Chapter 2-External environment Flashcards
- State two forms of insurance that are compulsory in some countries.
Examples include:
• employers’ liability insurance
• motor third party liability insurance.
- Give an example of how regulations may influence the type of product most suited to a customer’s needs.
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.
- Give an example of how regulation of the sales process for different products may influence the type of financial products brought to market.
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.
- Why don’t State benefits alone necessarily meet the needs of citizens?
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.
- Give two exampels of how an individual may achieve a higher level of benefits than those provided by the State.
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.
- Explain how State benefits should be taken into account when considering the financial planning needs of individuals.
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.
- Give an example of significant State involvement in controlling benefit provision by describing Singapore’s Central Provident Fund.
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.
- How will State requirements for individuals to save affect an individual’s savings?
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.
- Describe how tax can affect an individual’s financial planning.
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.
- Describe how accounting standards may affect both employer benefit provision and the financial products brought to market by providers.
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.
- Explain what capital adequacy and solvency requirements are and outline the capital requirements imposed on banks.
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.
- How may capital adequacy be measured?
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.
- Whay type of capital requirement are states moving to, driven largely by the availability of computing power?
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.
- Define the term ‘corporate governance’ and state its main aim.
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.
- Give an example of how good corporate governance can be used to alleviate a particular concern regarding the bhaviour of a company’s management.
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.
- State the different corporate structures of a financial product provider.
Product providers might be mutual societies or proprietary companies, and the latter might be private or public companies.
- Discuss the key features of mutual companies.
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.
- Discuss the key features of public and private proprietary companies.
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.
- Discuss the underwriting cycle.
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.
- Outline the consequences of failing to make profits at the bottom of the underwriting cycle.
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.
- When is a provider’s position in the underwriting cycle an important consideration?
The position of a class of business in the underwriting cycle is, therefore, an important consideration when making strategic decisions.
- Give three examples of how changing social trends can have an impact on financial products.
- 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.
- Explain why telematics may be used by an insurer writing motor insurance business.
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.
- Describe how demographic changes to a population can impact benefit providers.
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.
