Chapter 2: External environment

Question 1

What is the difference between regulation and legislation?

Answer 1

Legislation is law that has been formally declared by the parliament or congress or other governing body.

Regulation is a form of secondary legislation that is used to implement a primary piece of legislation appropriately or to take account of particular circumstances or factors

Question 2

What factors should be considered in relation to the external environment? (16)
CREATE GRAAND LISTS

Answer 2

Corporate structure
Regulation and legislation
Environmental issues and climate change
Tax
Economic outlook (e.g. interest rates, inflation, growth and exchange rates)

Governance (corporate)
Risk management requirements
Accounting standards
Adequacy of capital and solvency
New business environment
Demographic trends

Lifestyle considerations
International practice
State benefits
Technological changes
Social and cultural trends

Question 3

Implications of Legislation and regulation for providers of benefits

Answer 3

> require compulsory insurance in certain circumstances (e.g. Employers’ liability, motor third part liability, UIF)

> Influence of the types of products available - consider financial sophistication

> Regulate the sales process (cooling off period)

Question 4

Implication of State benefits for providers of benefits

Answer 4

1> individuals may need to provide less for themselves

2> There may not be a savings incentive

3> raise employers’/individuals’ awareness of the need to top-up state benefit (Complementary, supplementary, substitute)

4> reduce level of savings if benefits are means-tested

5> may require compulsory contributions

6> can introduce moral hazard, i.e. risk of individuals relying on the state and not purchasing their own cover

Question 5

Implications of tax

Answer 5

1> Affect the form of benefits within products (benefits can be tax free, excess of contributions taxed, entire benefit taxed)

2> means that product innovation may be designed to avoid paying tax
- e.g. tax-free saving vehicles
- retail savings bond

3> directs savings towards the most tax-effective forms (i.e. preference of income or capital gains)

Question 6

Implications of Accounting standards (2)

Answer 6

1> influence an employer’s provision of employee benefits

2> Influence range of products marketed
- e.g. provisions in different territories -> contract design
- e.g. wrapper; savings plan wrapped as endowment assurance etc

Question 7

Risk management requirements , capital adequacy and solvency (3)

Answer 7

> form part of banking and insurance regulation

> may impose minimum standards of risk governance, including risk management roles within a firm, as well as capital requirements

> are moving towards risk based capital
- Basis, connected to regulation and accounting standards

In S.A insurers are regulated by Solvency Assessment and Management (SAM) regime developed by FSCA

Banks - Basel iii

Question 8

What are likely aims of regulatory requirements relating to capital adequacy and solvency for insurers? (4)

Answer 8

> reduce the risk of insurers being unable to meet claims

> reduce the losses suffered by policyholders in the event that the insurer is unable to meet claims

> provide an early warning system so that regulators can intervene if capital is not adequate

> to ensure confidence in the insurance sector

Question 9

Corporate governance

Answer 9

Aim:
company should be managed efficiently in order to meet the requirements of its stakeholders - the shareholder, employees, pensioners, customers, suppliers, and others affected

Strategies:
> Incentivises managers accordingly
> may utilise non-executive directors (Impartiality, audit committee, setting renumerations)
> influences way in which stakeholders’ needs are met - King IV report: Outcomes based

Question 10

Corporate structure

Answer 10

Mutual societies
> have no shareholders and profits belong entirely to policyholders
> surplus distribution - to their members
> Pricing at cost - lowest margins consistent with the risk undertaken

e.g. medical schemes, mutual banks

Proprietaries
> Public proprietary benefits from easier access to capital markets for finance, and may also have greater economies of scale and more dynamic management than mutuals

> have an issue of how to distribute surplus between shareholders and any with-profit policyholders

Question 11

Competitive advantage and commercial considerations

Answer 11

An important concept is the underwriting cycle. The position in the cycle is important when making decisions

The underwriting cycle relates to:
1. When business in profitable => more insurers enter the market

