Lecture 8 business environment(2)
- 1. Lecture Notes: Life Assurance Lecture 8: The general business environment (2) By Omari C.O 1 The general business environment Objective: Describe the effect of the general business environment including the impact on level of risk to the insurer, in terms of: • Types of expenses and commissions including influence of inflation • Economic environment (including developing/ volatile economies and risky markets) • legal environment • regulatory constraints and opportunities • fiscal constraints and opportunities • professional guidance constraints and opportunities 1.1 Introduction In this lecture, we describe the main kinds of expenses, and we study the economic, legal, regu- latory, fiscal and professional influences that may affect the way that life insurance companies operate. 1.2 Types of expenses and commissions including influence of in- flation A life insurance company will incur costs in running its business, being commission payable to salespeople, and management expenses. Usually, initial commission is payable on the acquisition of a new policy, and renewal com- mission is payable each time a renewal premium is paid. If a policy lapses, part of the initial commission may be recoverable and there will be a risk of non-recovery. Management expenses consist of expenses that are incurred directly when new policies are written (new business) or maintained (in-force business), and overhead expenses that a com- pany has to incur regardless of the amount of new business it writes and the business it has in force. Thee overheads would include, for example, the costs of general management, at least part of the costs of a company’s service departments (such as IT and HR), and the cost of accommodation.
- 2. Life Assurance There may also be expenses associated with terminating a policy, for example the cost in- volved in making a death claim payment on a whole life insurance. These expenses would be split in various ways in order to determine, for example, the ex- pense loadings to be built into premium rates. The term “overheads” can be used to mean a number of different things. Here it is firstly used to refer to any type of expenses that is not specifically associated with policy activity (ie with its set up, maintenance or termination). An example might be the cost of electricity used to run the company’s offices and computer systems. There is a profitability risk that these loadings will prove insufficient to meet the actual expenses incurred. At a simpler level, risks can arise if a company finds it cannot contain costs, including the rate at which they increase due to inflation. Inflation affects underlying costs which in turn influence the level of expenses allocated to policies. Many underlying costs are directly or indirectly linked to wage and salary levels. Others are influenced by the general level of prices or by the prices of particular commodities. Pub- licly available data, eg retail price index, national average earnings index, and similar data internal to the life insurance company, can be used to decide what assumptions to make about general price, future wage or specific price inflation. A particular difficult aspect of managing a life insurer’s costs arises from the fact that new business may well be cyclical compared with the more predictable base of ongoing renewal and in-force business. A significant part of operating expenses arises from the need to employ experienced staff and if any of these are laid off in response to a downturn in new business, re-employing similar quality of staff may prove difficult when the new business improves again. The company would therefore like to have much more flexibility with regard to the num- ber of new business staff that it employs from time to time, whereas this is much less of an issue with regard to staff employed on renewals. 1.3 Economic environment The state of the economy in which an insurer operates will carry risks for the insurer. The availability of asset types, and their short- and long-term expected yields, will determine how well an insurer can choose investments and the probability of securing the return assumed Omari C.O Page 2 of 12
- 3. Life Assurance when setting premium rates. From the consumers’ point of view, insurance products may be seen as more or less attractive compared with other available investments (or not investing at all). Economies in which the investment markets are more volatile will tend (other thing being equal) to have more expensive insurance products and possibly less take up of them. The insurers will tend to have relatively higher capital requirements as a result of increased un- certainty of investment return. This will increase the cost of capital and so increase product charges and premiums. An insurer investing in more risky/speculative markets is likely to seek a greater expected rate of return on capital, and hence there is a relatively greater risk of the required return not being achieved. This is an additional reason for increasing the cost of capital, as it will mean a higher risk discount rate will be used for discounting profits. 