Chapter 27: Financial product and benefit scheme risks Flashcards
(19 cards)
What are the 2 key risks to a beneficiary?
The 2 key risks are:
1. The benefits may be less valuable than required (or expected), or
2. 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 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 benefits than expected)
What is means-testing?
Means-testing is a process for establishing whether an individual is eligible to receive benefits and/or how much benefit they should receive. It is often based on an individual’s income or assets or both.
What are the 4 key areas of benefit risk when the benefits are known in advance?
- Risk of inadequate funds
- Risk of illiquid assets
- Risk of benefit changes
- Risk of failing to meet the beneficiaries’ needs
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 vehicle (like annuities)
- Not meeting beneficiaries’ needs
- Higher than expected claim payments on non-life insurance policies (e.g. due to 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 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?
- Default at the time when the funds held are insufficient or when the funds held include loans to the sponsor / provider
- Failure by the sponsor to pay contributions in a timely manner
- Takeover by an organisation unwilling to continue to meet benefit promises
- Decision to reduce future benefits
- Inadequate communication with beneficiaries on issues such as benefit guarantees, leading to complaints / need for compensation
- General economic mismanagement by a sponsor / provider of assets and liabilities, leading to a benefit shortfall
What are the key contribution / premium risks if contributions / premiums are known in advance?
- Contributions are unaffordable to sponsor (because of 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
What are the key contribution / premium risks when contributions / premiums are not known in advance?
- 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 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
- Takeover by a third party who is unwilling to make the contributions
- The sponsor / provider will incur the extra costs if there is a minimum guarantee applying to the level of benefits.
(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 guarantess costing more than expected)
Whether contributions / premiums are defined or not, what are the other factors that may lead to uncertainty in the required contributions / premiums?
- 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
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 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 costs
- 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 errors in determining the contribution / premium requirements may result in risks to the overall security of a fund or policy?
- 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
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, e.g. inappropriate reinsurance chosen
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.
What are the risks arising from new business volumes not being as expected?
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.
Higher than expected volumes of business sold can lead to solvency problems from new business strain, and can also lead to administrative operational problems due to the high workload for the admin team.
Volumes of new policies also directly affect expense unit costs, and so link to expense risk. If lower than expected volumes of business is sold, then there is a risk of fixed expenses not being met.
What are the key risks arising from the new business mix not being as expected?
It is often the case that certain types of business subsidise other types. This means that an insurance compnay will be at risk of selling a higher volume of smaller benefit policies relative to larger benefit policies.
There may also be subsidies by distribution channel.
If profit margins differ by product, there is a risk that the mix of new business may be weighted more (than expected) towards those products or rating factors with lower profit margins
