Chapter 3 - External Environment Flashcards
List 19 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?
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 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
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 II, for banks
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
- Reduce financial crime
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
- should be monitored for effectiveness
- may utilise non-executive directors
- influences the way in which stakeholders’ needs are met
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
- Products are either priced “at cost” or for allowance of surplus distribution to with-profit policyholders
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
External Environment:
Demographic changes
- mortality/fertility/unemployment/immigration
- can have major impact on main benefit providers, eg State
- Affordability of pension plans affected by longevity
- Increasing longevity and falling birth rates may result in ageing population
Results of ageing population
- less spending, as older people more likely to save
- strain on social welfare systems
- increased cost of healthcare
- cost of education falling