1.4 Legal environment Assuming a politically stable operating environment in which the legal processes of contract law operate efficiently, the written contract between insurer and policyholder should normally avoid any significant legal risk. Particular cae, however, is needed with regard to those areas of the contract where the insurer has discretion. In this event, the insurer is at risk of: • some principle related to PRE acting unfavourably to the office – for example, the flex- ibility it would like to adopt in declaring differing levels of bonus across with profits policies may be constrained. A company may well be legally required to distribute profits in a way that is “con- sistent with PRE” However, PRE is very difficult t pin down in a legal sense, and interpretation might only be settled by court rulings in particular cases. (nevertheless, such things can and do happen, so they can have as much effect in constraining insur- ance company behavior as a more precise requirement.) In any case, companies would no wish to be taken to court in the first place, and they will always have a desire to keep their policyholders happy so as to improve their company image and increase sales. In this way, a rather loosely defined PRE requirement might even have greater constraining influence than might a more rigidly defined rule. • Unfair contract terms voiding clause of the contract – for example, if a contract confers Omari C.O Page 3 of 12
- 4. Life Assurance a right for the charges on unit-linked contracts to be increased by a fixed annual rate which is considered unfair in the country concerned, the legal process may act to void the clause. A particular risk is that the ability to review charges at all is removed completely, rather than the clause being replaced with a percentage increase which is acceptably lower than before. In most cases it would be hoped that these kinds of issues would be sorted out during the de- velopment of any product. So if legal requirements prevented certain kinds of charge increases from being made, then the product design would not incorporate such features. naturally this puts a constraint on product design; which could ultimately mean that whole classes of business might not be offered if insurers felt they were too risky. A compounding difficulty here is that insurance contracts span many years and are hence open to developing legal cultures, interpretations, and court judgements. So one of the biggest risks here is that new legislation could be introduced that could change the legal contract between the insurer and its existing policyholders. For example, it might prevent a company from making further increases in charges on existing policies under which increases could hitherto have been made. Beyond the written contract, legal risks may arise from inconsistencies between the policy document and any other relevant representations made by the company or its agents. For example, an intermediary may have told a client that a policy had a certain feature that, in reality, it did not possess. The client, having taken out (and maybe even claimed under) the policy, later finds out the discrepancy and makes a complaint to the regulator. The insurer may well lose money (and face) if the complaint were to be upheld. (Naturally we will assume that the intermediary did not tell the falsehood deliberately!) 1.5 Regulatory constraints and opportunities Governments may impose restrictions on the way that life insurance companies operate. The aim of such restrictions is usually stated to be the protection of the policyholder. Historical experience has shown that insurance companies could not always be trusted to manage their affairs appropriately without legislative control. People who take out long-term insurance contracts are giving large sums of money to insurance companies, often over very long periods of time, in return for a “promise” by the company to pay the contractual sum assured at some (often distant) future date. The public needs to have well-founded confidence that insurance companies will still be in business and able to honour their obligations when Omari C.O Page 4 of 12
- 5. Life Assurance policyholders claim. Without this confidence people will be reluctant to buy insurance, and will therefore be denied this essential financial service as a result (in other words, taken to the extreme, the industry will fail). Countries have therefore found it necessary ro regulate their insurance industries in order to ensure the security of the policyholders’ interest (ie that the companies should not become insolvent), thereby achieving the necessary public confidence in the industry to the benefit of both parties (the public receives service and the insurance companies do business). Although the restrictions will usually meet this aim, they may also have the effect of either restricting innovation or reducing the benefits that could otherwise be given to policyholders. The following are the more common of such regulatory restrictions. 1. A restriction on the type of contract that a life insurance company can offer. For example, in Italy, there are six classes of life insurance product, based on contract type. For example, unit-linked business is one class. Companies have to be authorized separately for each class. Some companies may be authorized to write only one or two of the six classes. In South Africa, life insurance contracts have to be of term at least five years. This was introduced to prevent competition with banks for short-term contracts. 