sponsor / provider at a time when the funds held are insufficient
2. Default by sponsor / provider when funds held include loans to the sponsor / provider
3. Failure by sponsor / provider to pay contributions / premiums in a timely manner
4. Takeover of the sponsor / provider by an organisation unwilling to continue to meet benefit promises
5. Decision by the sponsor / provider that future benefits will be reduced
6. 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
7. General economic mismanagement by sponsor / provider of assets and liabilities may also lead to a risk of a benefit shortfall

Question 20

Contributions / premiums that are known in advance - Risk of unaffordable contributions / premiums

Answer 20

If the contributions / premiums are pre-defined, there is a risk that the payer will be unable to afford them. There is a particular risk if the payer and the beneficiary are not the same person, for example in the case of a company sponsored benefit scheme providing pension payments for employees.

The risk is that the specified contributions / premiums are not made because:

1. the party is unable to afford the contributions because it is in poor financial circumstances (or, in the extreme, bankrupt)
2. the party’s immediate cashflow position is poor and assets cannot be liquidated readily to meet the contribution / premium requirements.

Contributions / premiums that are defined in real terms will create a risk that the inflationary factor to which they are linked increases at a rate greater than that anticipated.
If contributions are fixed in monetary terms, there is the risk that the resultant benefits are unable to provide for an expected standard of living.

Question 21

Contributions / premiums that are not known in advance - Uncertain level of future contributions / premiums (5)

Answer 21

If benefits, rather than contributions / premiums, are defined, it will not be possible to be certain about the level of contributions required until all benefits have been provided and no further liabilities exist. These issues are relevant to a sponsored benefit scheme where the sponsor (usually the employer) is not the beneficiary.

The overall level of the contributions required will depend on:

1. the amount of the promised benefit
2. the probability of individuals being eligible to accrue the benefits
3. the probability of individuals being eligible to receive the benefits
4. the effect of inflation on the level, or the real level, of the benefits
5. the investment return achieved on the contributions (net of tax expenses, if appropriate)

To the extent that liquid funds are not set aside in advance of benefits being provided, the above factors will also lead to uncertainty about the incidence of contributions.

Question 22

Contributions / premiums that are not known in advance - Risk of insufficient assets

Answer 22

Other uncertainties relating to the incidence of contributions result from the extent to which the value of any funds set aside does not equal the value of funds that are expected to be required to cover future benefit payments.

For example, if it is thought that the funds set aside will not be sufficient to meet the benefits for which they were intended, additional funds will be required. In theory, these additional contributions could be provided at any point in time before the benefits need to be provided. However, in practice there may be either legislative or self-imposed constraints on the timing of these contributions or the sponsor may become insolvent before the additional funds are provided.

Question 23

Suggest ways in which a deficit in a defined benefit scheme can be corrected (3)

Answer 23

1. An immediate lump sum contribution
2. An addition to the contribution paid each year for several years to eliminate the deficit
3. A reduction in the benefits payable (although this is not normally allowable retrospectively in many regulatory regimes)

Question 24

Contributions / premiums that are not known in advance - Liquidity risk

Answer 24

Any requirement to make good any shortfall by payment of extra contributions clearly creates a risk that the sponsor / provider has insufficient liquid funds to do so. If re-assessments are frequent, changes in contributions are likely to be of a manageable size.

Question 25

Contributions / premiums that are not known in advance - Excessive contributions required

Answer 25

A further risk that may be a result from excessive contributions is that the sponsor / provider itself may become insolvent. This may affect a beneficiary’s total income more than the loss of insecure benefit promises. There may be a balance to be struck if the employer is the sponsor of the benefits.

Question 26

Contributions / premiums that are not known in advance - Takeover risk

Answer 26

There is also the risk that if the sponsor / provider is taken over by a third party, the new owner may not be willing to continue to sponsor / provide the benefits.

Question 27

Contributions / premiums that are not known in advance - Cost of guarantees

Answer 27

If contributions / premiums are pre-defined but there is a minimum guarantee applying to the level of benefits, the sponsor / provider will incur extra costs, which will arise if those guarantees ever apply. To reduce the extent of these risks a sponsor / provider, who meets the balance of the cost, the cost of any guarantees should be taken into account in setting the defined contributions and the investment strategy.
(e.g. defined ambition scheme)

Question 28

General contribution risks (7)

Answer 28

Whether contributions / premiums are defined or not, there are a number of other factors that may lead to uncertainty in the contributions / premiums required.
These are:
1. loss of funds due to fraud or misappropriation
2. incorrect benefit payments
3. inappropriate advice
4. administrative costs, especially resulting from compliance with changes in legislation
5. decisions by parties to whom power has been delegated
6. fines or removal of tax status resulting from non-compliance with legislative requirements
7. changes to tax rates or status

Question 29

General contribution risks - Inappropriate advice may result from (6)

Answer 29

1. Incompetence or insufficient experience of the advisor
2. Lack of integrity of the advisor, perhaps due to sales related payments
3. The use of an unsuitable model or parameters
4. Errors in the data relating to the beneficiaries
5. State-encouraged but inappropriate actions
6. Over-complicated products

A major example of the risks of inappropriate advice arose in the UK in relation to the mis-selling of personal pension policies to individuals who had better provision through an employer-sponsored arrangement. This is thought to have been caused by a combination of some of the above factors.

Question 30

General contribution risks - Guarantees

Answer 30

Any guarantees provided by the sponsor / provider reduce uncertainties for the beneficiaries. However, they lead to an uncertainty for the sponsor / provider because of the risk of the guarantees biting and causing an increase in costs.
The benefits of guarantees and the costs of meeting them is an important feedback loop into the actuarial control cycle.

