The External Environment - Chapter 2

Question 1

Acronym to remember factors in the external environment?

Answer 1

D GREAT CLASS LIST

Question 2

Give relevant points of the effects of demographic changes has on benefit providers (particularly th STATE)

Answer 2

• 2 main sources of demographic changes leading to population ageing – declining mortality and declining fertility
• Developing countries are transitioning from high mortality, high fertility to low mortality, low fertility

Effects of an aging population (COUL):
o Cost of healthcare systems increase dramatically
o Older population more likely to save money than spend it, therefore lower interest rates and deflationary pressures on economies
o Unsustainable PAYG pensions
 Working population decreases over time and contributions fall (higher dependency ratio)
 More people surviving to retirement and need a pension
 People living longer in retirement so benefit paid for longer
o Lower cost of education since older population

• Government wants to be re-elected, so their decisions are likely to be influenced by donors/electoral base and have to consider implications of hiked taxes or reduced government role in providing benefits in health/retirement

Question 3

Define corporate governance and discuss its aims

Answer 3

• CG: High level framework within which managerial decisions are made in a company
• Aim: company should be managed in order to meet the needs of stakeholders: shareholders, employees, pensioners, customers, suppliers and anyone directly affected by companies operations

Question 4

In corporate governance, what are strategies to incentivize management to make best decisions in interest of stakeholders?

Answer 4

o Principles vs rules based
o Remuneration incentives (share options could be potential incentive but may be a lack of a downside )
o Non-executive directors NEDs
 Impartial view
 Review board decisions and ensure that they represent shareholder’s interest
 Setting remuneration for executive directors
 Leading role in audit committee with no members of executive present

Question 5

Give any relevant points to risk management

Answer 5

• This ties in with capital and solvency requirements
• Regulations may impose minimum standards of risk governance as well as risk management roles within a firm
• Measuring, monitoring and controlling of the risks on a firm’s balance sheet.
• Regulations based on Basel II framework.
• Market risk- variations in value of assets and liabilities
• Credit Risk- Failure of 3rd parties
• Operational Risk- Failures of people, processes and systems within company.

Question 6

Environment and Climate change can be split into 3 subcategories, what are they?

Answer 6

Climate Change
Impact of environmental and ethical issues on providers
Emissions Trading

Question 7

Discuss a few points relevant to climate change and its affects on the business environment

Answer 7

• Climate change will have a material impact on financial markets and institutions
• Risks and opportunities associated with legislation directed at reducing greenhouse gas emissions.
• Patterns of investment will have to change in order to meet agreed target of global temperature
• Demand for capital from private sector – investments in green energy
• Climate change/extreme weather will affect assets and investments – agriculture and food supply, infrastructure, precipitation and water supply
• Climate change affects demographic experience – increasing temperatures can have impact on spread of disease, increase instances of floods, threaten availability of food and water. These issues may impact pension schemes, life, health and general insurers. Patterns of claims will change for these product providers.

Question 8

Discuss the impact of environmental and ethical issues on providers

Answer 8

• Concern felt by public on environment and ethical issues impacts behaviour of financial markets
• This has led to providers of benefits offering products that promote environmental and ethical issues
• Way in which providers communicate may also need to be reconsidered i.e. large volumes of paper produced which aren’t read

Question 9

Discuss a few points related to emissions trading

Answer 9

• Market-based approach to address pollution
• Emissions trading plan aims to minimize cost of meeting set emissions targets
• Government gives permits to regulated polluters equal to their historical emissions, and lowers the limit over time
• Permits can be bought and sold, therefore, a participant can choose:
o To use its permits exactly
o Emit less than its permits and sell excess permits
o Emit more than its permits and buy permits from other participants
• Trade of permits creates a market in which financial institutions and product providers can participate

Question 10

Discuss how accounting standards impacts firms

Answer 10

• The way that benefits need to be reported in company accounts may influence type of benefits provided for their employees
• Presentation of financial instruments in accounts of provider impacts range of products brought to market e.g. different provision requirements in different territories may influence design of products

Question 11

Tax can be divided into 5 subcategories, what are they?