2. Restrictions on the premium rates or charges, that can be used for some types of contract. Such restrictions have been common in many European countries and in some States in the United States. The rates themselves might be restricted, or certain elements of the premium rate basis, such as mortality and interest, might be controlled. 3. Requirements relating to the terms and conditions of the contracts offered, for example with regard to how paid-up policy and surrender values are to be calculated. Customers and regulators in a number of countries have been concerned about poor value for money on early withdrawal from life insurance contracts. High initial ex- penses, including up-front commission, are responsible for this problem. One possible solution is for regulators to impose minimum values (for example specified percentages of premiums paid). Alternatively, where policy values are calculated on a prospective basis, the basis for the calculation could be specified or restricted. 4. Restrictions on the channels through which life insurance may be sold or re- quirements as to the procedures to be followed or the information required Omari C.O Page 5 of 12
- 6. Life Assurance to be given as part of the selling process. For example this might involve: • minimum training requirements for insurance salespeople, • the right of cancelation of contract by the policyholder • he illustration of possible maturity values and surrender values, perhaps on specified or restricted bases. Where bases, for illustrative values are not restricted, experience shows that (wildly) over optimistic projections can result. 5. Restrictions on the ability to underwrite, for example a prohibition on the use of the results of genetic testing, or to differentiate between different classes of policyholder, eg males and females. In New Zealand, anti discrimination law prevents life insurers refusing to insure anyone, whatever their state of health. However, insurers are allowed to charge an appropriate premium for the risk. 6. An indirect constraint on the amount of business that may be written. In most countries there are regulations regarding the minimum level of mathemati- cal reserves that must be held, often combined with minimum requirements regarding the solvency margin of the company. These regulations have the effect of firstly limiting the capital available within a com- pany to write new business and, secondly effectively placing a minimum requirement on the finance required to write a contract. The capital that a company has available to write new business is, broadly speaking, the supervisory value of its assets minus the supervisory value of its liabilities (including any required solvency margin (RSM)). This difference is sometimes referred to as the “free assets”, “free capital”, or “free reserves” of the company. If the company uses up more than the amount of its free assets in writing new business (or any other way) it will be insolvent in the supervisors’ eyes. Quite simply, the larger the value of supervisory reserves plus RSM that the insurance company has to hold to satisfy the regulators on the existing in-force business, the smaller the free assets and hence the capital available for writing new business. What is more, the bigger the reserves plus RSM that have to be set up for for any Omari C.O Page 6 of 12
- 7. Life Assurance new contract, the greater the amount of the limited capital available that will be used up when the new contracts are written. 7. The regulatory framework within a country may limit what a company would like to do in terms of investment. There may be restrictions on: • the types of assets that a life insurance company can invest in • the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency • the extent to which mismatching is allowed at all. For example, in some countries there is a requirement to hold minimum proportions of total assets in certain types of investment, such as government stock or bank deposits. Investment in assets perceived to be risky, such as equities, property and derivatives, might be restricted (eg to x% of total funds or liabilities) or even forbidden. An alternative is to allow largely unrestricted investment, but to permit only a certain per- centage of some asset classes to count when demonstrating statutory solvency. For example, equities might only be allowed to count for 25% of assets in demonstrating solvency. So a company with, say, 40m in equities and 60 in gilts would only be able to show assets of 80m in its statutory balance sheet. Another approach adopted in some countries focuses on preventing over-concentrations in individual assets (eg the shares of one particular company), rather than in particular asset classes. For example, a restriction that shares in any one company may amount to no more than 1% of the assets used to demonstrate solvency. The regulatory environment can also affect the choice of assets through their relationship with the investment assumptions used to value the liabilities. A particular asset distribution may allow a company to use a higher investment assumption and thereby reduce the value of the liabilities and increase the free assets. Typically, however, such distributions will not enable the company to maximize the expected investment return. Finally there may be a regulatory requirement to allow for mismatching. This could involve the possible setting up of an investment mismatching reserve. The more a company decides to invest in risker assets with a higher expected return, the higher could be any such resulting reserve. This would increase the value of the liabilities and reduce the available free assets. There may be regulations specifying what changes in conditions should be considered for Omari C.O Page 7 of 12
