Chapter 2-External environment

Question 1

1. State two forms of insurance that are compulsory in some countries.

Answer 1

Examples include:
• employers’ liability insurance
• motor third party liability insurance.

Question 2

2. Give an example of how regulations may influence the type of product most suited to a customer’s needs.

Answer 2

For example, limitations on charges for certain types of collective investment scheme may make that type of contract more suitable than another without the charge limitation, even though there are other disadvantageous features.

Question 3

3. Give an example of how regulation of the sales process for different products may influence the type of financial products brought to market.

Answer 3

Requirements for detailed explanation to consumers may mean that complex products, in particular those involving benefit smoothing processes or derivative investment strategies, are not marketed however suitable they might be for consumers’ needs.

Question 4

4. Why don’t State benefits alone necessarily meet the needs of citizens?

Answer 4

Where the State provides benefits to its citizens these are often at a low level which may only be sufficient to keep individuals just out of poverty. Many individuals will want have a higher level of benefit.

Question 5

5. Give two exampels of how an individual may achieve a higher level of benefits than those provided by the State.

Answer 5

An employer may provide this through a retirement benefits scheme or membership of a private health arrangement. Alternatively the individual may wish to provide personal benefits either through saving or through the purchase of insurance.

Question 6

6. Explain how State benefits should be taken into account when considering the financial planning needs of individuals.

Answer 6

There are two aspects to this:
• Individuals may need to provide less for themselves. For example, in the UK where emergency hospital treatment is free, very few individuals will take insurance out against this, but they may take out private medical insurance against the need to have non-urgent treatment such as a hip replacement or dental care. Another example is an employer sponsoring a benefit scheme. When considering the total benefit needed by employees, the employer may deduct any State benefits in order to minimise the cost of the scheme.
• There may not be a savings incentive. Where State benefits are means-tested, individuals on a low income who only have a limited ability to save may find that it is better value for them not to save at all, as any savings they have will be offset against the benefits that they are entitled to from the State and result in a lower level of income. For example, the amount of long-term care or housing benefit provided by the State may be reduced for those with assets worth more than a certain value.

Question 7

7. Give an example of significant State involvement in controlling benefit provision by describing Singapore’s Central Provident Fund.

Answer 7

An example of significant State involvement in controlling benefit provision is Singapore’s Central Provident Fund. This was set up in 1955 to provide financial security for workers in their retirement or when they were no longer able to work. It requires compulsory contributions from employees and employers. Since 1955, it has evolved into a comprehensive social security savings scheme, which not only covers members’ retirement needs but also their needs for:
• home ownership
• healthcare
• education of their children
• financial protection through insurance.

Question 8

8. How will State requirements for individuals to save affect an individual’s savings?

Answer 8

If the State requires individuals to save for their retirement or other benefits, this will reduce the amount that individuals feel they can or need to invest in individual arrangements.

Question 9

9. Describe how tax can affect an individual’s financial planning.

Answer 9

The tax treatment of benefits arising from financial products and schemes can have an impact on the needs of individuals.
• Benefits can be received free of tax.
• The excess of the benefit received over the contributions paid can be taxed, either as income or as a capital gain.
• The benefit can be taxed entirely as income.
There are common hybrid options where a portion of the benefit can be taken tax-free, with the balance being taxed. In these cases, the portion can be a monetary amount, a percentage of the total benefit or a combination of these approaches. Where benefits are taxed, the normal or special tax rates can be used.
Some territories use all these options, depending on the legislation under which the product or scheme is written.
The impact of tax on contributions towards financial products should also be considered. Some arrangements may offer tax relief on contributions paid. These would normally be coupled with tax on the resulting benefits. Other types of arrangement require contributions to be paid from taxed income. These arrangements normally offer some relief from tax on the ultimate benefit.
Governments also have the option of taxing the income and gains of products and schemes during the accumulation phase.
In developed countries, to provide an incentive to save, the general principle is that double taxation is avoided. Therefore if a provider is taxed on income and gains in the accumulation phase of a product, there is unlikely to be a charge to tax on the policyholder’s gain.
Tax may also need to be considered when considering the inheritance that an individual will pass on. If tax is payable on the individual’s estate on death, it may be possible to take out insurance to cover this tax liability.

Question 10

10. Describe how accounting standards may affect both employer benefit provision and the financial products brought to market by providers.

Answer 10

The way that benefit schemes need to be reported in company accounts may influence the types of benefits that employers are prepared to provide for their employees.
The presentation of financial instruments in the accounts of product providers also impacts on the range of products that is brought to market. For example, the different accounting requirements for setting the provisions for different types of insurance contract in different territories can influence the design of contracts. Similarly whether a fund manager brings investments to market within an insurance wrapper through a subsidiary company, or through a collective investment scheme, might depend on the presentation and results shown in the company’s accounts.

