Chapter 2: External Environment

Question 1

List the factors to consider in relation to the external environment

Answer 1

CREATE GRAND LISTS

Competetive structure
Regulation and legislation
Environmental issues and climate change
Accounting standards
Tax
Economic outlook

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

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

Question 2

Mutual Societies

Answer 2

• Founded by a benefactor or group who were concerned about the welfare of a defined group of people
• Mutual societies have no shareholders and profits belong entirely to policyholders
• Mutuals should be able to provide better benefits for the same cost than proprietaries because no funds are diverted to provide a dividend stream to shareholders
• The disadvantage of mutuality is that finance cannot be readily raised from capital markets. This is likely to restrict the products that a mutual might be prepared to offer. In particular, products that are capital intensive will be less attractive to mutuals and may be priced accordingly

Question 3

2 Ways in which mutuals approach product pricing

Answer 3

Surplus distribution
- Mutuals may offer specific distributions of surplus to their members. With profit insurance companies, friendly societies and co-operative organisations tend to do this

Pricing at cost
- The alternative is to design products with the lowest margins which are price consistent with the risks undertaken and benefit members receive

Question 4

Proprietaries (compared to mutuals)

Answer 4

Public proprietary companies benefit from easier access to capital markets for finance, and may also have greater economics of scale and more dynamic management than mutuals

Private companies may be as restricted as mutuals for raising capital, but often benefit from the close involvement of the owners, which is a management advantage. The owners of private companies may have access to significant additional capital, providing an edge over both mutuals and public proprietary companies

Question 5

Legislation

Answer 5

Law that has been formally declared by a parliament or congress or other governing body

Question 6

Regulation

Answer 6

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

• Require compulsory insurance in certain circumstances
• Influence the types of product most suited to a consumer’s needs - for example limitations on charges on a CIS may make the product more suitable than another without the limitation
• Regulation the sale process may influence the types of product that are brought to the market by product providers
• Due to information and knowledge asymmetries, regulation often places responsibility on product providers to demonstrate that consumers fully understand the product and risks. This may prevent complex products, such as those involving derivatives, are not marketed however suitable they are to consumers needs

Question 7

What two forms of insurance cover are compulsory in many countries?

Answer 7

1. Employer’s liability insurance

Question 8

Explain the concept of emissions trading

Answer 8

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 permit 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.

Question 9

Accounting Standards

Answer 9

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

For example, if the company provides large extra benefits to the staff in retirement, they might choose not to this anymore as it would look bad in the balance sheets.

The presentation of financial instruments in the accounts in the accounts of product providers also impacts the range of products that is brought to the market

Question 10

List four examples of how benefits from financial products and schemes can be taxed

Answer 10

1. Benefits can be received free of tax
2. The excess of benefits over contributions can be taxed as income or as capital gains
3. Benefits can be taxed entirely as income
4. A portion of the benefits can be tax-free, with the balance being taxed

Question 11

Explain how items other than benefits can be taxed

Answer 11

Some arrangements may offer tax relief on contributions, normally coupled with tax on the resulting benefits. Alternatively, contributions may be paid from taxed income, normally coupled with tax relief on the resulting benefits.

Income and gains may be taxed during the accumulation phase, normally coupled with no tax on the policyholder’s gains.

Tax may be payable on inheritance. Insurance can be available to cover this tax liability.

Question 12

Describe the underwriting cycle

Answer 12

Profitability in the various insurance classes tend to go in cycles, driven by market forces of supply and demand combined with actual claims experience and 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 to losses, loss of business and reduced solvency, and the cycle goes into depression. The position may be accentuated by catastrophes or by the economic climate.

At the bottom of the cycle, insurers leave the market or reduce their involvement in the classes concerned. Eventually, premium rates increase to cover the losses being incurred and in the light of emerging experience.

Question 13

Explain why an insurer might stay in a market that was loss-making

Answer 13

An insurer may believe that the accumulated losses, during the bottom of the cycle, are outweighed by the expected profits during the anticipated subsequent upswing in the market

The cycles of two or more insurance markets may be out of phase. A company working in these markets may use losses in one to cross-subsidise the others

The cost of withdrawing from a market and subsequently re-entering that market when it picks up 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 (loss-leading)

Question 14

Define corporate governance and outline the features of a good corporate governance framework

Answer 14

Corporate governance is the high-level framework within which a company’s managerial decisions are made.

A good corporate governance framework:

1. Encourages managers to act in the best interests of stakeholders, rather than in their own personal interests
2. Incentivises managers in a way to achieve the first aim
3. Utilises non-executive directors
4. Influences the way in which stakeholders’ needs are met

Question 15

Suggest likely aims of regulator requirements relating to capital adequacy and solvency for insurance

Answer 15

• 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

Question 16

Give 4 examples of the effects of an ageing population on the economy or State

Answer 16

1. Older people tend to spend less and save more. This leads to lower interest rates and deflationary pressures on the economy.
2. Some pay as you go State pension schemes are becoming unsustainable as the income received from the working population falls short of that needed to pay the retired population
3. Increasing costs of healthcare systems lead to either higher levels of tax to be paid or reduced healthcare provision by the state
4. The cost per capita of educating the population will tend to fall

Question 17

International practice

Answer 17

• Providers may look at the suitability of replicating overseas products in the domestic market
• differences in tax and legislature must be considered

Question 18

Technological changes

Answer 18

• impacts the distribution of financial products
• easier to reach specific target markets
• better pricing and may reduce costs

Question 19

Give 6 examples of technological advances that can have an impact on the availability of financial products, schemes, contracts and transactions

Answer 19

1. Internet quotation and sales
2. Price comparison websites
3. Banking over the internet and phone
4. Social media for advertising and links to sales/enquiry websites
5. Insurance companies increasingly using websites to capture customer enquiries and register claims and transactions
6. Email as a fully accepted and widely used means of communication

Question 20

Give four examples of changing social and cultural trends

Answer 20

1. Increased home ownership increases the demand for mortgages
2. Cuts in state healthcare increases the demand for private health insurance
3. Increasing prosperity increases the demand for savings products
4. 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

Question 21

Wrapper

Answer 21

A way of bringing a contract to the market.

For example, the underlying contract might be a simple savings plan. However, it can be wrapped up as an endowment assurance, a unit trust, an investment trust company, etc.