Chapter 26-Financial product and benefit scheme risks Flashcards
- Outline the main uncertainties that exist for the parties involved if there is a delay between a benefit being promised and the benefit being provided.
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 the benefits, or to the level or the incidence of the contributions/ premiums required to pay for those benefits.
There is a risk that the beneficiary’s circumstances will have changed and that the benefits will be less valuable than required or that they will not be received at the required time.
In circumstances where there is no uncertainty about the level or incidence of the benefits or contributions, there may still be a risk that inflation has adversely affected the value of the amount.
There may be a risk for the State that it is expected to put right any losses that the public incurs.
- Outline an uncertainty that the State is creating for members of the public if it offers a minimum level of income, on a means-tested basis.
This is particularly relevant if the State provides means-tested benefits, for example a minimum income level in retirement. If an individual believes that the minimum income level is sufficient for all their needs, they would be better advised to spend surplus funds on improving their immediate lifestyle. If the surplus funds were invested to provide a future income, this income might simply reduce the sum that the State would provide by exactly the same amount. The individual would forgo immediate consumption for no increase in income later.
- Describe the benefit risks for DB schemes.
Inadequate funds
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:
* insufficient funds having been set aside, ie underfunding
* the 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
The funds, although sufficient, are not available when they are required to finance the benefit. This illiquidity may arise when assets have been set aside to fund the benefits, but it is more likely to occur if no separate assets exist.
Benefit changes
A further risk is 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.
Members’ needs not met
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, or inflation eroding the value of the benefits or beneficiaries’ circumstances changing.
- Describe the benefit risks for DC schemes.
Lower than expected investment return
There is further uncertainty, and hence risk, for the beneficiary that the level of the benefits will be lower than expected if the investment return is lower than had been anticipated, eg due to:
* under-performance of assets leading to lower than expected investment income
* under-performance of assets leading to lower than expected capital growth
* contribution being paid later than expected, so there is less time to earn investment return
* a fall in market values at the time that the pension annuity is purchased
* investment expenses being greater than expected
Poorer than expected annuity purchase terms
The level of the benefits will also be reduced if the terms of purchase for any investment vehicles are worse than had been anticipated, eg due to:
* a fall in the investment return the annuity provider expects to receive post-retirement
* improving mortality, so more benefit payments are expected to be made
* a change in the type of annuity purchased, for example a inclusion of spouse pension or pension increases
* expense and profit allowance in the cost the annuity may be greater than expected
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.
Members’ needs not met
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.
- Describe the inflationary risks to a general insurance company that pays out benefits on the occurrence of insured events.
For non-life insurance policies there is also 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.
- List the additional benefit risks irrespective of whether the benefits are defined or not.
Whether benefits are defined or not, there are some general factors that create uncertainty around the benefits to be received. 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 benefits will be reduced
* inadequate communication by 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.
- Describe the contribution risks for DC schemes.
Unaffordable contributions
If the contributions/ premiums are pre-defined, there is a risk that the payer will be unable to afford them.
Insufficient liquidity to make the payments in a timely manner
Contribution linked to an inflationary factor introduces an inflation risk
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.
Contribution not linked, benefits may be eroded by inflation
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.
- Describe the contribution risk for DB schemes.
Future contribution unknown
It will not be possible to be certain about the level of contributions required until all benefits have been provided and no future liabilities exist. 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).
Extra contributions required to meet a shortfall
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.
Takeover by third party not willing to continue contributions
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.
Guarantees incurring extra costs
If there is a minimum guarantee applying to the level of benefits, the sponsor / provider will incur extra costs (depending on who has given the guarantee), which will arise if the guarantees ever apply. To reduce the extent of these risks for 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.
- List the additional contribution risks irrespective of whether they are defined or not.
Whether contributions / premiums are defined or not, there are several other factors that may lead to uncertainty in the contributions / premiums required. These are:
* 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.
- Describe the uncertainties relating to the incidence of contributions in a defined benefit scheme.
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.
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 either be legislative or self-imposed constraints on the timing of these contributions or the sponsor may become insolvent before the additional funds are provided.
- How might legislation impact on the level and timing of contributions to a defined benefit scheme?
One legislative approach is to require that the values of assets and liabilities are regularly assessed and compared, with corrective action being required if the assets are not sufficient. Furthermore, in some countries a minimum capital requirement must be held in addition to the value of the liabilities.
- List six factors that may lead to inappropriate advice being given and give a real life example.
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
* State-encouraged but inappropriate actions
* 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.
- Discuss the impact of benefit guarantees on risk and uncertainty.
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 becoming relevant 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.
- Describe the factors that could affect the security of members’ benefits.
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.
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:
* the use of an unsuitable model
* the use of unsuitable parameters
* errors in any data used to determine parameters for the models
* errors in the data relating to the beneficiaries.
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.
- List the main claim-related business risks for a life insurance company.
For a life insurance company, the main claim-related business risks relate to:
* Mortality
* Longevity
* morbidity:
○ critical illness incidence rates
○ income protection claim inception/ termination rates
○ long-term care claim inception/ termination rates
* medical advances (diagnosis, cures etc) loose
* policy wordings
* accumulations of risk and catastrophes
* anti-selection
* moral hazard
* selective withdrawals (increasing mortality/ longevity/ morbidity risk)
* use of reinsurance
* mortality/ morbidity options.