Question 11

11. Explain what capital adequacy and solvency requirements are and outline the capital requirements imposed on banks.

Answer 11

Capital adequacy and solvency form part of banking and insurance regulation which sets a framework on how financial institutions measure their capital adequacy and solvency.

Question 12

12. How may capital adequacy be measured?

Answer 12

Capital adequacy is then measured as the excess of assets over the sum of liabilities and capital requirements. This might be expressed as a monetary amount but is more commonly stated as a percentage of liabilities plus capital requirements or a multiple of the capital requirements. Capital requirements for financial product providers are discussed in more detail later in the course.

Question 13

13. Whay type of capital requirement are states moving to, driven largely by the availability of computing power?

Answer 13

Increasingly, and largely driven by the availability of computing power, states are moving towards risk-based capital requirements such as the structures behind the European Solvency II regime. Simple formulae-based approaches are used in some countries, but the general global trend is towards a more risk-based capital framework.

Question 14

14. Define the term ‘corporate governance’ and state its main aim.

Answer 14

Corporate governance refers to the high-level framework within which a company’s managerial decisions are made. The aim of good corporate governance is that a company should be managed efficiently in order to meet the requirements of its stakeholders - the shareholders, employees, pensioners, customers, suppliers and others who may be affected by the company’s operations.

Question 15

15. Give an example of how good corporate governance can be used to alleviate a particular concern regarding the bhaviour of a company’s management.

Answer 15

One concern of regulators is that management might make decisions based more on their own personal interests than on those of other stakeholders.
Good corporate governance can be enhanced by ensuring that remuneration incentivises management to act in the interests of stakeholders. Share options may be part of this, though the lack of sufficient downside for management can limit how well share options achieve this objective. Non-executive directors are also often part of a structure aimed at good corporate governance.

Question 16

16. State the different corporate structures of a financial product provider.

Answer 16

Product providers might be mutual societies or proprietary companies, and the latter might be private or public companies.

Question 17

17. Discuss the key features of mutual companies.

Answer 17

Mutual societies have no shareholders and profits belong entirely to policyholders. On the face of it mutuals should be able to provide better benefits for the same cost than proprietaries, because no funds are diverted to provide a dividend stream to shareholders. The disadvantage of mutuality is that finance cannot readily be raised from capital markets. This is likely to restrict the products that a mutual might be prepared to offer. In particular, products that are capital intensive will be less attractive to the mutual and may be priced accordingly.
Mutuals may offer specific distributions of surplus to their members.
With-profit insurance companies, friendly societies and co-Operative organisations tend to do this. The alternative is to design products with the lowest margins in the price consistent with the risks undertaken and benefit members by that route.

Question 18

18. Discuss the key features of public and private proprietary companies.

Answer 18

Public proprietary companies benefit from easier access to capital markets for finance, and may also have greater economies of scale and more dynamic management than mutuals. These benefits may pay for the dividends to shareholders themselves, and the company may have a competitive edge over the mutual.
Private companies may be as restricted as mutuals for raising capital, but often benefit from the close involvement of the owners, which is a management advantage. The owners of private companies may have
access to significant additional capital, providing an edge over both mutual and public proprietary companies.
For proprietary life insurance companies the apportionment of surpluses between with-profit policyholders and shareholders is also important.

Question 19

19. Discuss the underwriting cycle.

Answer 19

A consequence of the competitive nature of the insurance business is what is known as the underwriting cycle. Profitability in the various insurance classes tends to go in cycles, which are driven by market forces of supply and demand combined with actual claims experience and the economic climate.
When business is profitable, more insurers enter the market. Premium rates will reduce as insurers compete for market share. This will lead to reduced profits or to losses, and the cycle will go into depression.
The position is often accentuated by catastrophes or by the economic climate.
At the bottom of the cycle, insurers will leave that market or reduce their involvement in the classes concerned, as premiums are too low to be profitable. Eventually premium rates will increase to cover the losses being incurred. The speed with which this occurs will depend on the position adopted by the leading insurers in that business, and insurers’continuing demand for market share.
In the long term, the pattern of profits and losses should even out. In the short term, profitable classes may be able to cross-subsidise losses in other classes. However, new entrants in the market will restrict the ability of other insurers to recoup historical exceptional losses.

