Chapter 27: Financial product and benefit scheme risks Flashcards
(17 cards)
What are the 2 key risks to a beneficiary?
- The benefits may be less than required (or expected)
- They may not be received at the required time
What is the key risk 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 privides means-tested benefits such as a minimum income level at retirement.
(For e.g. if the public does not make adequate retirement provision but instead spends money on their immediate lifestyle, there may be more pensioners eligible for means-tested benefits than expected)
What are the 4 key areas of benefit risk when the benefits are known in advance?
- Inadequate funds to provide the benefits
- Illiquid assets
- Benefit changes
- Not meeting beneficiaries’ needs
What are the 4 key areas of benefit risks when the benefits are not known in advance?
Lower than expected benefits due to lower than expected investment returns or higher than 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 payments on non-life insurance policies (e.g. due high property or court-award inflation) = risk to provider
Lifestyling
In the 5 plus years approaching retirement, the investments in the defined contribution pension scheme should be switched into the type of assets that are likely to underlie the annuity, i.e. bonds.
This way, if bond yields fall, causing the cost of purchasing annuities to rise, 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 loans to the sponsor / provider
* fail to pay contributions in timely manner
* be taken over by an organization that is unwilling to contribute to meet benefit promises
* decide to reduce future benefits
* communicate 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 contribution risks?
- Unknown future level of contributions. Contributions depend on the promised benefits, 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 requirements 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 3rd party who is unwilling to make the contributions.
- (In a defined ambition 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 withwhich to make the contributions
- If contributions are linked to inflation or 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 advide
- Administrative costs, especially compliance with changes in legislation.
- Wrong decisions mae by those 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)
* Integrity of advicer lacking
* Model of parameters unsuitable
* Errors in data relating to beneficiaries
* State-encourages 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
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
- Risk of diversification
- Changes in taxation of investment income and gains
What is meant by “sponsor covenant”
This refers to the ability and 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
- Changes in the cover provided or in the characteristics of policyholders
- Reinsurance, e.g. inappropriate reinsurance chosen
Explain how expense, presistency 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 business volume and / or higher than expected withdrawals will mean a lower than expected overall contribution to overheads.
What are the risks arising from new business volumes not being as expected?
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 admin department might struggle to deal with very high new business volumes, leading to potencial operational and reputational issues.
Less than expected:
-The company may not cover its fixed overhead expenses.
