Chapter 2 Flashcards
What are the factors that need to be considered when looking at the external environment?
- Legislation and regulations
- State benefits
- Tax
- Accounting standards
- Risk management requirements, capital adequacy and solvency
- Corporate governance
- Corporate structure
- Competitive advantage and commercial requirements
- Other external issues
- Changing cultural and social trends
- Demographic changes
- Climate change and other environmental issues
- Lifestyle considerations
- International practice
- Technological changes
What are the factors that need to be considered when looking at the external environment: Legislation and regulations
Legislation is law that has been formally declared by parliament
Regulation is form of secondary legislation – used to implement a primary piece of legislation appropriately or take account of particular circumstances
Forms of insurances in some countries that are compulsory
Influence the types of product available
Regulate the sales process – regulations often place responsibility on providers to demonstrate that consumers fully understand the products and risks
THUS, complex products (benefit smoothing and derivative investment strategies) are not marketed even if they are suitable for consumers’ needs.
What are the factors that need to be considered when looking at the external environment: State benefits
State benefits often at low level, not sufficient – individuals will require higher level of benefit: provided by employer through retirement benefits schemes or membership of private health arrangement OR saving OR purchase of insurance
Level of state benefit will influence level and form of additional non-state benefits provided
Raise employers’ and individuals’ awareness of need to top-up state benefits
Reduce levels of saving if benefits are means-tested – individuals on low income with limited saving ability find that it is better value to not save = savings will be offset against benefits that they are entitled to from state = result in lower level of income
May require compulsory contributions
Can introduce moral hazard – risk of individuals relying on the state and not purchasing own cover
What are the factors that need to be considered when looking at the external environment: Tax
3.1. Benefits
Tax treatment of benefits can impact needs of individuals
Benefits can be free of tax
Excess received over contributions paid can be taxed (as income or capital gain)
Benefit taxed entirely as income
3.2. Contributions
Impact of tax on contributions towards financial products must be considered
Some arrangements may offer tax relief on contributions paid – coupled with tax on benefits
Other arrangements require contributions to be paid from taxed income – usually offer some relief from tax on ultimate benefit
3.3. Accumulation of return
Governments have option of taxing income and gains of products and schemes during accumulation phase
Refers to tax that provider pay on investment income and capital gains on assets backing financial products and schemes
In developed countries – double taxation is avoided which provides incentive to save
THUS, if provider taxed on income and gains unlikely to be charged tax on policyholder’s gain
3.4. Inheritance tax
Possible to take out insurance to cover this tax liability
Means that product innovations may be designed to avoid paying tax
3.5. Influence on products
Because of above, tax systems can influence the types and forms of products made available by financial services industry
Examples of products and benefits heavily focused around a particular tax system:
Pension provision and lump sum benefits payable upon retirement
Tax-free savings vehicles
Tax-free government savings schemes
Retail savings bonds in SA
Some types on investment vehicles – exchange traded funds, unit trusts or fixed deposits
Qualifying life assurance products – endowment policies that benefit from reduced rates of taxes
What are the factors that need to be considered when looking at the external environment: Accounting standards
Way that benefits schemes needs to be reported in company accounts may influence the types the benefits that are provided for employees
Also impacts the range of products brought to market
What are the factors that need to be considered when looking at the external environment: Risk requirements, capital adequacy and solvency
Some regulations impose min standards of risk governance and requirements relating to risk management roles within firms
Financial institutions need to determine the minimum capital that they are required to hold.
Capital adequacy is then measured as excess of assets over sum of liabilities and capital requirements
This is usually stated as % of liabilities plus capital requirements or multiple of capital requirements
World is moving towards risk-based capital framework
Principles for measuring capital adequacy are risk-based – so level of capital held in excess of provisions depends on amount of risk taken on
What are the factors that need to be considered when looking at the external environment: Corporate governance
- Corporate governance
Refers to high-level framework within which a company’s managerial decisions are made
6.1. Aims
Aim of good corporate governance is that company should be managed efficiently in order to meet requirements of its stakeholders
One concern of regulators is that management might make decisions based more on own personal interest than those of other stakeholders
6.2. Strategies
Good corporate governance can be enhanced by ensuring remuneration incentivises management to act in the interests of stakeholders
Share option packages may not provide sufficient incentive (lack of sufficient downside) for management to control risk
Non-executive directors often part of structure aimed at good corporate governance
Role of non-executives in corporate governance is to:
Provide impartial view and represent the shareholders’ interests
Play leading role in setting remuneration for executive directors’ pay
Play leading role in audit committee
Governance arrangements of product provider have major influence on ways in which stakeholder needs are met
Guidance on corporate governance developed by regulatory bodies and governments
What are the factors that need to be considered when looking at the external environment: Corporate structure
- Corporate structure
Product providers might be mutual societies or proprietary companies (private or public companies)
7.1. Mutual societies
Start by an altruistic gesture – someone lending initial capital without need to payback loan unless profits emerge
Have no shareholders and profits belong entirely to policyholders
Mutual should be able to provide better benefits for the same cost than proprietaries – since no funds diverted for dividend to shareholders