2. Leads to greater competition, premium rates reduce
3. This leads to reduced profits or losses, loss of business and reduced solvency

– cycle goes into depressions —

4. insurers leave the market or reduce their involvement in the class concerned
5. Eventually premium rates rise to cover the losses being incurred and in light of reduced competition

> Profitability in various insurance classes>
Driven by forces of market supply and demand
AND economic climate

Banks and the business cycle
> for banks the equivalent business cycle is largely driven by the variation in interest rates and economic activity over the wider economic cycle

1. When interest rates are high => greater demand for bank savings product and reduction in borrowing
2. When there is strong economic growth, there may be increased demand to borrow (e.g. mortgages, expanding)

Question 12

Changing cultural and social trends

Answer 12

1> include aspects such as the level of home ownership

2> impact on the financial products schemes, transaction and risk assessment approaches available

> Green
Wearables/telematics
incentives
Virtual offerings
Shariah compliant (islmic law)

Question 13

Demographic changes

Answer 13

1> can have a major impact on main benefit provider e.g. state
2> Include aging population: increased support
- less spending, as people of working age save more as they get older
- a strain on social welfare system
- an increased cost of healthcare
- the cost of education falling

falling birthrates, mortality, morbidity
immigration

Question 14

Climate change and environmental issues

Answer 14

1> influence the ways in which the Government, advocacy groups and individual participants act, and hence the behaviours of the financial market

2> have led to providers offering products that promote environmental and ethical issues

3> affect how providers communicate with customers e.g. reducing the amount of paperwork

4> the government may seek to control emissions by issuing permits, which may be traded between polluters and organisation that do not pollute

5> Climate change may lead to physical risk, transition risks and liability risks for the insurance sector

Question 15

Lifestyle consideration (3)

Answer 15

Change in needs
1> younger people have preference for loans rather than savings
2> people with children may have a need for life insurance protection products
3> older people may have a need for annuities and long-term care products

Question 16

International practices (1)

Answer 16

> may lead to overseas products being replicated in the domestic market, subject to tax and legislative considerations

Question 17

Technological changes

Answer 17

1> impact on the way in which financial products are provided; e.g. internet, comparisons websites, telephone banking, AI - diagnosis

2> impact on wider administration processes e.g. registering claims, customer enquiries

Question 18

How might regulation ensure that a customer enters into a contract that is suitable for their financial needs?

Answer 18

1> Limits on the charges levied by the provider, e.g. on unit trusts or unit-linked contracts
2> regulation on the sales process, e.g on advice given and disclosure of information

Question 19

How might accounting standards affect employer benefit provision and the financial
products brought to the market?

Answer 19

> Way benefits schemes need to be reported in company accounts may affect the
type of benefits that employers are prepared to offer their employees

> Presentation of financial instruments in the accounts of product providers +> affects the range of products brought to the market

> Different acc requirements => provisions => design of contracts in various territories

> Fund manager invests in an insurance wrapper or through a collective investment scheme => depend on the presentation and results shown in a company’s accounts

Question 20

How are benefits arising from financial products and schemes taxed?

Answer 20

> Benefits can be received free of tax
Excess of benefits over contributions => taxed as income or capital gains tax
Benefits taxed entirely as income
A portion of the benefit can be tax-free, with the balance being taxed
Normal or special tax rates can be used

Question 21

How are other items other than benefits taxed?

Answer 21

> some arrangements => tax relief on contribution - coupled with tax on resulting benefits

> OR contributions may be taxed and - tax relief on the resulting benefits

> Income + gains may be taxed during the accumulation phase and no tax on the policyholder’s gain

> tax payable => inheritance
Insurance may be able to cover this liability

Question 22

What is corporate governance and what are the features of a good corporate governance
framework?

Answer 22

High level framework within which a company’s managerial decisions are made.

