Chapter 2: External environment Flashcards
List the factors to consider in relation to the external environment
CREATE GRAND LISTS
- Corporate structure
- Regulations and legislation
- Environmental issues and climate change
- Accounting standards
- Tax
- Economic outlook
- Governance
- Risk management requirements
- Adequacy of capital and solvency
- New business environment
- Demographic trends
- Lifestyle considerations
- International practices
- State benefits
- Technology
- Social and cultural trends
Legislation and regulations
Legislation: Law that has been formally declared by a parliament or congress or other governing body
Regulation: 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
- Some countries have some forms of insurance that are compulsory
- Regulation can influence the types of products that are brought to the market
- There is often information asymmetry. Therefore, regulation can also regulate the sales process
What 2 forms of GI cover are compulsory in many countries?
- Employers’ liability insurance
- Motor third party liability insurance
State benefits
Where the state provides benefits, these are often at a low level which may only be sufficient to keep individuals just out of poverty.
The level and form of state benefits will influence the level and form of additional non-state benefits provided.
There are 2 aspects to this:
* Individuals may need to provide less for themselves.
* There may not be a savings incentive
Tax
- Tax treatment of benefits from financial products and schemes can have an impact on the needs of the individuals.
- Affects the type and form of products offered by the financial service industry
- Can also influence the types and forms of products made available by the financial services industry
- Inheritance tax needs to be considered when inheritance is received, it may be possible to take out insurance to cover this tax liability.
- Tax directs saving into the most tax-efficient forms of tax shelters
List 4 ways in which benefits from financial products and schemes can be taxed
- Benefits can be received tax free
- 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
- A portion of the benefits can be tax-free, with the balance being taxed.
Explain how items other than benefits can be taxed
Some arrangements may offer tax relief on contributions paid, normally coupled with tax on the resulting benefit
Alternatively, contributions can be paid from taxed income, normally coupled with tax relief on the resulting benefits.
Income and gains may be taxed in the accumulation phase of a product, normally coupled with tax relief on the policyholder’s gain.
Tax may be payable on inheritance. Insurance can be available to cover this tax liability.
Accounting standards
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.
This can also impact the range of products that the provider brings to the market.
Similarly, whether a fund manager brings investments to the 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.
Risk management requirements, capital adequacy and solvency
- Some regulatory regimes impose minimum standards of risk governance
- There may also be specific regulatory requirements relating to risk management roles within a firm
- Capital adequacy and solvency form part of banking and insurance regulation
Capital adequacy is measured as the excess of assets over the sum of liabilities and capital requirements.
In South Africa the principles for measuring capital adequacy are risk-based, meaning that the level of capital that has to be held in excess of provisions depends on the amount of risk taken on.
Suggest likely aims of regulatory requirements relating to capital adequacy and solvency for insurers
- To reduce the risk of insurers being unable to meet claims
- to reduce the losses suffered by policyholders in the event that an insurer is unable to meet claims
- to provide an early warning system so that regulators can intervene if capital is not adequate
- to ensure confidence in the insurance sector
Define corporate governance and outline the features of a good corporate governance framework
Corporate governance refers to the high-level framework within which a company’s managerial decisions are made.
A good corporate governance framework:
1. Remuneration incentivises managers to act in the best interest of stakeholders, rather than their own personal interest
2. Incentivises managers in a way to achieve the first aim
3. Utilises non-executive directors
4. Influences the ways in which stakeholder needs are addressed.
What are the key features of mutual and proprietary financial providers?
Mutual Societies
* Mutual societies have no shareholders and profits belong entirely to policyholders
* Therefore, should be able to provide beter benefits for the same cost compared to proprietaries.
* However, finance cannot be readily raised from capital markets, which may restrict the products offered.
* Product pricing can be done as surplus distribution or pricing at cost
Surplus distribution: Offers specific distributions of surplus to their members.
Pricing at cost: Product design is done with the lowest margins in the price consistent with the risks undertaken.
Proprietaries
- Public proprietaries:
* Benefits from easier access to the capital markets for finance.