- 8. Life Assurance the purpose of determining a mismatching reserve, or such guidance might come from a pro- fessional actuarial association or the regulatory authorities. Alternatively the decision might be left to the individual actuary’s professional judgement. Another regulatory constraint which might be important is the method required to value the assets. For instance, in countries where assets are valued at book value, there is a disin- centive to invest in property because any increase in value in the properties could only be seen after sale, and having to sell frequently would be expensive and inconvenient. Even simple equity investment is less attractive in such a country, since gains can only be seen on sale and there will be times when the company might not want to sell. The wider regulatory environment The wider regulatory environment in terms of which institutions are allowed to transact life insurance type business is also important. In practice, life insurance companies are likely to have the monopoly of providing pure protection benefits, but not of providing savings benefits. Other pooled savings vehicles are likely to exist, for example unit trusts and investment trusts in the UK, or their approximate equivalents in the US, mutual funds and investment companies. Direct investment in shares or other assets will also be an option for some indi- viduals. The other institutions offering savings contracts, for example banks, will usually be subject to different regulatory controls from life insurance companies, leading to a non-level playing field with regard to the terms on which such contracts can be offered. The differences may be to the benefit or detriment of insurance companies. Possible examples of a sloping playing field include: • different for demonstrating capital adequacy, • different rules on advertising of products, • different rules for benefit illustrations The regulatory environment is likely to have a significant effect on the design of the contracts sold by life insurance companies, as the companies will want to make the best use of any regulatory opportunities available to them. Conversely, contract design will have to take into account any constraints imposed. Question 1.1. The regulatory authorities in a particular country have just introduced a re- quirement for life insurers to illustrate, to prospective policyholders, withdrawal values for each Omari C.O Page 8 of 12
- 9. Life Assurance of the first ten years of contracts. Comment briefly on how this change may affect contract design and benefits paid to policyholders on unit-linked endowment assurances. 1.6 The fiscal regime 1.6.1 Approaches to taxation Life insurance business may be taxed in a number of different ways. The most common methods are: • A tax on the annual profits of the business, where broadly profits means the excess of the change in the value of the assets over the change in the value of the liabilities. • Tax payable on investment income less some or all of the operating expenses of the company. In addition, there may be a tax on premium income. One way of looking at the two above approaches is that they recognize different aspects of the nature of a life insurer. The “profits” approach recognizes that a life insurer, at least if it has shareholders, is a company trying to make a profit like any other. The “investment income” approach could be though of as treating the insurer as a group of individuals pooling their resources for investment. If the investment return of individuals is taxed then it is logical that this return should be taxed if it is earned within a life insurance company. 1.6.2 The profits approach The profits calculation described above essentially measures taxable profit as the increase in the free assets of the company over the year, where free assets is defined as the value of assets minus the value of liabilities. (Any required solvency margin may or may not be added to the value of liabilities in this calculation). Let us define: A0 = Assets at start of year A1 = Assets at end of year V0 = Liabilities at start of year V1 = Liabilities at end of year Omari C.O Page 9 of 12
- 10. Life Assurance Then profit would be stated as: 1. (A1 − A0) − (V1 − V0) 2. (A1 − V1) − (A0 − V0) ie increase in free assets over the year Generally the reserves used will be the supervisory reserves, because this limits the life in- surer’s freedom to manipulate the amount of the reserves and hence the taxable profit. It would also be unfair on insurance companies to use reserves in the tax computation which are calculated any less prudently than the supervisory reserving basis. This is because the company is only allowed to distribute profits which are earned in excess of the supervisory reserves, so a tax assessment on profits bases on smaller reserves would be asking the company to pay tax on profits before they have actually been earned. With an approach based on profit the focus is usually on shareholders’ profit. Profit dis- tributed to policyholders on with-profits policies may well be automatically excluded from the profit calculation. For example, where policyholder bonus increase the liabilities at the end of the year (V1) the value of those bonuses would be excluded from the profit figure. Similarly, if cash bonuses are paid out to policyholders these reduce the end of year asset figure (A1). 