Chapter 27 - Financial product and benefit scheme risk Flashcards
Discuss the risks associated with benefits for benefit schemes and their members.
Risks may differ when benefits are known in advance as opposed to uncertain benefits. There are also some general benefit risks. Also remember to keep in mind if you are talking from the provider or beneficiary’s POV.
BENEFITS KNOWN IN ADVANCE
These risks relate, for example, to DB schemes, without-profit life insurance policies and fixed benefit general insurance policies.
Risk of inadequate funds
- Risk there are insufficient funds to pay benefits
- May be due to:
1) underfunding
2) insolvency of sponsor/provider
3) inappropriate mismatching of assets and liabilities
4) combination of above
Risk of illiquid assets
- Risk funds are unavailable when they are required, even if there are sufficient funds
Risk of benefit changes
- Risk benefits are changed/changeable within the terms of the contract
Risk of failing to meet beneficiaries’ needs
- Risk that benefits, when paid out, do not meet the needs for which the benefit was designed
- May be due to:
1) Poor benefit offered (even if this was not intentional)
2) Inflation eroding benefit value
3) Change in beneficiaries’ circumstances
BENEFITS THAT ARE UNKOWN IN ADVANCE
These risks relate, for example, to DC schemes, with-profit and unit-linked life-assurance policies, many general insurance policies and medical scheme benefits.
Investment Risk
- Risk that level of benefits will be lower than anticipated if investment return is lower than expected
Expense Risk
- Risk that expense charges which were deducted are higher than expected
Basis risk
- Risk that benefits will be less than expected if basis used to make assumptions was inaccurate.
- Assets used to “back” benefits may perform worse than expected.
- Risk lies mostly on scheme member
Risk of inadequate benefits
- Risk of failure to recognise benefits needs at the outset leading to poor planning and insufficient benefits
Inflation risk
RISKS RELATING TO ALL BENEFIT TYPES
Fraud
Default by sponsor/provider
Takeover of the sponsor/provider
Decision by sponsor/provider to reduce future benefits
Inadequate communication of sponsor/provider with beneficiaries
General economic mismanagement by sponsor/provider of assets and liabilities may lead to shortfall in benefits
Discuss the risks related to contribution/premium risks for providers and members.
Risks can differ between when premiums are known in advance or unknown. There are also some general risks related to contributions/premiums. Also remember to keep in mind if you are talking from the provider or beneficiary’s POV.
CONTRIBUTIONS/PREMIUMS KNOWN IN ADVANCE
Risk of unaffordable rates
- Risk a time comes where payer cannot afford contributions/premiums, particularly if payer and beneficiary are different people
- Especially a risk when the beneficiary and contributor are not the same person
- Also refers to risk that payments are made late instead of not at all
Inflation risk
- If predetermined rates are not related to an inflationary factor, it is likely they will not be sufficient in coming years to cover expenses or provide a sufficient benefit (if contributions and benefits are linked)
CONTRIBUTIONS/PREMIUMS UNKNOWN IN ADVANCE
Risk of underfunding
- Premiums/contributions may not be sufficient to fund expected liabilities and benefits in the case of defined benefit (or similar) schemes
- May be internal and/or regulatory constraints on provider/sponsor inserting additional funds to cover benefits
- Normally must hold minimum capital requirement above expected value of liabilities
Liquidity risk
- Risk that occasionally contributions cannot be made on time, or are not made at all, due to lack of liquidity
Excessive contributions required
- May lead to insolvency of sponsor/provider
Guarantee risk
- Guarantees increase risk for the provider/sponsor because early payment will probably mean losses are not fully recouped from contributions/premiums
GENERAL CONTRIBUTION RISKS
Incorrect benefit payments
Inappropriate advice due to
- incompetence
- lack of integrity
- unsuitable model or parameters used
- errors in data analysed
- over-complicated products
- state-encouraged inappropriate actions through improper legislation
High admin costs during changes in ownership or legislation
Takeover risk
- New sponsor/provider may no longer be willing to continue to sponsor/provide benefits
Fines or removal of tax status due to non-compliance with legislation
Changes in tax rates or tax status
Discuss the risk factors affecting the security of benefits, contributions and investment returns.
Investment risk
- Risk exposure depends on nature of the product and what assets are used to “match” potential benefits payoffs
Model, parameter and data risk
- Incorrect models, parameters, or error-strewn data can lead to incorrect pricing of benefits and lead to unsuitable contribution rates
Strength of sponsor/provider promise
- This refers to the certainty with which promises made can be met by provider through benefits
- This should be appropriately conveyed to the member
Discuss the main business risks for financial product providers.
Business risks, in the context of FSPs, typically relate to: Underwriting Claims Expenses Withdrawals/renewals New business volume and mix Options and guarantees Use of reinsurance Exposure Financing
Now the main business risks.
Mortality and longevity risks
- Risk that mortality assumptions are significantly wrong, leading to under or over estimation of mortality
- Could be due to once-off shocks or random variation
Morbidity risk
- Risk that morbidity assumptions are significantly wrong
- Could be due to new illnesses, duration of illness or once-off shocks (e.g. pandemic)
Indemnity risks
- Risk that benefits paid are larger than expected due to incorrect assumptions
Expense risks
- Mostly related to fixed expenses as variable costs can be managed more easily
- Partly related to exposure risk, as a drop in business volume results in less cover for fixed costs
- Also related to expenses being larger than expected
- Several ways to express expenses such as:
1) Unit costs = expenses/volume (some measure of volume)
2) Cost per in-force policy
3) Cost of each claim paid
Persistency or renewal risk
- Part of exposure risk
- Risk that lapse rate is different from what was assumed and leads to a deficit
- This will also affect spread and recovery of fixed costs
Business volume and mix risks
- Part of exposure risk
- Risk that capital requirement held is insufficient to support new business strain
- Different mix of business from what was expected may be a risk if specific assumptions were made to account for cross-subsidies
Option and guarantee risks
- Related to experience on products with various guarantees and options
- Leads to higher capital strains and potential solvency issues
Reinsurance risk
- Risk that reinsurance is insufficient for the scale of risks taken on
- May also be limited availability of reinsurance
- Also failure to comprehend the coverage/limits of reinsurer