Chapter 26 Flashcards
Risk Identification and classification (20 cards)
What is Risk Classification?
*the grouping of risks into homogeneous cells in order to allow the data to be used for various purposes
Describe the techniques that can be used to identify the risks associated with financial products or with the providers of benefits on contingent events. (4)
- Use of risk classification to ensure that all types of risks have been considered
- Use of techniques from project management
a) high level preliminary risk analysis
-confirms there are no large risks such that there is no worth in continuing with the project
b) Brainstorming with project experts to:
▪ Identify likely/unlikely, upside/downside risks.
▪ Discuss these risks and their interdependency.
▪ Broadly evaluate the frequency and severity of each risk.
▪ Generate and discuss initial mitigation options.
c) Desktop analysis
-supplements results from brainstorming by looking at similar projects taken by the sponsor in the past
d) Consult with experts (who are familiar with the details and financing of the project)
e) Risk register or risk matrix (sets out risks and interdependencies)
-reminder to consider certain types of risks
-is linked to the use of risk checklists - Risk checklists
o There may be lists of risks that regulators believe are relevant to the business. (e.g. the standard formular for calculating capital requirements may cover many risks relevant to financial product providers.)
o Such lists are not exhaustive - Use of experience of staff who have joined from similar organisations, and of consultants with broad experience of the industry concerned.
Categories of risks that could be used in a risk matrix for a typical project: (7)
o Political - opposition to project, war, terrorism, etc
o Natural - earthquakes, hurricanes
o Economic - interest rate or exchange rate movements
o Financial - sponsor default, incorrect cashflow estimates
o Crime - fraud, theft
o Project - time delays, budget overruns, bad design
o Business - competition/lack of demand, operational problems
Key risks to a Beneficiary and Provider in relation to benefit provision: (2:2)
o the benefits may be less valuable than required (or expected)
o the benefits may not be received at the required time.
xxxxx
o There’s a risk that benefit payments will be greater than expected.
o Benefit payments will be required at an inopportune time.
key risks to the State in relation to benefit provision: (2)
o 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.
o 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 benefits than expected.
Key areas of benefit risks when the benefits are not known in advance (DC fund): (4)
o Investment risk and expense risk:
▪ Lower than expected benefits due to lower than expected investment returns or higher than expected expense returns.
o Annuity risk:
▪ Lower than expected benefits due to worse than expected purchase terms for any investment vehicles (like annuities)
o Risk of inadequate benefits:
▪ Not meeting beneficiaries’ needs
o Inflation risk:
▪ Higher than expected claim payments on non-life insurance policies (e.g., due to high property or court-award inflation) = risk to provider
Key areas of benefit risks when the benefits are known in advance (DB fund): (6)
o inadequate funds having been set aside, i.e., underfunding.
o insolvency of sponsor/provider.
o asset/liability mismatching.
o illiquid assets, i.e., funds, although sufficient, may not be available when required.
o changes in benefit promise, e.g., by the state or provider
▪ For example, critical illness contracts, may have definitions of an insured event that are not guaranteed throughout the terms of the contract.
o beneficiaries’ needs not being met, e.g., due to misunderstanding, inflation erosion of value, changed circumstances.
General factors that create uncertainty around the benefits to be received (Benefits known or unknown in advance): (7)
o Default by sponsor/provider at a time when the funds held are insufficient.
o Default by sponsor/provider when the funds held include loans to the sponsor/provider.
o Failure by the sponsor to pay contributions in a timely manner.
o Takeover of the sponsor/provider by an organisation unwilling to continue to meet benefit promises.
o Decision by the sponsor/provider that future benefits will be reduced.
o Inadequate communication by the sponsor/provider with beneficiaries.
o General economic mismanagement by a sponsor/provider of assets and liabilities may also lead to a risk of a benefit shortfall.
Key contribution risks in a defined contribution scheme (contribution known in advance):
o Contributions are unaffordable to sponsor (because in poor financial circumstances)
o Insufficient liquid assets with which to make the contributions.
o If contributions are linked to inflation or a salary index, that index may increase faster than expected.
o If contributions are fixed, benefits may be less than expected / unable to provide for an expected standard of living.
General factors that create uncertainty around the benefits to be received (Contributions known or unknown in advance): (7)
o loss of funds due to fraud or misappropriation.
o incorrect benefit payments.
o inappropriate advice.
o administrative costs, e.g., to comply with changes in legislation.
o decisions by parties to whom power has been delegated.
o fines or removal of tax status resulting from non-compliance with legislation.
o changes to tax rates or status.
