Chapter 27: Financial products and benefit scheme risks

Question 1

What are the two key risks to a beneficiary?

Answer 1

1. The benefits may be less valuable than
   required (or expected), or
2. They may not be received at the required
   time

Question 2

What are the two key risks to the provider?

Answer 2

1. The benefit payments will be greater
   than expected, or
2. Payments will be required at an
   inopportune time.

Question 3

What is the key risk to the State in relation to benefit provision?

Answer 3

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)

Question 4

What are the key areas of benefit risk when the benefits are known in advance?

Answer 4

1. inadequate funds having been set aside,
   i.e. underfunding
2. insolvency of sponsor / provider
3. asset / liability mismatching
4. illiquid assets, i.e. funds not available
   when required
5. change in the benefit promise, e.g. by the
   state or provider
6. beneficiaries’ needs not being met, e.g.
   due to misunderstanding, inflation
   erosion of value, changed circumstances

Question 5

What are the four key areas of benefit risk when the benefits are not known in advance?

Answer 5

1. Lower than expected benefits due to
   lower than expected investment returns
   or higher than expected expense returns.
2. Lower than expected benefits due to
   worse than expected purchase terms for
   any investment vehicles
3. Not meeting beneficiaries’ needs
4. Higher than expected claim payments on
   non-life insurance policies (e.g. due to
   high property or court-award inflation)

Question 6

Lifestyling

Answer 6

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.

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.

Question 7

Whether benefits are defined or not, how might sponsor / provider actions contribute to the uncertainty surrounding the benefits?

Answer 7

• default by the sponsor / provider
• failure by the sponsor / provider to pay
  contributions / premiums in a timely
  manner
• takeover of 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 8

In a defined benefit scheme, what are the key contribution risks?

Answer 8

1. 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.
2. Unknown timing of future contributions
   if not funded in advance.
3. The requirement to put in extra funds if
   there is a shortfall in the scheme - the
   amount and timing of which is unknown.
4. Insufficient liquid assets with which to
   make the contributions.
5. Insolvency risk due to excessive
   contributions.
6. Take-over by a third party who is
   unwilling to make the contributions.
7. Extra costs incurred through the
   provision of guarantees.

Question 9

In a DC scheme, what are the 4 contribution risks?

Answer 9

1. The contributions / premiums are
   unaffordable and hence not made
2. Insufficient liquidity to make the
   payments in a timely manner
3. The contributions / premiums are linked
   to an inflationary factor, thereby
   introducing the risk that they increase
   more rapidly than anticipated
4. The contributions / premiums are not
   linked to inflation and therefore the
   resultant benefits are eroded by inflation.

Question 10

List 7 operational or external risks that may lead to uncertainty in the contributions required for a benefit scheme.

Answer 10

1. Loss of funds due to fraud or
   misappropriation of assets.
2. Incorrect benefit payments.
3. Inappropriate advice.
4. Administrative costs, especially
   compliance with changes in legislation.
5. Wrong decisions by those to whom
   power has been delegated.
6. Fines or removal of tax status resulting
   from non-compliance.
7. Changes to tax rates or status.

Question 11

List six possible causes of inappropriate advice in relation to the provision of benefits.

Answer 11

CRIMES

• Complicated products
• Rubbish (incompetent) adviser
• Integrity of adviser lacking
• Model of parameters unsuitable
• Errors in data relating to beneficiaries
• State-encourages 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.

Question 12

What is meant by ‘sponsor covenant’?

Answer 12

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.

Question 13

List 10 investment risks associated with a financial product.

Answer 13

1. Uncertainty over the level and timing of
   investment returns (both income and
   capital)
2. Mismatching of assets and liabilities
3. Reinvestment risk
4. Default risk
5. Investment returns being lower than
   expected, increasing provider cost
6. Lack of appreciation of benefits by
   recipients due to poor returns
7. Higher than expected investment
   expenses
8. Liquidity risk
9. Lack of diversification
10. Changes in taxation of investment
    income and gains

Question 14

List the typical business risks faced by life insurance companies.

Answer 14

1. Mortality and longevity
2. Morbidity
3. Pandemics
4. Expenses
5. Withdrawals/ renewals
6. New business volumes
7. New business mix
8. Option take-up
9. Reinsurance
10. Anti-selection and moral hazard
11. Loose policy wording
12. Lack of data
13. Poor underwriting
14. Guarantees

Question 15

List the typical business risks faced by general insurance companies.

Answer 15

1. Claim amounts, including claim
   inflation/court awards
2. Claim frequencies
3. Accumulations and catastrophes
4. Expenses
5. Renewals and lapses
6. New business mix
7. Anti-selection and moral hazard
8. Loose policy wording
9. Lack of data
10. Poor underwriting
11. Changes in the cover provided or in the
    characteristics of policyholders
12. Reinsurance, e.g. inappropriate
    reinsurance chosen

Question 16

Explain how expense, persistency and new business volume risks are inter-related.

Answer 16

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.

Question 17

What are the risks arising from new business volumes not being as expected?

Answer 17

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.
- The administration department might
struggle to deal with very high new
business volumes, leading to potential
operational and reputational issues.

Less than expected:
- The company may not cover its fixed
overhead expenses.`

Question 18

What are the key risks arising from the new business mix not being as expected?

Answer 18

If there are cross-subsidies in the pricing basis, there is a risk that fixed expenses will not be covered and/or that profits will not be as expected if the mix of business differs from that expected.

For example, larger policies may contribute more to fixed expenses and profits than smaller policies. There is a risk that fixed expenses are not met and/or profits are lower than expected if fewer larger policies and more small policies are written than expected.

Not all products or policies may have been priced to generate the same level of profit. There is therefore a risk that the actual mix of new business sold is weighted more towards those products or rating factors with lower profit margins than had originally been expected.