Question 31

Security

Answer 31

The overall security of benefits is related to all of the factors that affect the uncertainty of benefits, contributions and investment returns.
The security is affected to the extent that a need for extra contributions, for whatever reason, is not met immediately.

Question 32

Investment risks associated with a financial product (10)

Answer 32

1. Uncertainty over the level and incidence of investment income
2. Uncertainty over the level and incidence of capital gains
3. Reinvestment risk arising from mismatching assets and liabilities
4. Default risk
5. Investment returns being lower than expected
6. Benefits not being appreciated due to poor investment returns
7. Liquidity risk
8. Lack of diversification
9. Changes in the taxation of investment income and gains
10. Investment expenses

Question 33

Model, parameter and data risk

Answer 33

There may also be risks to overall security that result from errors in determining the contribution / premium requirements. Such errors may be a result of:

1. the use of an unsuitable model
2. the use of unsuitable parameters
3. errors in any data used to determine parameters for the models
4. errors in the data relating to the beneficiaries

Question 34

Strength of the sponsor / provider promise

Answer 34

The strength of the promise by the sponsor / provider and the impact of the asset allocation on the ability to meet promises made in adverse circumstances should be communicated to the beneficiaries.

Question 35

Sponsor covenant

Answer 35

The ability and the willingness of the sponsor to pay sufficient contributions to meet benefits as they fall due.
It is a source of credit risk, but is very difficult to measure.

Question 36

Business risks for financial product providers

Answer 36

These risks relate to:

1. claims: mortality / longevity, morbidity, general insurance claim rates and amounts
2. expenses
3. withdrawals / renewals
4. new business volume and mix
5. options and guarantees
6. use of reinsurance (insurance company) or insurance (benefit scheme)

Question 37

Business risks for financial product providers - Mortality and longevity risks

Answer 37

Longevity risk: the risk of individuals living for longer than expected, i.e mortality rates lower than expected.
Mortality risk: the risk of higher than expected mortality rates

These are examples of insurance risk and also relate to underwriting risk.

These are the risks that assumptions made about the future mortality of lives taking out new products, or with existing contracts, are not borne out in practice.
This may be 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, or even random variation.

Question 38

Business risks for financial product providers - Morbidity risk

Answer 38

This is the risk that the actual morbidity experience of existing and new customers differs from assumptions made.

As with mortality experience, differences between the actual and assumed morbidity experience could be due to changes such as the duration of illness, the rate of incidence of illness or a one-off pandemic shock.

Question 39

Business risks for financial product providers - General insurance claim risks

Answer 39

There is a risk that claim volumes or claim amounts may be significantly different to those expected.

For general insurance products this might be due to climate change, exceptional natural events, changes in customer behaviour, unexpected increases in court award inflation etc.
These risks can be categorised as insurance (claim variation), underwriting (inappropriate rating approach) and exposure (concentration) risks.

Question 40

Business risks for financial product providers - Expense risk (5)

Answer 40

Expense risks include:

1. higher than expected base expenses (e.g. due to budget over-runs, lack of expense control or poor estimation)
2. unexpected one-off or exceptional costs (e.g. due to dealing with unexpected regulatory change)
3. higher than expected levels or expense inflation
4. mismatching between the timing and level of expense outgo and charge income
5. inadequate spreading of fixed expenses

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.

Expenses comprise variable costs, directly related to business activity volumes, and fixed costs that are independent of business volume. Variable costs can generally be managed easily by expansion or contraction of operational areas. Fixed costs are less tractable and are where expense risk usually arises.

Expenses could also differ from the level expected, for example, due to an unplanned budget overrun.

Question 41

Business risks for financial product providers - Persistency or renewal risk

Answer 41

This can be considered to be an example of exposure risk, as it impacts the amount of in-force business.

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.

Question 42

Business risks for financial product providers - Volume and mix of business risk

Answer 42

These are more examples of types of exposure risk.

Writing new business requires capital to support the additional risks taken on and thus the available capital places an upper limit on new business volumes.

Volumes of new policies directly affect expense unit costs, and so link to expense risk.

All products carry risks, so a different volume and mix of business to that anticipated affects all other risk areas.

Question 43

Business risks for financial product providers - Option and guarantee risks (3)

Answer 43

If a financial product or scheme provider has offered options or guarantees, then it will be exposed to further risks:

1. There is a risk that the options become valuable to beneficiaries (and so are exercised) or that the guarantees bite, so that the cost to the provider will be higher than expected. This is normally driven by other sources of risk, e.g. market risk, depending on the precise nature of the option or guarantee offered.
2. There is a risk that more beneficiaries take up an in-the-money option than had been assumed, thus similarly increasing the cost.
3. By offering options and guarantees, the provider is likely to be required to hold more capital (to cover the extra risk). There is therefore a risk of higher than expected capital strain and potential solvency or surplus issues, if there is a high additional business volume.

Question 44

Business risks for financial product providers - Reinsurance risk (4)

Answer 44

An insurance company may choose to reinsure some of its risks and similarly a benefit scheme may choose to use insurance (e.g. for pensions in payment).

Using a counterparty in this way generates credit (default) risk, but there may also be business risk relating to uncertainties arising from:

1. inadequate appreciation of the scale of the risks assumed and hence of the (re)insurance needs
2. limited availability or prohibitive cost of the desired (re)insurance
3. failure to comprehend the coverage / limits of a (re)insurance arrangement