Chapter 3 - External Environment

Question 1

List 19 external environment considerations

Answer 1

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

Question 2

External Environment:
Legislation and regulations, definitions and explanation

How do they affect the financial services industry?

Answer 2

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

Question 3

External Environment:

State benefits

Answer 3

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.

Question 4

External Environment:

Tax

Answer 4

• 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

Question 5

External Environment:

Accounting Standards

Answer 5

• 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

Question 6

External Environment:

Capital adequacy and solvency

Answer 6

• 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

Question 7

External Environment:

Corporate governance

Answer 7

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

Question 8

External Environment:

Risk management requirements

Answer 8

• 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

Question 9

Capital is required to cover which 3 risks?

Answer 9

• market risk
• credit risk
• operational risk

Question 10

External Environment:

Mutuals

Answer 10

• 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

Question 11

External Environment:

Public proprietary company

Answer 11

• easier access to capital markets for finance
• economies of scale
• more dynamic management

Question 12

External Environment:

Private proprietary company

Answer 12

• may find same difficulties raising capital

- benefit from a close involvement of the owners

Question 13

The underwriting cycle

Answer 13

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

Question 14

External Environment:

Demographic changes

Answer 14

• 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

Question 15

Results of ageing population

Answer 15

• less spending, as older people more likely to save
• strain on social welfare systems
• increased cost of healthcare
• cost of education falling

Question 16

External Environment:

Environmental issues

Answer 16

• influence the ways in which Government, advocacy groups and individual participants act, and hence the behaviour of financial markets
• has led to providers offering products that promote environmental and ethical issues
• affects how providers communicate with customers, eg reducing the amount of paperwork

Question 17

External Environment:

Lifestyle considerations

Answer 17

• younger people have preferences for loans rather than savings
• people with children look towards life insurance protection products
• older people may have a need for annuities and long-term care products
• longevity => more saving and for longer, so assets aren’t exhausted before death

Question 18

External Environment:

International practice

Answer 18

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

Question 19

External Environment:

Technological changes

Answer 19

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

Question 20

External Environment:

Climate & Natural Perils

Answer 20

• Catastrophes can cause large claims/ acc. claims
• Sometimes difficult to obtain cover in certain areas => govt. might have to step in
• After a catastrophe reinsurance might be very expensive (burning cost) or unavailable in the mkt.

Question 21

External Environment:

Social Factors & Trends

Answer 21

• Common values/attitudes of population
  This affects:
• Underwriting practices e.g. no discrimination based on sex allowed, no DNA testing allowed
• This affects how products are priced

Question 22

External Environment:

Economic & Social Environment

Answer 22

Economic assumptions include:

• interest rate
• inflation
• investment returns
• Exchange rates
• tariffs on imported goods

Influence insurance sales/claims:

• theft, fraud, arson, crime rates
• business failure/unemployment rates
• willingness to buy insurance
• cost of repairs & replacement parts