Chapter 2 - External Environment Flashcards
List 15 external environment considerations
C - Competition & Underwriting Cycle R - Regulation & Legislature E - Environmental Issues A - Accounting Standards T - Tax E - Economic Outlook
G - Governance R - Risk Management Requirements E - Experience from Overseas A - Adequacy of Capital T - Trends (Demographic)
L - Lifestyle Considerations I - Institutional Structure S - Societal Trends T - Technological Changes S - State Benefits
P - Physical Environment (climate & natural perils, pandemics)
G - Globalization
C - Convergence of financial institutions
External Environment:
Legislation and regulations, definitions and explanation
How do they affect the financial services industry? (at least 8)
Legislation: Law formally declared by governing body
Regulation: secondary form of legislation, used to implement primary legislature
- Require compulsory insurance in certain circumstances
- Influence the types of product available and best suited for customer needs (tax)
- Competition & barriers to entry
- National control vs Privatisation
- Court judicial decisions (affects average future liab. claims)
- Crime & Punishment
- Financial Reporting
- Solvency/liquidity reqs.
- Ts & Cs of insurance contracts e.g. compulsory unlimited cover for liability products
- Regulate the sale process / providers required to fully explain products i.e TCF which is expensive
External Environment:
State benefits
For an individual:
- Less need for self-provision
- Discourages saving if mean tested
Employers and Employees:
- Raise employers’ awareness of the need to top up
State benefits:
- Introduce moral hazard, ie the risk of individuals relying on the State and not purchasing their own cover
- Reduce levels of additional savings if benefits are means-tested (social assistance)
- If benefits are contributory (social insurance), individuals may feel less wealthy and thus less able to purchase their own cover.
External Environment:
Tax
Tax Benefits
- The tax treatment of benefits arising from financial products and schemes can have an impact on the needs of individuals.
- Benefits can be tax-free, excess of the benefit received over the contributions paid can be taxed either as income or capital gain, benefit can be taxed entirely as income, or benefit taxed as a hybrid (tax-free + balance taxed)
- eg if premiums are taxed deductible and benefits taxed policyholders need to insure their gross salary in the event of disability, but vice versa net salary need to be insured
Tax Contributions
- The impact of tax contributions towards financial products should also be considered
- Some arrangements offer tax relief on contributions paid, but this is usually coupled with tax on the resulting benefits
- Other requirements require contributions to be paid from taxed income, but these arrangements usually offer relief from the tax on the ultimate benefit
Accumulation of return
- Governments have the option of taxing the income and gains of products and schemes during the accumulation phase
I developed countries as incentive to save 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 tax on the policyholders gain
Inheritance tax
- If tax is payable on the individual’s estate on death, it may be possible to take out insurance to cover this tax liability
Influence on products
- Tax systems can influence the types and forms of products made available by the financial services industry
- Examples of products and benefits that are heavily focused around a particular tax system include
> pension provision and lump sum benefits payable on retirement
> tax-free savings vehicles
> tax-free savings bonds in SA
> retail savings bonds in SA
ADDITIONAL:
- Tax treatments will have an impact on the needs of individuals/running of financial services businesses
- Affects pricing/valuations/profit calculations
- Affects individual need & ability to provide private benefits
- Affects the type and form of products offered by the financial service industry
- Means that product innovations may be designed to avoid paying tax
- Inheritance tax will change the amount of money passed down
- Encourages/discourages investment in products e.g. tax advantages for pension products
- Affects govt. ability to be a provider of benefits & enforcer of 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
External Environment:
Accounting Standards
- May influence an the types of benefits offered by employers to employees
- Influence the range of products marketed and their wrappers
- Accounting reqs. for reserving can influence contract design of products
External Environment:
Capital adequacy and solvency
- forms part of banking and insurance regulation
- is carried out using a complex capital adequacy framework, Basel III for banks, SAM for (SA) Insurers.
Capital Adequacy is measured as…
EXCESS of assets…
OVER sum of { LIABILITIES and CAPITAL requirements }
Can be % or multiple of capital requirements.
Aims of the regulator:
- Reduce risk of insurers being unable to meet claims
- Reduces losses suffered by p/h when insurers can’t meet claims
- Early warning system for regulators to intervene when capital is not adequate
- Ensure confidence in insurance sector
External Environment:
Corporate governance
High-level framework for managerial decisions in a company
Aims:
- encourages managers to act in the best interests of stakeholders
- incentivises managers accordingly… renumerate incentives to act on shareholders behalf, ex. share options
- should be monitored for effectiveness
- may utilise non-executive directors
- influences the way in which stakeholders’ needs are met
Based on King IV report
External Environment:
Risk management requirements
- are concerned with measuring, monitoring and controlling the impact of risks on a firm’s balance sheet e.g. perhaps by reinsurance
- Implemented by regulators to safeguard against systemic failure
Capital is required to cover which 3 risks?
- market risk
- credit risk
- operational risk
External Environment:
Mutuals
- No shareholders, profits belong to p/h
- Better benefits for the same cost
- Can’t readily raise finance by usual methods
- Certain products may be restricted or more highly-priced.
2 Ways in which mutuals approach product pricing:
Surplus Distribution
- Mutuals may offer specific distributions of surplus to their members. With-profits insurance companies, friendly societies and co-operative organizations tend to do this
Pricing at cost
- The alternative is to design products with the lowest margins in the price consistent with the risks undertaken and benefit members by that route
External Environment:
Public proprietary company
- easier access to capital markets for finance
- economies of scale
- more dynamic management
External Environment:
Private proprietary company
- may find same difficulties raising capital
- benefit from a close involvement of the owners
The underwriting cycle
Business is profitable => new entrants, greater competition, lower premium rates => reduced profits
=> insurers leave the market or reduce involvement => increased premium rates => profitable business
At the bottom of the cycle: loss of business is possible or reduced solvency (will increase need for capital)
- Long term: Profit and losses even out
- Short term: Profitable classes may subsidise losses in other classes
ADDITIONAL
- Profitability in the various insurance classes tend 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 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 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.
- 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 shares
- In the long term profits and losses should even out.
