South African Environment for New Business PDF

### **1.** South African environment for writing new business Growth is one of the key components of a successful company. Natural attrition through lapses and deaths must be offset by real growth in order to maintain critical mass. Excess growth increasing profits is a key requirement of sharehold...

### **1.** South African environment for writing new business Growth is one of the key components of a successful company. Natural attrition through lapses and deaths must be offset by real growth in order to maintain critical mass. Excess growth increasing profits is a key requirement of shareholders. The two main ways for companies to grow are: #### **1.1.** Regulation Regulation plays a significant role in the new business environment and affects: - Product design l Marketing l Commission and regulation of the sales force. Full details of the regulations impacting new business can be found in Chapter 7 (The South African regulatory environment). Below is a summary of the key areas where these regulations impact new business. Both the Long-term Insurance Act 1998 (as amended) and Insurance Act (2017) impact the new business environment in many ways, and the following list gives an overview of some of the key factors. Knowledge of both the Long-term Insurance Act and the Insurance Act beyond what is in these notes is not required. The Prudential Authority (PA) and Financial Sector Conduct Authority (FSCA) are charged with the administration and oversight of many of these aspects. Prior to 1 April 2018, this was done by a single entity, the Financial Services Board (FSB). l The Insurance Act details nine classes of business, and a company must have an insurance licence, which allows them to underwrite a particular type of business. l Commission restrictions detailed in the Long-term Insurance Act limit the amount of commission that is payable. l There are a number of requirements in the Acts that increase the costs of a life insurance company, and hence increase the premium rates. Such factors include the prudential valuation, regulatory capital requirements, and regulatory reporting requirements. l The minimum surrender values (or maximum penalties) are specified in Regulation 5 of the Long-term Insurance Act. l The Long-term Insurance Act states that the Head of the Actuarial Function (HAF) must be satisfied that the premiums, benefits and other values of a policy are actuarially sound. The Association for Savings and Investment South Africa (ASISA) has produced a number of codes, standards and guidelines which members are expected to abide by. Note that membership of ASISA is not compulsory. For example, there is a code for policy quotation, which governs the information that should be provided in the policy quotation and aims to reduce the risk of misleading policyholders. Other standards and guidelines include: - Standards that restrict the factors used when underwriting new products, such as HIV status and DNA testing l Standards on marketing and administration of living annuities l Guidelines on treating customer fairly (TCF). The Financial Advisory and Intermediary Services (FAIS) Act requires that a needs analysis be performed by the broker to ensure that the products sold are suitable for the policyholder. The Act also requires that brokers and agents pass the FAIS exam before they are permitted to sell life insurance products. #### **1.2.** Policyholder tax Taxation of policyholders and life companies is discussed in detail in Chapter 6. Beneficial tax treatment is a key incentive for people to choose life insurance savings products over other options, and companies will aim to design their products to take advantage of the tax rules. #### **1.3.** Economic conditions As in most economies, the levels of new business and retention of existing policyholders are affected by the economic environment. South Africa has had a significantly higher inflation rate compared to European countries, and policies will often include annual benefit and premium increases to offset the inflationary erosion of the real value of benefits. #### **1.4.** Publicity In the past the life insurance industry has suffered reputational damage from certain practices. Some examples are: Regulations have been put in place to attempt to address some of these issues. #### **1.5.** Technology Technology has had a major impact on new business: l Marketing and advertising through the internet and text messaging have increased significantly. l The internet allows a prospective policyholder to compare prices between companies quickly, increasing competitive pressure on companies. l Policies could be purchased directly online or through other integrated processes (e.g. supported by call centres, chatbots on social media sites, USSD, mobile applications). In South Africa, technology is key to expanding life insurance sales into areas with limited infrastructure and where customers may have limited access to branches of the company and/ or brokers #### **1.6.** Target markets South Africa has a wide range of potential markets for life insurance products. The population ranges from high- to low-earning households, and a large proportion of the population lives in rural areas. The target market affects the distribution method as well as the type of product sold, and should be clearly defined and researched before a product is designed. A large portion of South Africans have limited or no access to financial services, and as banks and insurance companies enter previously under-serviced areas, new markets are exposed. In rural areas with limited infrastructure, companies often partner with a bank or retailer to sell products. The partnering arrangement allows the company to access smaller areas with a large volume of potential customers while keeping costs low. The products sold will typically be simpler risk products targeted to low-income households. More complex products, targeted to higher income households, will be sold through brokers and companies' branches. #### **1.7.