Question 20

20. Outline the consequences of failing to make profits at the bottom of the underwriting cycle.

Answer 20

More extremely, the inability to make profits at the bottom of the underwriting cycle could lead to:
• loss of business, putting pressure on the ability to recoup fixed expenses and future growth prospects
• a reduced solvency position, requiring additional capital support or other remedial action.

Question 21

21. When is a provider’s position in the underwriting cycle an important consideration?

Answer 21

The position of a class of business in the underwriting cycle is, therefore, an important consideration when making strategic decisions.

Question 22

22. Give three examples of how changing social trends can have an impact on financial products.

Answer 22

• As home ownership becomes more widespread in the population there will be a greater demand for mortgages.
• If the State cuts back on healthcare provision for its citizens there will be a greater demand for products that meet the cost of private healthcare.
• If individuals have increased amounts of ‘spare’ income there may be an increased demand for savings products.

Question 23

23. Explain why telematics may be used by an insurer writing motor insurance business.

Answer 23

In many countries, for motor insurance business, there has been an increase in the use of telematics, whereby to assess the risk factors for an individual, the policyholder’s driving behaviour and other factors are monitored through a black box device, installed in the insured vehicle, or through a smart phone app. This makes information available to the insurer on some risk factors which would not normally be readily measureable. Examples of possible additional information include:
• information on the ability of the driver
• the speed at which the vehicle is usually driven
• the vehicle’s general level of performance.
The insurer could then use this additional information to help price the risks more accurately.

Question 24

24. Describe how demographic changes to a population can impact benefit providers.

Answer 24

Demographic changes to a population can have a major impact on the main providers of benefits on contingent events, particularly the State.
There are two main sources of demographic changes leading to population ageing:
• rising life expectancy and
• declining fertility.
The significant decline in the total fertility rate over the last 50 years is primarily responsible for the population ageing that is taking place in the world’s most developed countries. Many developing countries are going through faster fertility t ransitions and they will experience even faster population ageing than the currently developed countries in the future.

Question 25

25. List 4 effects of an ageing population.

Answer 25

The effects of an ageing population are considerable:
• Economically, older people are more l ikely to be saving money (eg for retirement) and less likely to be spending it. This leads to lower interest rates and deflationary pressures on economies.
• Social welfare systems have also begun to experience problems. Some pay-as-you-go State pension systems are becoming unsustainable.
• The cost of healthcare systems will increase dramatically as populations age. Governments will be faced with a choice between requiring higher levels of tax to be paid or accepting reduced government role in providing health care.
• However, the second largest area of expenditure for many governments is education. The cost of educating the population will tend to fall with an ageing population.

Question 26

26. Describe how climate change will impact the financial markets and institutions.

Answer 26

The key findings from the Intergovernmental Panel on Climate Change Fifth Assessment Report (2014) for investors and financial institutions are as follows:
• Climate change will affect all sectors of the economy, and is relevant to investors and financial institutions. However, not all macroeconomic changes and microeconomic conditions will apply equally to all investments.
• There are risks and opportunities associated with policy measures directed at reducing greenhouse gas emissions. To meet the internationally agreed target of keeping the global average temperature rise since pre-industrial times below 2°c, patterns of investment will need to change considerably.
• Physical impacts of climate change will affect assets and investments. Climate change and extreme weather events will affect agriculture and food supply, infrastructure, precipitation and the water supply in ways that are only partially understood.
• Decisions made by private sector investors and financial institutions will have a major influence on how society responds to climate change.
There will be significant demand for capital, with governments looking to the private sector to provide much of it. To keep the global temperature increase below 2°c, additional investment required in the energy supply sector alone is estimated to be between USO 190 and 900 billion per year through to 2051, accompanied by a significant shift away from fossil fuels towards low-carbon sources such as renewables and nuclear.

Question 27

27. Describe how environmental issues have impacted on financial products and providers.

Answer 27

Government, advocacy groups and the observed preferences of individual participants in investment markets have acted to ensure that the concern felt by the public on the environment and ethical issues impacts the behaviour of financial markets.
Providers that want to be attractive to the widest possible range of investors will provide products where environmental and ethical issues are part of the investment process and decision making.
These products have a ‘socially responsible overlay’ and the investment managers commit to engaging in a constructive dialogue with company management to promote environmental and ethical objectives.
The environmental impact of the way providers communicate with the public may also need to be considered, especially with regard to the volume of paper produced which is never read.

Question 28

28. Describe emissions trading and how it can be used to minise the impact of climate change.

Answer 28

Emissions trading is a market-based approach, among others, to address pollution. The overall goal of an emissions trading plan is to minimize the cost of meeting a set emissions target.
The government sets an overall limit on emissions and issues permits to emit, up to the overall limit.
Usually, the government lowers the overall limit over time, with an aim towards a national emissions reduction target.
In many emission trading schemes, polluters and organisations which do not pollute (and therefore have no obligations) may trade permits and financial derivatives of permits. This creates a market in which financial institutions and product providers can participate.

