Chapter 27: Financial product and benefit scheme risk

Question 1

Give two examples where benefits can be uncertain?

Answer 1

1. Defined contribution

2. Life insurance that is unit-linked

Question 2

Give two examples where contributions can be uncertain?

Answer 2

1. Defined benefit

2. Life insurance where the premiums are reviewable

Question 3

List benefit risks for a DB scheme (7)

Answer 3

1. Inadequate funds
   - Benefit scheme is unfunded (insufficient contributions being paid)
   - Insolvency of sponsor/provider of benefits
   - Holding an unmatched position
2. Illiquid assets
   - Funds are sufficient but not available when benefits fall due
   - Life insurance usually has enough cash in premiums, however, new business strains can hinder this
3. Benefit changes
   - Usually only for future accrual
4. Failure to meet members’ needs
   - Benefits insufficient at the outset
   - Benefits are not inflation protected
5. Investment and Expense risk
   - Benefits lower than expected due to higher expenses or lower investment returns than expected
6. Annuity risk
   - Returns is lower, due to investment vehicle being worse than expected
   - Lower annuity returns is due to lower bond yields and higher inflation
7. Inflation risk
   - Earnings growth lower than inflations (pre-retirement risk)
   - Pension grows lower than inflation (retirement risk)

Question 4

List contribution risks for a DB scheme (3)

Answer 4

1. Uncertain level of future contributions
   - Level of contributions uncertain until all benefits have been provided
   - If a shortfall occurs, members and sponsors have to correct by higher contributions (depending on regulation)
2. Liquidity risk
   - Following a valuation, the sponsor doesn’t have enough assets to correct the position
3. Insolvency (due to over-contribution) and takeover (new sponsor doesn’t continue to sponsor the scheme)

Question 5

List benefit and contribution risks for a DC scheme (4/3)

Answer 5

Benefit risks

1. Investment risk
2. Expense risk
3. Annuity risk (if purchased)
4. RIsk of failure to meet members’ needs
   - Benefits insufficient
   - Benefits are not inflation protected

Contribution risks

1. Contribution different than expected
   - The sponsor has illiquid assets so cannot pay contributions
   - Linked to payroll
2. Matching contributions
   - Employees contribute more than anticipated
3. Contribution increase with age and years if service
   - More older or longer servicing members

Question 6

What are the general risks for both DC and DB schemes (13)

Answer 6

• Default by sponsor or provider, at the time the funds are needed
• Mergers and Acquisisitons. The new takeover doesn’t want to continue the scheme
• Decision to reduce benefits
• General economic mismatch of assets and liabilities
• Loss of funds due to mismanagement
• Incorrect benefit payment
• Administrative costs due to changes and complying with legislation
• Changes in tax rate/status
• Fines or removal of tax status due to non-compliance
• Inappropriate advice due to:
• Lack of competence
• Model, parameter or data errors
• Overly-complicated products

Question 7

What are the main risks for financial products (6)

Answer 7

1. Claims risk
   - Mortality, morbidity or longevity risk
   - Claim rate higher than expected
   - Claims occur earlier than expected
2. Expense risk
   - Charges are insufficient if the experience is worse than expected
3. Persistency, renewal and withdrawal
4. Volume + mix of business risk
   - Higher new volumes -> new business strain
   - New business mix not as expected, particularly if there are cross-subsidies in the pricing basis, e.g., large policies subsidies expenses on smaller policies
5. Options or guarantees
   - Higher takeup rate
   - Cost to provide higher than anticipated
   - More capital requirement than expected
6. Reinsurance risk
7. Underwriting risk
8. Investment risk
9. Product not easily understood by market/sales team which leads to the product being mis-sold
10. Risk of poor policy wording in what constitutes a claim
11. Legislative or regulatory changes which cause changes in demand and capital held for the product