Chapter 27: Financial product and benefit scheme risks Flashcards
Explain how the following different types of schemes operate:
- a defined benefit scheme
- a defined contribution scheme
- a hybrid scheme
- a medical benefit scheme
Defined benefit scheme:
Under this scheme, the scheme rules define the benefit independently of the contributions payable, and benefits are not directly related to the investments of the scheme.
Defined contribution scheme:
This scheme provides benefits where the amount of an individual member’s benefits depends on the contributions paid into the scheme in respect of that member, increase by the investment return earned on those contributions.
Hybrid scheme
A hybrid scheme is designed such that risks are shared between the different parties involved.
Medical benefit scheme
A medical benefit scheme indemnifies, or partially indemnifies, members and their dependants from medical expenses incurred in hospital or out of hospital. It is funded by contributions which vary by the level of coverage selected by the member. Their ability to underwrite may be restricted by regulations.
What are the two things uncertainty may relate to?
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
- the contributions / premiums required to pay for those benefits
Explain the risks to the beneficiary, provider and to the state
Beneficiary:
There is a risk that the beneficiary’s circumstances will have changed and that:
- the benefits will be less valuable than required, or
- they will not be received at the required time.
In the 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.
Provider:
There is a risk to the provider that benefit payments will be greater than expected or that payments will be required at an inopportune time.
State:
The state is also at risk if it is expected to put right any losses that the public incurs, e.g. if it provides means-tested benefits such as a minimum level of income in retirement.
Describe the risks of benefits that are known in advance
Risk of 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 a result of:
- insufficient funds having been set aside
- 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.
Risk of illiquid assets:
A separate risk is that 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.
Risk of benefit changes:
There may be a further risk that a benefit promise is changed or is changeable within the terms of the contract.
Risk of failing to meet the beneficiaries’ needs:
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 a result of:
- a failure to recognise this when the benefit promise was made
- inflation eroding the value of the benefits
- beneficiaries’ circumstances changing
Describe the risks of benefits that are not known in advance
Investment and expense risk:
Where benefits 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:
- the investment return is lower than had been anticipated, or
- any expense charges deducted are higher than expected.
Annuity risk:
The level of the benefits will also be reduced if the terms of purchase for any investment vehicles are worse than had been anticipated.
The two main factors that would lead to worsening of annuity terms are falling bond yields and increased longevity.
The annuity risk can be mitigated to a certain degree by switching the assets of a retirement pension fund into those that underlie the annuity as retirement approaches.
Risk of inadequate benefits:
There is a risk that either inflation or a failure to recognise benefit needs when planning provisions leads to benefits that do not meet the beneficiaries’ true needs, and they consequently suffer a lower than expected standard of living.
Inflation risk:
There is inflation risk for both the provider and the beneficiary.
Discuss some general benefit risks
Whether benefits are defined or not, there are some general factors that create uncertainty around the benefits to be received
These are:
- default by the sponsor / provider at the time when the funds held are insufficient
- default by the sponsor / provider when the funds held include loans to the sponsor / provider
- failure by the sponsor to pay contributions 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 future benefits will be reduced
- inadequate communication by the sponsor / provider with beneficiaries, 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.
Discuss the risks of Contributions / premiums that are known in advance
If the contributions / premiums are pre-defined, there is a risk that the payer will not be able to afford them.
There is a particular risk that if the payer and the beneficiary are not the same person.
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.
Discuss the risks of Contributions / premiums that are not known in advance
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 future liabilities exist.
These issues are relevant to a sponsored benefit scheme where the sponsor is not the beneficiary.
Risk of insufficient assets:
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.
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.
Liquidity risk:
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.
Excessive contributions required:
A further risk that may 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.
Takeover risk:
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.
Cost of guarantees:
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 every 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.
Discuss general contribution risks
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:
- 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.
Inappropriate advice:
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 relating to the beneficiaries
- state-encouraged but inappropriate actions
- over-complicated products
Any bad advice given or mistakes made by these specialists, may result in the sponsor having to make higher contributions than otherwise anticipated.
Guarantees:
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.
Discuss risks related to overall security of benefits
The overall security of benefits is related to all of the factors that affect the uncertainty of benefits, contributions and investment returns.
Investment risk:
Where the investment risk exposure lies depends on the nature of the scheme or product. This risk includes:
- uncertainty over the level and incidence of investment income and capital gains,
- reinvestment risk arising from mismatching assets and liabilities,
- default risk,
- investment returns being lower than expected,
- liquidity risk,
- lack of diversification,
- changes in the taxation of investment income and gains,
- and investment expenses.
Model, parameter and data risk:
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.
Strength of the sponsor / provider promise:
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 business risks that are typically faced by financial product providers.
- Claims: mortality / longevity, morbidity, general insurance claim rates and amounts
- Expenses
- Withdrawals / renewals
- New business volume and mix
- Options and guarantees
- Use of reinsurance or insurance
Discuss the mortality and longevity risks
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 might 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.
Discuss the morbidity risk
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.
Discuss general insurance and medical schemes claim risks
There is a risk that claim volumes or claim amounts may be significantly different to those expected.
For general insurance and medical schemes business, the equivalent to the insurance risk that arises in relation to mortality, longevity and morbidity rates is the uncertainty in relation to the claim rates or claim frequency of the business written.
There is also uncertainty relating to the amount of claim.
Discuss the expense risk
The main causes of expense risk is:
- higher than expected base expenses
- unexpected one-off or exceptional costs
- higher than expected levels of expense inflation
- mismatching between the timing and level of expense outgo and charge income
- inadequate spreading of fixed expenses.
A low volume of new and / or retained business means having to spread fixed expenses over a smaller number of contracts. Therefore, expense risk is partially related to exposure risk
Discuss Persistency or renewal risk
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.
There is a risk of policyholders withdrawing at a time when the amount of premiums less expenses accrued in respect of that policy is negative and/or is less than any surrender value payable.
A higher than expected number of such withdrawals will cause a deficit.
For annually renewable business, renewal risk can be considerable, leading to expense risk and mix of business risk.
Increased lapses will always adversely affect expense unit costs.
There may also be a risk of selective withdrawals, with ‘better than average experience’ policies withdrawing, leaving a set of policies with ‘worse than average experience’.
Discuss the volume and mix of business risks
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.
If higher than expected volumes of business are sold, the company might face solvency issues arising from new business strain.
Furthermore, it could lead to operational and reputational issues if the administrative department can’t keep up with the high volume of business.
All products carry risks, so a different volume and mix of business to that anticipated affects all other risk areas.
Discuss the option and guarantee risks
If a financial product or scheme provider has offered options or guarantees, then it will be exposed to further risks:
- There is a risk that the options become valuable to beneficiaries, or that the guarantees bite, so that the cost to the provider will be higher than expected.
- There is a risk that more beneficiaries take up an in-the-money option than has been assumed, thus similarly increasing the cost
- By offering options and guarantees, the provider is likely to be required to hold more capital. There is therefore a risk of higher than expected capital strain and potentially solvency or surplus issues, if there is a high additional business volume.
Discuss reinsurance risk
An insurance company may choose to reinsure some of its risks and similarly a benefit scheme may choose to use insurance.
Using a counterparty in this way generates credit risk, but there may also be business risk relating to uncertainties arising from:
- inadequate appreciation of the scale of the risks assumed and hence of the (re)insurance needs
- limited availability or prohibitive cost of the desired (re)insurance
- failure to comprehend the coverage / limits of a (re)insurance arrangement