Question 29

29. Describe the three catogories of risk arising from climate change as set out in ‘The impact of climate change on the UK insurance sector’ by the Prudential Regulatory Authority.

Answer 29

• Physical risks arise from the effects of a changing climate itself. Such risks may arise in the short term from damage to property and from business disruption due to extreme weather events. In the longer term, chronic impacts may dominate, such as rising temperatures, rising sea levels and changes to rainfall patterns affecting use of land for agriculture.
• Transition risks arise from the shift away from fossil fuel use. Sources of t ransition risk include policy measures (eg carbon taxes and energy efficiency standards), technological change (eg a move to renewable energy and electrical vehicles) and changing customer preferences (eg increased demand for ‘green’products).
Transition risk is a particular concern for fossil fuel-dependent companies and associated infrastructure.
• Liability risks relate to the potential costs from third parties seeking compensation because they have suffered loss or damage from the effects of climate change. It is possible that actuaries and their clients could face legal claims themselves in future if they fail to consider climate-related risks.

Question 30

30. Outline how climate change can provide opportunities to companies.

Answer 30

Climate change brings opportunities as well as risks. Companies that offer solutions to climate change, such as lower emission technologies and energy efficiency measures, are well-placed to benefit from a low carbon transition.

Question 31

31. Explain how climate change might impact on actuaries when modelling.

Answer 31

There is widespread concern among policymakers and financial regulators of the damage that climate change could cause to the financial system and, conversely, the role that the financial system can play in achieving an orderly t ransition to a low carbon economy.
In May 2017, the IFoA issued a risk alert highlighting that actuaries are expected to consider climate risks and communicate their approach. A particular challenge is that the future may look very different to the past, so models that are calibrated using past data may give misleading results.

Question 32

32. Describe how the financial needs of individuals change with age.

Answer 32

Younger members of the population will have a high demand for loans and mortgages and are less likely to be saving towards retirement.
As individuals age they will pay off some of their loans and begin to save. They may also have an increased demand for life insurance protection products as they have dependent children and longer working lifetime.
Once members of the population retire from employment, they are likely to reduce the amount they save and start spending the funds they have saved. They may have a need for annuities and products providing long-term care. Their need for life insurance may decline, if their dependants become more self-sufficient. However, 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.
At the time at which investors move from savings accumulation to savings decumulation, many may wish to secure certainty of value and avoid investment in volatile markets and volatile instruments. This suggests a gradual move from equity-type towards fixed interest-type assets. However, better-off investors may be able to afford to take more risk during the decumulation phase in order to gain a better investment return.
As people live longer they will need to save more and/or save for longer to ensure that their assets do not run out before they die.

Question 33

33. Why may replicating the financial products sold in overseas countries be difficult?

Answer 33

Often the difference in tax and legislative requirements between other countries and the providers’own country makes this difficult.

Question 34

34. Give two examples of financial products imported to the UK from overseas in recent years.

Answer 34

One example of a product that has been imported to the UK from Australia is a mortgage product under which the homeowner can offset any monies they have in current and savings accounts against the capital owed on the mortgage loan. Interest is usually calculated daily and charged on the balance of the difference between the loan and balances in the borrower’s current and savings accounts.
Another example is critical illness cover, which was developed in South Africa.

Question 35

35. Describe how technological changes have influenced financial products and providers.

Answer 35

The ways in which financial products are provided for individuals has changed significantly over recent years.
For example:
• Financial products used to be mainly sold by insurance intermediaries who would aim to find the best contract in terms of benefits and premiums for their client. Now, many of these products are sold over the internet with clients being able to obtain a range of quotations for themselves. Clients can purchase the product without ever speaking to a representative of the provider.
• For commodity products (motor insurance, household insurance, term life insurance and annuities) there are price comparison sites that save the individual accessing many companies’ sites - although not all providers choose to be included on price comparison sites, for which there is a substantial fee to be paid.
• Banking and saving services are also now provided over the internet and by telephone as well as in the traditional bank and building society branches.
• Insurance companies increasingly use websites to:
- capture enquiries from clients
- record changes to clients’ personal details
- register claims
- perform other administrative tasks.
• Financial product providers are establishing presences on social media, not only for general advertising purposes but also to provide direct links to product sales and customer enquiry websites.
• Email is a fully accepted and widely used means of communication.