Disadvantage, finance cannot be readily raised from capital markets – restrict products that mutual prepared to offer (capital incentive products less attractive to mutual so priced higher)
Mutuals approach product pricing:
Surplus distribution – offer specific distributions of surplus to their members (with-profit insurance companies)
Pricing at cost – design products with lowest margins in price consistent with the risks undertaken and benefit members by that route
7.2 Proprietaries
Public proprietary companies benefit from easier access to capital markets for finance
have greater economies of scale
more dynamic management that mutuals
benefits pay for the dividends to shareholders and company may have competitive edge over the mutual
Private companies may be as restricted as mutual for raising capital
But benefit from close involvement of owners – management advantage
Owners may have access to significant additional capital – gives edge over both mutual and public proprietary companies
For proprietary life insurance companies – apportionment of surpluses between with-profit policyholders and shareholders is NB
What are the factors that need to be considered when looking at the external environment: Competitive advantage and commercial requirements
8.1. The underwriting cycle
Consequence of competitive nature of the insurance business
Position in cycle important consideration when making strategic decisions
Relates to:
Profitable business leading to new entrants, greater competition, soft premium rates and reduced profits, leading to… …insurers leaving market or reducing involvement, increased premium rates or loss of business or reduced solvency and the need for capital
Inability to make profits at bottom of cycle:
Loss of business – putting pressure on ability to recoup fixed expenses and future growth prospects Reduced solvency position – requiring additional capital support
What are the factors that need to be considered when looking at the external environment: Changing cultural and social trends
Can have impact on financial products, schemes, contracts and transactions available
For example:
Greater demand for mortgages as home ownership increases Greater demand for products that meet cost of private healthcare if state cuts back on healthcare provision for citizens Increased demand for savings products if individuals have increased amounts of spare income
What are the factors that need to be considered when looking at the external environment: Demographic changes
Have major impact on main providers of benefits on contingent events
Two main sources of demographic changes leading to populations ageing:
Rising life expectancy Declining fertility
Effects of an ageing population:
Less likely to spend, older people more likely to be saving money – leads to lower interest rates and deflationary pressures on economies Strain on social welfare systems – pay-as-you-go state pension systems are becoming unsustainable:
o Fewer people working therefore falling contributions
o More people surviving to retirement to start receiving benefit
o People living longer in retirement, so benefit is paid for longer
Cost of healthcare systems will increase dramatically – governments faces with choice between higher levels of tax or reduced government role in providing healthcare Cost of education falling – education big expenditure for governments
What are the factors that need to be considered when looking at the external environment: Climate change and other environmental issues
Climate change
More apparent the climate change will have material impact on financial markets and financial institutions
Will affect all sectors of the economy and relevant to investors and financial institutions – not all macroeconomic changes and microeconomic conditions will apply equally to all investments
Risks and opportunities associated with policy measures directed at reducing GHG – to meet agreed target, patterns of investment will need to change considerably
Physical impacts of climate change will affect assets and investments – agriculture and food supply, infrastructure, precipitation and water supply
Decisions made by private sector investors and financial institutions will have influence on how society responds to climate change
Significant demand for capital and governments looking to private sector to provide it
Can also affect demographic experience – increasing temp can have impact on spread of diseases & increase instances of natural disasters (impact on food security and water)
Effects generally negative for mortality and morbidity
Reduced cold-related deaths in northern hemisphere could be positive
Impact of environmental and ethical issues on providers
Providers that want to be attractive to widest possible range on investors will provide products where environmental and ethical issues are part of the investment process and decision-making
The environmental impact of the way providers communicate with public may also need to be considered
What are the factors that need to be considered when looking at the external environment: Climate change and other environmental issues - Emission trading
Emissions trading
It is a market-based approach to address pollution
Overall goal of emissions trading plan is to minimise the cost of meeting a set emissions target
Government sets limit on emissions and issues permits to emit, up to limit
May sell permits or gives permits to participants equal to each participant’s historical emissions
Lowers overall limit over time
Participant must hold permits at least equal to quantity of pollution it actually emitted during time period to avoid penalties
Because permits can be bought and sold, a participant can choose either:
To use permit exactly Emit less than permit and sell excess permit Emit more than permit and buy permits from other participants
Buyer pays charge for pollution and seller gains reward for having reduced emissions
Organisations which do not pollute may trade permits and financial derivative for permits – creates market in which financial institutions and product providers can participate
What are the factors that need to be considered when looking at the external environment: Lifestyle considerations
Younger people will have high demand for loans and mortgages and less likely to be saving for retirement
People with children may have need for life insurance protection products
Older people may have need for annuities and long-term care products
Longer working lifetimes and increases in life expectancy will increase the amount of life insurance required and increase the age to which it is required
What are the factors that need to be considered when looking at the external environment: International practice
Providers may need to look to international markets to see if products sold in other countries could be replicated in their own country
Difference in tax and legislative requirements between countries makes this difficult