* Benefits from greater economies of scale
* More dynamic management than mutuals.
- Private proprietaries:
- Restricted, like mutuals, for raising capital.
- Possibly benefits from the close involvement of the owners , which is a management advantage. (Owners may have access to significant additional capital, providing an edge over both mutual and public proprietary companies)
- Profts may be shared between shareholders and with-profit policyholders
Describe the underwriting cycle
Profitability of 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 reduce as insurers compete for market share.
This leads to reduced profits or losses, and the cycle will go into depression. The position may be accentuated by catastrophes or by the economic climate.
At the bottom of the cycle, insurers will leave the 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.
For banks, the equivalent business cycle is largely driven by the variation in interest rates and economic activity over the wider economic cycle.
Explain why an insurer might stay in a market that was loss-making
- The insurer believes that the accumulated losses, are outweighed by the expected profits during the anticipated subsequent upswing
- The cycles of two (or more) isnurance markets may be out of phase. A company working in these markets may use profits in one to offset losses in the other.
- The costs of withdrawing from a market and subsequently re-entering that market might be prohibitive
- The insurer may need to offer such a product in order to attract sales of other more profitable products that it sells. The loss-making product is known as the loss leader.
Give examples of changing cultural and social trends
- Increased demand for home ownership increases the demand for mortgages.
- State healthcare provision cuts will increase the demand for products that meet the cost of private healthcare
- Individuals with increased amounts of ‘spare’ income will increase the demand for savings products
- Increased use of telematics for motor insurance, in many countries, allows the risk factors of the individual, the policyholder’s driving behavior and other factors to be monitored through a device installed in the insured vehicle or a smart phone app
List 2 main sources of demographic changes leading to population ageing
- rising life expectancy, and
- declining fertility
List the effects of an ageing population on the economy and state
- Old people are more likely to save money and less likely to spend it. This leads to lower interest rates and deflationaary pressures on economies.
- Some pay-as-you-go state pension systems are becoming unsustainable as the taxes from the current working population are used to pay benefits of current pensioners.
- The cost of healthcare systems increase dramatically as populations age. This leads to either increased tax levels or reduced healthcare provising by the government
- The cost of educating the population will tend to fall with an ageing population.
List the potential impacts of climate change on population trends
- Mass migration from areas at higher risk of flooding due to heavy rainfall and rising sea levels
- Increased morbidity and mortality
- Increased incidence of disease in some areas
- Increased conflict and wars
Explain the concept of emissions trading
This is a market based approach to address pollution, with the aim of minimizing the cost of meeting an emissions target set by the government.
The government issues permits to emit up to the overall limit. Permits are sold or are equal to historical trading emissions for each polluter. A participant can use permits exactly, or emit less and sell the excess permits, or emit more and buy permits from other polluters.
The usual aim is for the government to lower the overall limit over time.
Lifestyles considerations
- Younger people will have a higher demand for loans and mortgages, and are less likely to be saving towards retirement
- People with children will have an increased demand for life insurance protection
- Older people may have a need for annuities and products providing long-term care.
International practice
- Providers may need to look to the international markets to see if products sold in other countries could be replicated in their own country.
- Often the difference in tax and legislative requirements between countries makes this difficult.
Technologic changes
- Impacts how financial products are distributed. Used to be through insurance intermediaries, but is now done over the internet.
- Easier to reach specific target markets
- Better pricing and may reduce costs
- May also mean improved healthcare and medical techniques, affecting the profitability, and possibly pricing, of relevant products in the future.
Give 6 examples of technological advances that can have an impact on the availability of financial products, schemes, contracts and transactions
- Internet quotation and sales
- Price comparison websites
- Banking over the internet and phone
- Social media for advertising and links to sales/enquiry websites
- Insurance companies increasingly using websites to capture customer enquiries and register claims and transactions
- Email as a fully accepted and widely used means of communication
Capital is required to cover which 3 risks?
- Market risk
- Credit risk
- Operational risk