1.6.3 The investment income approach First it is worth pointing out that “investment income” is not always the precisely correct term, although it may frequently be used colloquially. The taxable amount may include some or all capital gains, as well as investment income. Allowing a deduction for expenses is reasonable because such expenses must reduce any re- turns actually available to policyholders or shareholders. To get a full picture of the impact of taxation on investment return one must consider the total effect of taxation within the life insurance company and on the benefits received by the policyholders. 1.6.4 The effect of the fiscal regime Within a particular country, different types of life insurance business may be taxed on different methods. “Different types” here could refer to various possible classifications of business. For example, business classed as “pensions” might be taxed differently from other business. Other possibil- ities could include different treatment of with-profits and unit-linked business, or of “savings” and “protection” polices. Omari C.O Page 10 of 12
- 11. Life Assurance This can means that it is lower cost for the consumer if certain forms of benefit can be offered as one type of business rather than another. The taxation treatment of life insurance business may make life insurance more or less at- tractive as a savings medium than contracts offered by other savings institutions, subject to a different fiscal regime. Tax concessions available to individuals may make the sale of certain types of contract easier. The tax treatment in the hands of policyholders of policy proceeds can distort buying habits. The last three paragraphs illustrate the point that the overall attractiveness of a life in- surance product compared with other products (be they from life insurers or other savings institutions) depends on a combination of: 1. the taxation treatment of premium paid, in particular whether the premiums are de- ductable from the individual’s taxable income in full, in part or not at all. 2. the taxation of the life insurer’s funds during the life of the contract, and 3. the taxation treatment of the eventual policy benefits. As with the regulatory environment, product design will want to make the best use of any opportunities provided by the fiscal environment. On the other hand, the ability to avail of favourable taxation treatment may force constraints on product design. For example, tax authorities may be keen that pure savings business should not be “dressed up” as life insurance in order to secure favourable tax treatment where this exists. If so, they might therefore specify minimum levels of life cover necessary to secure tax concessions. This would then represent both an opportunity and a constraint. The tax concessions might allow a competitive product to be produced, but the design would have to include at least the minimum level of life cover. It should be noted that both the fiscal and regulatory environments are very significant drivers of product design in the insurance industry. Taxation risk Taxation can change over time so it is important to bear this in mind when benefits are guaranteed over the long term. Existing policies are usually not immune from the effects of changes in taxation (methods Omari C.O Page 11 of 12
- 12. Life Assurance or rates), so the company has a risk of making less (net) profit than anticipated from any policy as a result of future taxation changes. 1.7 Professional guidance We look at the professional guidance constraints and opportunities that may exist. Actuarial associations will often issue professional guidance for actuaries advising life insurance companies. These will typically give such actuaries a framework of points that they need to consider in carrying out their responsibilities in order to maintain professional standards. The extent to which this is considered necessary will depend on the extent to which actu- aries’ scope for judgement is limited by legislation, which will vary from country to country. As such, professional guidance should not restrict the actions of actuaries and may even provide protection against pressure from proprietors to agree to courses of action that may not be in he best interests of policyholders. Actuarial associations may also issue professional guidance on the interpretation of govern- ment regulations. This may typically arise where the government does not want to overly prescriptive in its requirements so as not unduly to restrict the actions of life insurance com- panies. The government will then look to the actuarial profession to set limits as it were, on what would be acceptable behavior. To the extent that professional guidance adds safeguards as to the proper running of life insurers, it effectively provides an opportunity for insurers to encourage consumers to invest in life insurance products. Such products should then be lower cost and more flexible on account of enjoying an appropriate, but not undue and over costly, regulatory regime. Omari C.O Page 12 of 12