** Micro-insurance Legislation relating to micro-insurance has been issued, as part of the Insurance Act (2017). The legislation proposes a new category of insurers that are permitted to sell only simple risk products of limited size. These insurers will have simplified governance and capital requirements. The financial soundness, governance and operational requirements for micro-insurance business are set out in the prudential standards issued by the Prudential Authority (PA) of the South African Reserve Bank (SARB). The Policyholder Protection Rules (issued under the Long-term Insurance Act) have been amended to include requirements relating to micro-insurance and funeral products. See Chapter 7 Section 3.6 for more details of the Policyholder Protection Rules. The Insurance Act and supporting micro-insurance prudential and governance standards, and the micro-insurance and funeral product standards under the Long-term Insurance Act, create an opportunity for new insurers to enter the market, and for new and existing insurers to produce lower cost risk products. The targeted outcome is an increase in the supply of low cost insurance, increasing financial inclusion while maintaining adequate protection for policyholders in the low-income market. Micro-insurance is covered in more detail in Chapter 3. ### **2.** Competition Within the life insurance industry, competition between companies for new business sales is strong, so product propositions have to reflect this. But insurance companies also face strong competition from other financial service companies for a share of the savings and investment market. There is little direct competition to pure risk products such as death and disability cover. However, banks and investment managers provide products that compete with savings and guarantee return products, such as unit trust and capital guarantee investment products. Access and information on all of the products available have improved, in part due to the internet, but also as banks and investment management companies target customers and distributors more effectively. Insurance products currently have some tax advantages over non-insurance equivalents, such as: l High net worth individuals have the advantage of being taxed at the rate applicable to the Individual Policyholder Fund (IPF), which is most likely lower than their marginal rate. l Some companies have an Excess E (XSE) position in their IPF due to relatively low reserves (and hence low investment income) compared to expenses. This means that they can provide tax-free investment income on savings products. l Retirement annuities (RA's) allow policyholders to save tax-free for retirement. In addition, RA premiums are tax-deductable (up to a certain level), and although the income purchased with the proceeds of the RA are taxable, a portion can be taken as a tax-free lump sum at retirement. On the other hand, products sold by insurance companies usually have to have higher expense loadings to cover several costs unique to life companies. Some factors resulting in these additional costs are: - The need to hold regulatory reserves and capital - Training and regulation of the sales force, although there are Financial Advisory and - Additional regulatory requirements. For example, the requirement for the HAF to review the premium rates. Life insurance savings products tend to be less flexible than alternatives offered by other institutions. The reduced flexibility is reflected in the ability to adjust premiums and benefit withdrawals without incurring penalties. The reduced flexibility is also reflected in the fact that commission and acquisition expenses are typically allocated to policies upfront, reducing the policy value for early terminations. Methods of promoting the sale of savings products are to package the product with a risk product and/or to offer products that have with-profits or smooth bonus features. Historically, with-profits and smooth bonus products have offered policyholders returns with lower volatility than the equity market, as well as possible profits on other lines of business. These products have become less popular with policyholders due to lack of transparency in the return received. Some specific examples of non-life savings options are: - Unit trusts - Fixed term and call deposits l Money market accounts l Exchange traded funds - Guarantee investment products l Direct investment in the market. ### **3.** Operational risk The identification and management of operational risk is important in a life insurance company. An assessment of operational risk is included in the SCR calculation and is part of the risk management system that insurers are required to have. Refer to Chapter 18 Section 1.8 for more details on insurers' operational risk management requirements. Operational risk can include: - Product mis-selling l Mis-pricing l Administrative errors l IT failures l Data issues - Poor standards of policy service, which can lead to reducing new business, high levels of complaints, and/or regulatory fines l Staff retention. When administrative or other activities are outsourced, a life insurer is still responsible to its customers for the service provided. The terms of the outsourcing contracts, together with the financial strength of the outsourced service provider, will influence whether the insurer needs to set aside additional capital for operational risks in respect of outsourced functions. The assessment of operational risk capital will require input from all areas of the business, and may warrant the construction of a dedicated operational risk model should the more approximate methods typically used prove to be inadequate. ### **4.