Chapter 27: Financial product and benefit scheme risk Flashcards
What are the 2 key risks to a beneficiary?
- The benefits will be less valuable than required, and
- They will not be received at the required time.
What are the key risks to the State in relation to benefit provision?
The risk is that the State is expected to put right any losses that the public incurs, especially if the State provides means-tested benefits such as a minimum income level in retirement.
(For example, if the public does not make adequate retirement provision but instead spends money on their immediate lifestyle, there may be more pensioners eligible for the means-tested benefist than expected)
What are the 4 key areas of benefit risk when the benefits are known in advance?
- Insufficient funds having been set aside, i.e. 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.
What are the 4 key areas of benefit risk when the benefits are not known in advance?
- Lower than expected benefits due to lower than expected investment returns or higher than expected expense returns.
- Lower than expected benefits due to worse than expected purchase terms for any investment vehicles (like annuities)
- Not meeting beneficiaries’ needs
- Higher than expected claim paymetns on non-life insurance policies = risk to provider
Lifestyling
In the five plus years approaching retirement, the investments in the defined contribution pension scheme could be switched into the type of assets that are likely to underlie the annuity, i.e. bonds
This way, if bond yields fall, causing annuity rates to reduce, then this is offset by a corresponding increase in the market value of the bonds in the pension scheme fund.
Whether benefits are defined or not, how might sponsor / provider actions contribute to the uncertainty surrounding the benefits?
The sponsor / provider may:
* default at the time when funds held are insufficient or when the funds held include loands to the sponsor / provider.
* fail to pay contributions in a timely manner
* be taken over by an organisation that is unwilling to contribute to meet benefit promises
* decide to reduce future benefits
* communciate poorly to beneficiaries on issues such as benefit guarantees, leading to complaints / need for compensation.
* generally mismanage the scheme / business, leading to a benefit shortfall.
In a defined benefit scheme, what are the 6 key contribution risks?
- Unknown future level of contributions. Contributions depend on the promised bneefits, the eligibility of members to accrue / receive benefits, inflation and investment returns net of tax and expenses.
- Unknown timing of future contributions if not funded in advance
- The requirement to put in extra funds if there is a shortfall in the scheme - the amount and timing of which is unknown
- Insufficient liquid assets with which to make the contributions
- Insolvency risk due to excessive contributions
- Take-over by a third party who is unwilling to make the contributions
(In a defined benefit scheme, such as a defined benefit promise with a defined contribution underpin, there is also the risk that contributions have to increase due to the guarantee costing more than expected)
In a DC scheme, what are the 4 contribution risks?
- Contributions are unaffordable to sponsor (because in poor financial circumstances)
- Insufficient liquid assets with which to make the contributions
- If contributions are linked to inflation or a salary index, that index may increase faster than expected
- If contributions are fixed, benefits may be less than expected / unable to provide for an expected standard of living
List 7 operational or external risks that may lead to uncertainty in the contributions required for a benefit scheme
- Loss of funds due to fraud or misappropriation of assets
- Incorrect benefit payments
- Inappropriate advice
- Administrative costs, expecially compliance with changes in legislation
- Wrong decisions by those to whom power has been delegated.
- Fines or removal of tax status resulting from non-compliance
- Changes to tax rates or status.
List 6 possible causes of inappropriate advice in relation to the provision of benefits
CRIMES
- Complicated products
- Rubbish (incompetent) adviser
- Integrity of adviser lacking
- Model of parameters unsuitable
- Errors in the date relating to beneficiaries
- State-encourages but inappropriate actions
List 10 investment risks associated with a financial product
- Uncertainty over the level and timing of investment returns (both income and capital)
- Mismatching of assets and liabilities
- Reinvestment risk
- Default risk
- Investment returns being lower than expected, increasing provider cost
- Lack of appreciation of benefits by recipients due to poor returns
- Higher than expected investment expenses
- Liquidity risk
- Lack of diversification
- Changes in taxation of investment income and gains.
What is meant by ‘sponsor covenant’?
This refers to the ability and the willingness of the sponsor to pay sufficient contributions to meet benefits as they fall due. Sponsor covenant is a source of credit risk.
List the typical business risks faced by life insurance companies
- Mortality and longevity
- Morbidity
- Pandemics
- Expenses
- Withdrawals
- New business volumes
- New business mix
- Option take-up
- Reinsurance
- Anti-selection and moral hazard
- Loose policy wording
- Lack of data
- Poor underwriting
List the typical business risks faced by general insurance companies
- Claim amounts, including claim inflation / court awards
- Claim frequencies
- Accumulations and catastrophes
- Expenses
- Renewals and lapses
- New business mix
- Anti-selection and moral hazard
- Loose policy wording
- Lack of data
- Poor underwriting
- Changes in the cover provided or in the characteristics of policyholders
- Reinsurance
Explain how expense, persistency and new business volume risks are inter-related
A product provider’s expenses can be expressed in terms of unit costs, e.g. the cost per new policy written or per in-force policy
Unit costs comprise expenses as the numerator and volume measure as the denominator
Lapses and new business volumes directly affect the denominator. However, the numerator will partly be fixed and will not vary exactly in line with the volume measure.
Lower than expected new business volume and/or higher than expected withdrawals will mean a lower than expected overall contribution to overheads.