> A good corporate governance framework=>

i. Encourages managers to act in the best interest of stakeholders rather than
in their own best interest
ii. Incentivises manages to achieve the first aim
iii. Utilises non-executive directors

Question 23

What is the broad approach of banking and insurance regulation to ensuring the capital
adequacy and solvency of a provider?

Answer 23

➢ Regulation=> Framework on how financial institutions measure their capital
adequacy and solvency

➢ Financial institutions needs to determine the minimum capital that they are
required to hold. Capital adequacy is measured as the excess of assets over the
sum of liabilities and capital requirements.

➢ Might be expressed as a monetary amount.

➢ Or might be expressed as a percentage of liabilities and capital requirements

➢ Or a multiple of the capital requirements

➢ Availability of computing power=> Risk based requirement.

➢ Rather than simple formulae based approached=> outdated

Question 24

How does age affect lifestyle considerations when it comes to the need for financial
products? (6 points)

Answer 24

➢ Young people=> loans and mortgages
i. Few demand savings

➢ Slightly older people=> pay their loans and start to save.
i. Protection for dependents

➢ Longer working lifetimes and increases in life expectancy will increase the need
for savings products, life assurances and the age to which it will be required.

➢ Move away from volatility more towards security prior to retirement.

➢ Older (still in retirement)=> demand for savings diminishes, but is replaced with
demand for post-retirement income plans and long term care products

➢ Children become less dependent

Question 25

What are the effects of an ageing population on the economy or state? (4)

Answer 25

➢ Older people=> save more spend less=> lower interest rates and deflationary
pressure on the economy

➢ Some pay-as-you-go state pensions systems are becoming unsustainable=> as
income received from the working class falls short of that needed to pay retired
population.

➢ Increasing cost of healthcare=> increased taxes or reduced healthcare provided
for by the state

➢ Cost per capita of educating the population will fall

Question 26

What is emission trading?

Answer 26

➢ Market based approach to address pollution

➢ Aim of minimising the cost of meeting an emission target set by government.

➢ Government issues permits=> to emit up to a level

➢ Permits are sold or are equal to historical emissions for each polluter.

➢ Participant=Use exactly

➢ Participant= Use less and sell the excess permits

➢ Participant=Buy more from another participant

➢ Trade permits or derivatives on permits=> creating a wider market.

Question 27

What are the key features of mutual and proprietary financial providers?

Answer 27

➢ Mutuals=> no shareholders

i. Better benefits as profits=> belong entirely to with-profits policyholders
ii. Restricted access to capital restricts products
iii. Specific distribution of profits made or contracts are priced at cost

➢ Proprietary=> Shareholders

i. Public proprietary companies
ii. Private proprietary companies
iii. Profits may be shared with shareholders and with profit policyholders

Question 28

What are examples of changing social trends that could have an impact on financial
products, schemes, contracts, and transactions available? (4)

Answer 28

➢ Increase home ownership=> demand for mortgages
➢ Cuts in state healthcare=> demand for medical aid
➢ Increasing prosperity=> demand for savings products
➢ Increased telematics=> allow the risk factors for the individual monitored

Question 29

What are examples of technological advances that can have an impact on the availability
of financial products, schemes, contracts and transactions?

Answer 29

➢ Internet quotations and sales
➢ Price comparison websites
➢ Banking over the internet and telephone
➢ Insurance companies using website to capture customer enquiries and register
claims
➢ Social media for advertising and links to sales/ enquiry websites
➢ Email as fully accepted and widely used means of communication

Question 30

How can state benefits influence an individual’s needs for benefits?

Answer 30

➢ State benefits=> minimum standard of living=> supplement this with benefits=>
employer sponsored benefit scheme, insurance medical aid

➢ State benefits can remove the need for individual provision=> public health care,
state pension.

➢ State benefits disincentive to save=> means tested benefits

➢ If state compels individuals to save=> reduce the amount individuals are prepared
to save voluntary in individual arrangements