Investment risks associated with a financial product: (10)
o Uncertainty over the level and timing of investment returns (both income and capital)
o Mismatching of assets and liabilities.
o Reinvestment risk.
o Default risk.
o Investment returns being lower than expected, increasing provider cost.
o Lack of appreciation of benefits by recipients due to poor returns.
o Higher than expected investment expenses.
o Liquidity risk.
o Lack of diversification.
o Changes in taxation of investment income and gains.
Business risks faced by general insurance companies: (12)
o Claim amounts, including claim inflation/court awards.
o Claim frequencies.
o Accumulations and catastrophes.
o Expenses.
o Renewals and lapses.
o New business mix.
o Anti-selection and moral hazard.
o Loose policy wording.
o Lack of data.
o Poor underwriting.
o Changes in the cover provided or in the characteristics of policyholders.
o Reinsurance, e.g., inappropriate reinsurance chosen.
Business risks faced by life insurance companies: (14)
o Mortality and longevity.
o Morbidity.
o Pandemics.
o Expenses.
o Withdrawals.
o New business volumes.
o New business mix.
o Option take-up.
o Reinsurance.
o Anti-selection.
o Moral hazard.
o Loose policy wording.
o Lack of data.
o Poor underwriting.
Main causes of expense risk: (5)
o higher than expected base expenses (e.g., due to budget over-runs, lack of expense control or poor estimation)
o unexpected once-off or exceptional expenses (e.g., due to dealing with unexpected regulatory change)
o higher than expected level of expense inflation.
o mismatching between the timing and level of expense outgo and charge income.
o inadequate spreading (allocation) of fixed expenses.
Relationship between expenses, persistency, and new business volume risks: (4)
o 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.
o Unit costs comprise expenses as the numerator and volume measure as the denominator.
o 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.
o Lower than expected new business volume and/or higher than expected withdrawals will mean a lower-than-expected overall contribution to overheads.
Risks arising from new business volumes not being as expected:
o Greater than expected:
▪ Writing new business requires capital to support the additional risks taken on.
▪ If too much new business is written, the company will incur greater than expected new business strain and might face solvency issues.
▪ Also, the administration department might struggle to deal with very high new business volumes, leading to potential operational and reputational issues.
o Less than expected:
▪ The company may not cover its fixed overhead expenses.
Possible causes of inappropriate advice in relation to the provision of benefits: (6)
CRIMES
o Complicated products.
o Rubbish (incompetent) adviser lacking experience.
o Integrity of adviser lacking.
o Model and model parameters unsuitable.
o Errors in data relating to beneficiaries.
o State-encouraged but inappropriate actions, e.g., encouraging people to save for retirement when this might reduce the level of State benefits they are entitled to and reduce their overall standard of living in retirement.
what is lifestyling? (3)
o Lifestyling is an investment strategy which provides automatic switching of your pension savings into another fund, or funds which generally have a lower risk profile or aligns your pension savings more closely to your plans for using these, as you get closer to your planned retirement age.
o 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.
o 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.
Describe how risk classification can aid the design of financial products that provide benefits on contingent events. (6)
o A company selling financial products would want to classify its risks into broadly homogeneous and credible risk sub-groups.
o This will enable the company to charge premium rates that fairly reflect the relative risk of each sub-group.
o This will reduce the likelihood of anti-selection by policyholders.
▪ Where a higher proportion of the policies are taken up within the risk sub-groups that are relatively under-priced.
o Underwriting is the mechanism by which insurers will group risks into broadly homogeneous risk sub-groups.
o The underwriting process can determine:
▪ Which policies receive standard terms.
▪ Which policies should have special terms applied and what those special terms should be.
o Rating factors are used to classify the risks into broadly homogeneous risk sub-groups.
▪ A rating factor is a measurable objective factor which relates to the likelihood and/or severity of the risk.
Why risk classification is important: (9)
CHAMPION
C – Credibility vs Homogeneity: A balance must be struck between grouping data homogeneously and ensuring there’s enough data to be statistically credible.
H – Homogeneous Groups: The main aim is to obtain groups of similar risks.
A – Appropriate Projections: Enables better use of data for projections (e.g. claims, mortality).
M – Monitoring Experience: Important for monitoring claims and mortality.
P – Premium Accuracy: Inaccurate groupings can lead to incorrect premiums or contributions.
I – Inappropriate Groupings Distort: Heterogeneity distorts results and affects provisions.
O – Over-splitting Risks: Too much splitting can lead to small, unreliable data groups.
N – Need for Grouping: Sometimes necessary to combine less homogeneous but credible groups.
S – Sensitivity Testing: Used to check the robustness of groupings.