** Corporate finance and securitisation There are several sources of capital available to life insurance companies in South Africa: l Life insurance companies were originally mutual companies with large capital reserves, but the majority of companies are now proprietary with their equity listed on the stock exchange. l Life insurers can raise capital by issuing additional shares or debt instruments such as bonds. Securitisation refers to the sale of future profits expected on in-force business. The purchaser of the security will receive repayment of the capital and interest on the nominal value of the security only if sufficient profit emerges from a specified block of business. The insurance company receives payment for these profits, which immediately improves its solvency position. From the perspective of the purchaser of the security, it can receive an attractive rate of interest for what it might assess to be an acceptably small probability of non-repayment. Financial reinsurance is where a reinsurer provides reinsurance which, in addition to some element of risk transfer, provides capital relief against new business strain through an upfront reinsurance premium rebate payment from the reinsurer to the insurer, in return for an additional reinsurance premium to be paid on agreed terms (or over a specified period). Additional risk may be transferred to the reinsurer in these arrangements, such as lapse risk. Contingent loans and subordinate debt instruments are forms of debt instruments where the repayment is either contingent on surplus emerging or subordinated to (i.e. ranks beneath) the interest of policyholders. In South Africa, the methodology used to determine the prudential supervision reporting balance sheet allows insurance companies to take credit for the expected future profits of the underlying insurance business (albeit with some restrictions), and this has made securitisation less popular in South Africa compared to some other markets. ### **5.** Mergers and acquisitions The large number of life insurers that historically existed in the South African market has been reduced in recent years (although this may change as the number of micro-insurers grows). This consolidation has been driven by: - The increased cost of regulation - More focus on efficiencies and economies of scale l Life insurers not meeting capital requirements due to poor performance. There is also a trend for large insurers to expand into new markets through acquisition. In the merger and acquisition process, there will often be an auction managed by investment banks. The seller and potential buyers are normally advised by external investment bankers, actuaries, accountants and lawyers. Some recent South African transactions include: l The merger of two of the largest insurance companies, Momentum and Metropolitan l The purchase of Guardrisk by Momentum Metropolitan Holdings l The buy-out of Liberty Life minority shareholders by Standard Bank ### **6.** Demutualisation In the 1990\'s many of South Africa's mutual life insurers found that they were unable to write new business profitably or that their structure constrained their ability to raise capital to write profitable new business or acquire other companies. Thus, they have chosen to demutualise either by being acquired by another life insurer or through flotation on the stock market. PPS and Avbob remain the largest mutual companies. Sections 50 and 51 of the Insurance Act state that demutualisation must be approved by the court. When such an application is made, the PA will appoint an independent actuary to advise on the demutualisation. Actuarial Practice Note (APN) 108 contains guidance for someone acting as an independent actuary. ### **7.** Cell captive insurers #### **7.1.** Structure Cell captive insurers are a mechanism by which companies (the cell owner) can participate in insurance business without obtaining their own insurance license. The cell captive insurer "rents out" their insurance license to different cell owners in exchange for a fee and (typically) the capital needed to support their cell structure. Cell insurers are separated into: l First party cell business, where the cell owner and the policyholder of the insurance issued through the cell are the same l Third party cell business, where the cell owner and the policyholders are different l Promoter cell business, which is insurance business written directly on the cell captive insurer\'s licence and not ring-fenced in a cell structure. This business is "owned" by the ordinary shareholders of the insurance company. It can include business where cell owners have \"reinsured\" some or all of their underwriting risk to the promoter cell (this is not real reinsurance, but rather a change in the sharing and ring-fencing of risk on the licence). From an operational perspective, each cell effectively operates as an individual insurance company, with income and outgo for each cell ring-fenced from the other cells and with cell owners typically providing the capital required for the business in the cell. However, from a regulatory perspective, the regulators consider the regulatory position of each cell as well as of the licensed insurance entity as a whole. If the solvency position of the licensed insurance entity was ever threatened, the divisions between cells would be ignored in order to keep the insurance company solvent. In addition, the licensed insurance entity is still ultimately responsible for appropriate governance and compliance across all cells. Cell owners are typically: *Table 1.1: Typical owners of cells* **1^st^ Party Cells 3^rd^ Party Cells** - Large