Answer 11

Benefits
Contributions
Accumulation of return
Inheritance Tax
Influence on products

Question 12

Discuss how tax influences the benefits of products

Answer 12

• Tax treatment of benefits can have impacts on the needs of individuals
• Benefit can be tax-free, taxable as income, excess of benefit received over contributions paid can be taxed as income or CGT. Hybrid options exist as well.

Question 13

Discuss how tax influences the contributions towards benefits

Answer 13

• Impact of tax on contributions is also important
• Some arrangements offer tax relief on contributions but are coupled with tax on benefit.
• Others require contributions to be paid from taxed income and tax relief on benefit payment
• In SA, system of tax is EXEMPT-EXEMPT-TAX i.e. from the period of income contribution to investment accrual it is tax exempt, but is taxed when paid

Question 14

Discuss how tax is involved in the accumulation phase

Answer 14

• Gov. can tax in the accumulation/investment accrual phase

* Double taxation in the different periods of the investment unlikely in developed countries

Question 15

Discuss how inheritance tax has affected products

Answer 15

• Product innovations may be designed to avoid paying tax e.g. inheritance tax
• Life insurance can be taken out to cover this liability in the event of a family member dying

Question 16

Discuss how tax influences products

Answer 16

• Tax systems influence types and forms of products made available
• For example:
o Pension provision and lump sum benefits payable on retirement
o Tax-free savings vehicles
o Tax-free government savings schemes
o Retail savings bonds (SA)
• Need to consider variety of taxes: income, corporate, VAT, CGT, Interest income, tax on foreign nationals (double taxation agreements), dividends, state duty (inheritance).
• Tax incentives (for example on pension funds or saving)
• Wrapping- different taxes may be more beneficial depending on financial standing and thus products can be wrapped differently depending on target market

Question 17

Competitive advantage and commercial requirements:

Differentiate between a hard and soft market

Answer 17

• A hard market is characterized by a high demand for insurance and a reduced supply. Insurers impose strict underwriting standards and issue a limited number of policies. Premiums are high and insurers are disinclined to negotiate terms.
• A soft market is characterized by competition and premiums (and profits) are generally low. Insurers relax their underwriting standards and coverage is widely available. Underwriters are generally flexible and willing to negotiate coverage terms

Question 18

Lifestyle considerations:

Discuss how the lifestyle consideration of a person influences the economy

Answer 18

• Younger population high demand for loans & mortgages, less likely to save towards retirement
• As people become older
o They begin to pay off loans and save more for retirement
o Increase demand for life insurance since they have dependants and have a longer working lifetime
• Old population eventually reduce saving and later start to spend saved funds
o Increasing longevity will mean people will need to save more & for longer to make sure assets do not run out before they die
o Old population have need for annuities and LT care products
• When investors move from accumulation to decumulation, they may wish to secure certainty of value and avoid investment in volatile markets like equities and move towards fixed-interest type assets

Question 19

What is capital adequacy and solvency?

Answer 19

• Capital adequacy – excess of assets over the sum of liabilities and capital requirements (monetary amount or %)
• Falls under banking and insurance regulation which sets a framework for how institutions measure capital adequacy and solvency

Question 20

What are the aims of regulatory requirements?

Answer 20

RsquaredEsquared
o Reduce risk insurers unable to meet claims
o Reduces losses suffered by p/h’s
o Early warning system so regulators can intervene
o Ensure confidence in insurance sector

Question 21

Discuss how societal trends affect products

Answer 21

• Changing cultural and social trends affects financial products, schemes, contracts and transactions
• As home ownership becomes more widespread, may increase demand for mortgages
• State healthcare provision affects demand for private healthcare
• If individuals have increased amounts of disposable income, affects demand for saving products
• Digitalization affects pricing of most products – discovery black box

Question 22

Corporate Structure:

Discuss the properties of a mutual and how this may affect its products

Answer 22

o Concerned about welfare of a defined group of people
o Start through altruistic gesture
o Someone lends initial capital which is only repaid if profits emerge
o No shareholders and all profits belong to p/h’s
o Disadvantage: capital can’t be raised from capital markets – may restrict products mutual prepared to offer (capital intensive products)
o Two products pricing methods used by mutuals:
a. Surplus Distribution - distribution of surplus to members. With profits insurance companies, friendly societies and co-operative org. do this
b. Pricing at cost - lowest margins in the price consistent with risk undertaken

Question 23

Corporate structure:

Discuss the properties of proprietaries and how this may affect their products

Answer 23

• Can be public or private companies
• Public companies have easy access to capital markets for finance
• Greater economies of scale
• More dynamic management
• Disadvantage: shareholders expect dividends
• Private Companies restricted (like mutuals) for raising capital, benefit from close involvement of owners which is a management advantage
• Owners may have access to significant additional capital – edge over mutual/public companies
• For life insurance companies, apportionment of profits between with-profits p/hs and shareholders NB

Question 24

Legislation and Regulation

Discuss how legislation and regulation affect products

Answer 24

• Legislation – Law that has been formally declared by parliament/governing body
• Regulation – subordinate legislation that is used to implement legislation appropriately
• Some countries may have legislation that requires individuals/organisations to have certain insurance – employers’ liability insurance, motor third party liability insurance
• Regulations may influence the type of financial product most suited to consumer’s needs
• Regulation of sales process may influence types of product brought to market
• Owing to information asymmetries, regulation places onus on product providers to demonstrate consumers fully understand the product and risks
• This may mean complex products (benefit smoothing processes/derivative strategies) are not marketed no matter how suitable they are for customers’ needs

Question 25

Legislation and Regulation

What types of regulation are there in the financial services industry and what professional guidelines are there?

Answer 25

• 3 types of regulation in financial services:
o Product Standards (min list of conditions, max changes allowed)
o Prudential requirements
o Market conduct: sales and treating customers fairly (TCF)

Industry best practice:
o	Governance (King Code)
o	Risk Management
o	Code of Conduct 
Role of Professional bodies:
o	Accounting Standards
o	Actuarial Standards of Practice

Question 26

How does International practice affect products?

Answer 26

• May look at international market to explore replication of products used overseas
• Tax and legislative differences may restrict this process

Question 27

State benefits:

Why would the state provide benefits?

Answer 27

(REMPI):
o Redistribution of wealth
o Elections
o Might be most efficient provider – economies of scale
o Pressure from external bodies
o Inertia – continue what has been done in the past

Question 28

State Benefits:

How do state benefits affect products?

Answer 28

• Level and form of state benefits influences level and form of non-state benefits provided
• Considerations for financial planning when state benefits provided:
o Less need for provision – either individually in the case of NHI or for the employer in the case of state pension provision
o Disincentive to save → if state benefits are means-tested, individuals on low income may find better value for them not to save at all, as any savings will offset against benefits they are entitled to from state and result in a lower level of income

Question 29

State benefits:

What are issues with means-testing?

Answer 29

o Costly (admin intensive)
o Demeaning
o Open to fraud
o Encourages people to hide wealth

Question 30

Discuss how technological changes have affected products and pricing

Answer 30

• The way in which products are provided has changed with technology
• Internet
• Insurance products - price comparison sites (not all providers may be on here as may be expensive)
• Banking – internet, mobile apps as well as physical branches
• Use of social media by product providers for advertising as well as links to product sales/customer enquiry websites (engaging with customer)
• Email widely used
• Technological changes have improved healthcare/medical techniques, impacting profitability and pricing of relevant products
• Access to mobile phone technology contributed to growth of microinsurance in developing countries – distribution and administration more efficient
• Telematics
o Encourage good behaviour
o Reduce moral hazard

Question 31

Technological changes:

How do insurance companies benefit from websites

Answer 31

o Capture enquiries from clients
o Record changes to clients personal details
o Register claims
o Perform other administrative tasks