Chapter 1- South African General Business Environment

Question 1

List the 7 main factors in the general business environment that influences Life insurance companies?

Answer 1

• New business volumes
• Wider competitive environment (non-life savings vs. traditional life savings)
• Operational risk
• Corporate finance and securitisation
• Mergers and acquisitions
• Demutualisation
• Cell captives (interesting)

Question 2

List the 7 sub-factors in the general business environment regarding writing new business that influences Life insurance companies?

Answer 2

• Regulation
• Tax (policyholder)
• Economic conditions
• Publicity
• Technology
• Target markets
• Micro-insurance

Question 3

How does the Insurance Act and long-term insurance Act (regulation) impact the writing of new business (6)

Answer 3

• Authorisation: Life insurance licence which allows the company to sell a particular type of business (9 types in total)

• Commission: Limit on commission payable (Regulation 3 Section 49 LTA)

• Product design: minimum surrender values (or maximum penalties)

• Solvency valuation and capital adequacy requirements –> increases company costs and hence premium rate

• Reporting requirements –> increases company costs and hence premium rate

• Statutory actuary must be satisfied that the premiums, benefits and other values of a policy are actuarially sound

Question 4

How does the Other regulation and FAIS Act impact the writing of new business? (5)

Answer 4

• Policy quotation: Governances around info to be provided in policy quotation so as to reduce risk of misleading policyholders (ASISA)

• Testriction Rating factorse.g. HIV status, DNA testing
• TCF guidelines
• Marketing and admin of living annuities

• The representatives and independent brokers needs to be FAIS compliant e.g. certifications and conducting a needs analysis

Question 5

How does taxation impact the writing of new business?

Answer 5

• Beneficial tax treatment is a key incentive for people to choose life insurance savings products over other options

• Companies aim to design products to take advantage of tax rules

Question 6

How does the state of the economy influence writing new business? (1)

Answer 6

• Affects new business levels and retention of existing policyholders

Question 7

How has new business been affected by poor publicity in the past? (4)

Answer 7

• Poor surrender values

• Brokers promoting living annuities instead of life annuities (lack of disclosure)

• Benefit projections on policy quotations were shown using unrealistically high investment returns

• Financial advisers encouraged policyholders to surrender one policy in favour of another, to the detriment of policyholder value

Question 8

How does technology influence writing new business? (3)

Answer 8

• Marketing through texts and the internet have increased significantly

• The internet allows prospective policyholders to compare price quickly resulting in additional competition

• Policies could be purchased online

Question 9

How does target market influence writing new business? (4)

Answer 9

• Affects: distribution method & type of product sold

• Wide range in RSA (high-earning, low-earning, rural areas)

• Rural areas with limited infrastructure:
Partner with a bank or retailer to sell products
Gives insurer access to many smaller areas while keeping costs low
Simple risk products

• Affluent market:
Complex products
sold through brokers and company branches

Question 10

How does mirco-insurance influence writing new business? (2)

Answer 10

• New category of insurers
Permitted to sell only simple risk products of limited size

• These insurers will have reduced regulatory and capital requirements
to produce lower cost risk products
and compete in the low-income market

Question 11

List the financial instruments impacting the competitive environment for savings products? (6)

Answer 11

Banks and investment managers sell unit trusts and capital guarantee investment products which compete in insurance savings products and guaranteed return products.

Examples of non-life savings products:
• Unit trusts
• Fixed term and call deposits
• Money market accounts
• Exchange traded funds (“closed ended” investment trust of index funds)
• Guaranteed investment in the market
• Direct Investment in the market

Question 12

What tax advantages do insuranance savings products have over non-life savings products? (4)

Answer 12

• High net worth individuals taxed at lower rate
taxed at rate applied to the Individual Policyholder Fund (IPF) 30%,
likely lower than their marginal rate

• Excess E (XSE) position in IPF (for some insuers)
due to relatively low reserves (and hence investment income) compared to expenses
provide tax-free investment income on savings products

• Retirement annuities (EET)
Tax-free savings for retirement
Premiums are tax-deductible
Income at retirement is taxable (but now in lower income bracket less tax)
& part of proceeds can be taken as tax-free lump sum

• With-profit and smooth bonus products have offered:
Policyholder returns with lower volatility than the equity market
Possible profits on other business lines

Question 13

What tax disadvantages do insurance savings products have over non-life savings products? (4)

Answer 13

• Access to savings and guarantee return products offered by banks / investment managers has vastly improved
o Internet
o Target customers and distributors more effectively

• Insurers have higher expense loadings to cover costs unique to insurers
Regulatory reserves and SCR
Training and regulation of the sales force – although FAIS requirements for non-insurance also
Additional regulatory requirements
(e.g. statutory actuary to review premium rates)

• Life savings products less flexible
inability to adjust premiums and benefit withdrawals without incurring penalties
Commission and acquisition expenses are typically allocated to policies upfront,  reduce policy value for early terminations

• With-profit and smooth bonus have become less popular due to lack of transparency in the return achieved

Question 14

How does operational risks influecne life insurers?

