Chapter 27 - Financial Product & Benefit Scheme Risks Flashcards
Risks & Uncertainties
This uncertainty may relate to the level or the incidence of:
- benefits
- contributions / premiums required to pay for those benefits
Beneficiary Risk
- beneficiary’s circumstances will have changed by the time of payout
- benefits will be less valuable than required, or
- they will not be received at the required time
Risks to the provider
- benefit payments will be greater than expected
- payments will be required at an inopportune time
Risks to the state
The state is also at risk if it is expected to put right any losses that the public incurs, e.g. if it provides means-tested benefits such as a minimum level of income in retirement
Benefit Risks related to Benefits that are known in advance
- Risk of inadequate funds
This may a result of:
- insufficient funds having been set aside
- holding of investments which are not matched to the liabilities - Risk of illiquid assets
A separate risk is that the funds, although sufficient, are not available when they are required to finance the benefit - Risk of benefit changes
There may be a further risk that a benefit promise is changed or is changeable within the terms of the contract. - Risk of failing to meet the beneficiaries’ needs
Where funds are sufficient and liquid, and the level and incidence of benefits is exactly as promised, the beneficiaries are still exposed to the risk that these promised benefits do not meet their needs
This may be as a result of: ·
- failure to recognise this when the benefit promise was made
- inflation eroding the value of the benefits
- beneficiaries’ circumstances changing
Benefit Risks related to Benefits that are not known in advance
- Investment and expense risk
Where benefits are not fully defined, but are instead linked in some way to the funds available and investment conditions, there is further uncertainty, and hence risk, for the beneficiary that the level of the benefits will be lower than expected if:
- the investment return is lower than had been anticipated, or any
- expense charges deducted are higher than expected. - Annuity risk
The level of the benefits will also be reduced if the terms of purchase for any investment vehicles are worse than had been anticipated. - Risk of inadequate benefits
There is a risk that either inflation or a failure to recognise benefit needs when planning provision leads to benefits that do not meet the beneficiaries’ true needs, and they consequently suffer a lower than expected standard of living - Inflation Risk
General Benefit Risks
Whether benefits are defined or not, there are some general factors that create uncertainty around the benefits to be received.
These are:
- default by the sponsor / provider at a time when the funds held are insufficient
- default by the sponsor / provider when the funds held include loans to the sponsor / provider
- failure by the sponsor to pay contributions in a timely manner
- takeover of the sponsor / provider by an organisation unwilling to continue to meet benefit promises
- decision by the sponsor / provider that future benefits will be reduced
- inadequate communication by the sponsor / provider with beneficiaries
- general economic mismanagement by a sponsor / provider of assets and liabilities may also lead to a risk of a benefit shortfall
Contribution/Premium Risks
- Risk of unaffordable premiums
- If benefits, rather than contributions / premiums, are defined, it will not be possible to be certain about the level of contributions required until all benefits have been provided and no future liabilities exist. These issues are relevant to a sponsored benefit scheme where the sponsor (usually the employer) is not the beneficiary
- Risk of insufficient assets
- Liquidity Risk
- Excessive contributions required
- Takeover Risk
If the sponsor / provider is taken over by a third party, the new owner may not be willing to continue to sponsor / provide the benefits. - Cost of guarantees
General Contribution Risks
- General
- 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 - Inappropriate advice:
- incompetence or insufficient experience of the advisor
- lack of integrity of the advisor, perhaps due to sales-related payments
- the use of an unsuitable model or parameters
- errors in the data relating to the beneficiaries
- state-encouraged but inappropriate actions
- over-complicated products - Guarantees
Any guarantees provided by the sponsor / provider reduce uncertainties for the beneficiaries. However, they lead to an uncertainty for the sponsor / provider because of the risk of the guarantees biting and causing an increase in costs
Overall Security
The overall security of benefits is related to all of the factors that affect the uncertainty of benefits, contributions and investment returns
There may also be risks to overall security that result from errors in determining the contribution / premium requirements. Such errors may be a result of:
- use of an unsuitable model
- use of unsuitable parameters
- errors in any data used to determine parameters for the models
- errors in the data relating to the beneficiaries.
The strength of the promise by the sponsor / provider and the impact of the asset allocation on the ability to meet promises made in adverse circumstances should be communicated to the beneficiaries
Business Risks for financial product providers
These risks relate to:
- claims: mortality / longevity, morbidity, general insurance claim rates and amounts
- expenses
- withdrawals / renewals
- new business volume and mix
- options and guarantees
- use of reinsurance (insurance company) or insurance (benefit scheme)
