Risk And Uncertainties

Question 1

Risk and uncertainties

Answer 1

Key risks to beneficiaries:
• the benefits will be less valuable than required or expected
• they will not be received at the required time

Key risks to the provider:
• benefit payments will be greater than expected
• payments will be required at an inopportune time

There are also risks to the state, in particular the risk of having to put right any losses incurred

Question 2

Benefit risks

Answer 2

For benefits known in advance - a key principle is to ensure that sufficient assets are available to meet the liabilities as they fall due
The risks that need to be managed:
• inadequate funds having been set aside, i.e. underfunding
• insolvency of a sponsor/provider
• asset/liability mismatching
• illiquid assets, i.e. funds not available when required
• change in the benefit promise, e.g. by the state or provider
• beneficiaries’ needs not being met, e.g. due to misunderstanding, inflation erosion of value, changed circumstances

For benefits not known in advance, the risk of inadequate benefits arises from:
• investment returns being lower than expected
• expense charges being higher than expected
• where relevant, annuity purchase terms being poorer than expected (e.g. defined contribution scheme, if an annuity is taken)
• beneficiaries needs not being met, either due to design or inflation erosion of value

For both cases, there are further risks resulting in benefit uncertainty.
• default by the sponsor/provider
• failure by the sponsor/provider to pay contributions/premiums in a timely manner
• takeover over the sponsor/provider
• decision by the sponsor/provider that benefits will be reduced
• inadequate communication by the sponsor/provider with beneficiaries
• general economic mismanagement of assets and liabilities by a sponsor/provider

Question 3

Contribution/premium risk
For contributions/premiums known in advance

Answer 3

Risks for contributions/premiums known in advance:
• the contributions/premiums are unaffordable and hence not made
• insufficient liquidity to make the payments in a timely manner
• the contributions/premiums are linked to an inflationary factor, thereby introducing the risk that they increase more rapidly than anticipated

Question 4

Contribution/premium risk
For contributions/premiums not known in advance

Answer 4

Remember that costs and contributions/premiums are likely to be different.
Costs will not be known until no future liabilities exist
Future contributions/premiums will depend on:
• the amount of the promised benefit
• the probability of the individual being eligible to accrue the benefits
• the probability of individuals being eligible to receive the benefits
• the effect of inflation on the level, or the real level, of the benefits
• the investment return achieved on the contributions/premiums (net of tax and expenses, if appropriate)

Question 5

Risk associated to shortfall of a defined benefit scheme, when the sponsor may be required by legislation to make extra contributions/premiums

Answer 5

• lack of liquid funds
• excessive contributions, which the sponsor may not be able to afford

There are also risks relating to:
• takeover of the sponsor/provider by a third party that is not willing to continue to provide the benefits
• extra costs incurred through the provision of guarantees

For both cases (known or unknown premiums/contributions), there are further risks resulting in contributions/premium uncertainty
• loss of funds due to fraud and misappropriation
• incorrect benefit payments
• inappropriate advice
• administrative costs, e.g. to comply with changes in legislation
• decisions by parties to whom power has been delegated
• fines or removal of tax status resulting from non-compliance with legislation
• changes to tax rates or status

Question 6

Overall security

Answer 6

Other uncertainties are in relation to:
• investment risk
• model, parameter and data risk
• the strength and security of the sponsor/provider

Question 7

Business risks for financial product providers

Answer 7

The following generate risk for financial product providers
• claims: mortality/longevity, morbidity, general insurance claim rates and amounts
• expenses
• withdrawal/renewal
• new business volume and mix
• options and guarantees
• use of reinsurance (insurance company) or insurance (benefit scheme)