Answer 14

• Assessment of Oprisk included in SCR calculation
Require input from all areas of business
If approx. methods inadequate then dedicated oprisk model may be needed

• If the risk cannot be mitigated, then capital held to cover the potential cost

Question 15

Provide examples of operational risk? (7)

Answer 15

• Mis-selling
• Mis-pricing
• Administrative errors
• IT failures
• Data issues
• Standards of policy service (poor) ( lead to reduced NB)
• Staff retention (poor)

Additional causes third party dependencies, poor internal controls, human error, security breach, staff resources

Question 16

Corporate finance and securitisation

List sources of capital for life insurer? (6)

Answer 16

• Sources of capital to insurers:
o equity rights issue
o bond & other debt instrument issue
o subordinate debt
o securitisation
o financial reinsurance
o contingent loans

Question 17

Describe:

(1) Securitisation

(2) Financial reinsurance

(3) Contigent loan/surbordinated debt

Answer 17

Securitisation:

• Sale of future profits expected on in-force business
• Insurer receives payment for these profits which immediately improves solvency
• Purchaser of security will receive repayment of capital and interest only if sufficient profit emerges from a specified block of business

Financial reinsurance:

• Reinsurance which, in addition to some element of risk transfer, provides capital relief against new business strain through payment of initial commission from reinsurer to insurer

Contingent loans & subordinate debt:

• Debt instruments where the repayment is either
o contingent on surplus emerging or
o subordinated to (i.e. ranks beneath) the interest of policyholders

Question 18

List reason for mergers and acquisitions by insurance companies? (4)

Answer 18

• Number of life insurers have reduced because of:
o Increased cost of regulation
o Efficiencies and economies of scale
o Capital requirements not being met due to poor performance

• Trend for large insurers to expand into new markets through acquisitions

Question 19

Describe what are cell captives? (2)

Answer 19

• A mechanism by which companies/individuals (the cell owner) can perform the business of an insurer without obtaining their own insurance license

• An insurer (the cell captive) ‘rents out’ their insurance license to different cell owners in exchange for a fee

Question 20

Describe what are cell captives? (2/3/3)

Answer 20

• A mechanism by which companies/individuals (the cell owner) can perform the business of an insurer without obtaining their own insurance license

• An insurer (the cell captive) ‘rents out’ their insurance license to different cell owners in exchange for a fee

Cell owner:
• Provides capital to support business by holding a specific type of share in the cell captive
• Manages insurance business on behalf of the insurer
• Receives the profits from the business (through dividend payments)

Cell captive:
• Minimum services provided to cell owner: accounting and regulatory reporting services
• Specialized services to the cell owner: start-up assistance, pricing, underwriting, claims management, reinsurance and investment management
• May provide additional capital to a cell owner (for a fee)

Question 21

Describe regulations for cell captives?

Answer 21

• Same as other insurers except for additional reporting requirements

• Potential changes on legislation for:
o Structure
o Restrictions on who may own a third party cell
o Responsibilities of third party cell captive insurers
Wrt governance, risk management, market conduct, reporting, demonstrating financial soundness

Question 22

Described risks for policyholders of cell captives? (5)

Answer 22

• Risks of equivalent business sold through normal insurance structure

Although concerns:
• Insufficient controls over compliance
• Unfair treatment of policyholders by cell owner
• Conflicts of interest related to the profit share motive inherent in cell captive arrangements

• But, Ring-fencing cells –> cell owners unable to diversify cap requirements across product classes written in other cells –> higher cap requirements than traditional insurance

Question 23

Describe the risk to shareholders of cell captives? (4)

Answer 23

• Risks of equivalent business sold through normal insurance structure

• Exposure to losses on business written in other cells
o First party cells: losses are limited to the capital in respect of that cell
o (Limited via a recapitalisation requirement)
  risk to the other cell owners and the promoter cell is limited
o Third party cells: losses are first covered by the capital held in respect of the cell, then by capital held in the promoter cell, then by capital held in others cells (first and third party)
o If something like this happens, cell owners will likely start withdrawing from the cell captive
• Operational risk relating to functions outsourced to cell owners
• Reputational risk from actions of cell owners associated with the captive

Question 24

Describe the risk to shareholders of cell captives? (4)

Answer 24

• Risks of equivalent business sold through normal insurance structure

• Exposure to losses on business written in other cells
o First party cells: losses are limited to the capital in respect of that cell
o (Limited via a recapitalisation requirement)
 risk to the other cell owners and the promoter cell is limited
o Third party cells: losses are first covered by the capital held in
respect of the cell, then by capital held in the promoter cell, then by capital held in others cells (first and third party)
o If something like this happens, cell owners will likely start withdrawing from the cell captive

• Operational risk relating to functions outsourced to cell owners

• Reputational risk from actions of cell owners associated with the
captive

Question 25

Challenges for cell captives? (4)

Answer 25

• Ensure that third party cell owners abide to FAIS Act and Long-term Insurance Act
o Stipulate this in the business relationship agreement

• Solvency position of each cell must be monitored to ensure remedial action (e.g. recapitalisation) when necessary
o Regular valuations

• How to allow for Risk diversification benefits across cells when the cell captive calculates required capital
o & understand how this affects cell owners
o In most arrangements  diversification not allowed

• Tax calculations performed at company level (ignoring internal cell division)
o Ensure equity by performing independent tax calculations for each cell
 Otherwise, e.g. one cell may receive tax relief on profits by offsetting losses occurring in other cells