Chapter 27 - Financial product and benefit scheme risk Flashcards

1
Q

Discuss the risks associated with benefits for benefit schemes and their members.

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Discuss the risks related to contribution/premium risks for providers and members.

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

Discuss the risk factors affecting the security of benefits, contributions and investment returns.

A

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
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Discuss the main business risks for financial product providers.

A
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
How well did you know this?
1
Not at all
2
3
4
5
Perfectly