corporates who are looking to self-insure Ÿ Underwriting managers, who can design, price and their risks administer products, but can't sell products directly - Pension Funds and/or employers, where the Ÿ Intermediaries (typically large corporates, banks and the Pension Fund can self-insure its risk and retailers acting as an intermediary and the type of access the reinsurance market, and employers products sold form part of an affinity scheme) can use a cell to self-insure unapproved Ÿ Other insurers (e.g. a short term insurer looking insurance benefits (i.e. benefits that cannot be at writing a small amount of long-term business). provided by a Pension Fund). Note that the Cell Conduct Standards currently in development may introduce some restrictions regarding insurers being allowed to own a cell. - Other companies. The cell owner holds a specific type of share in the cell captive insurer, and in exchange they enter into a business relationship which allows the cell owner to place insurance business with the cell captive insurer. This insurance business is managed by the cell owner on behalf of the insurer and the cell owner receives the profits from the business. The profits are paid to the cell owner as dividend payments. As a minimum, the cell captive insurer provides the cell owner with compliance oversight, accounting and regulatory reporting services. In addition, the cell captive insurer can provide specialised services to the cell owner, such as start-up assistance, pricing, underwriting, claims management, reinsurance and investment management. Capital to support the business is provided by the cell owners' shareholding in the cell captive insurer, and can be supplemented by additional capital provided by the cell captive insurer (for a fee). The shareholder agreement typically allows for the recapitalisation of the cell when necessary. #### **7.2** Operations of cell captive insurers Cell captive insurers normally operate on an "outsourced business model" approach where the cell captive insurer will rely on cell owners, intermediaries and administrators (or binder holders) to conduct most of the business functions typical performed by traditional insurers. These functions are typically governed by binder agreements, outsourcing agreements and intermediary services agreements. However, there is increasingly more scrutiny of these arrangements by the regulator, as remuneration under these arrangements is regulated, and any payments over and above the regulated commission and binder fees could put the outsourced partners in a situation where there may be a conflict of interest resulting in, for example, unfair outcomes to customers. #### **7.3** Regulation of cell captive insurers Cell captive insurers are currently regulated in the same way as other insurers, with only some additional reporting requirements. A 2013 discussion paper produced by the FSB proposed changes to legislation relating to the structure of cell captive insurers, restrictions on who can own a third party cell, and the responsibilities of third party cell captive insurers with regard to governance, risk management, market conduct, reporting, and demonstrating financial soundness. Many of these have been implemented in the Insurance Act, with the remainder being addressed as part of the PA\'s Retail Distribution Review and through FSCA Conduct Standard 2 of 2022 (INS). In particular, FSCA Conduct Standard 2 of 2022 (INS) sets out the requirements that cell captive insurers must comply with in order to mitigate certain conduct of business-related risks that have been identified in respect of third-party cell captive insurance business arrangements. #### **7.4** Risks faced by policyholders The risks to policyholders of this business are generally the same as the risks from the equivalent business written within a normal insurance structure. A review of third party cell captive business by the FSB in 2013 expressed concern that policyholders could also be exposed to risks related to the fair conduct of business (through insufficient controls over compliance and the fair treatment of policyholder by cell owners), and conflicts of interest related to the profit share motive inherent in certain cell captive arrangements. This resulted in the publication of FSCA Conduct Standard 2 of 2022 (INS). However, it is also important to note that the ring-fencing of cells, leading to the inability of the cell owners to appropriately diversify capital requirements across product classes written in other cells, will result in higher capital requirements than under traditional insurance. #### **7.5** Risks faced by shareholders The underlying risks of the insurance products sold under a cell arrangement are identical to the risk of the same product sold via a non-cell insurance company. However, the cell owners are not only limited to the risks underlying the business sold within their particular cell -- in extreme events they could be exposed to losses on business written in other cells. For first party cells, the losses from business written within the cell are limited to the capital provided by the cell owner in respect of that cell (via a recapitalisation requirement), and hence the risk from this business to other cell owners and the promoter cell is limited (other than from any risks reinsured with the promoter cell). For third party cells, any losses are first covered by the capital held in respect of the cell, and then by the capital held in the promoter cell. Any excess losses will be covered by the capital held in other cells (both first and third party cells). Similarly, for business written in the promoter cell, any losses in excess of the capital held in the promoter cell will be covered by the capital held in the first and third party cells. Should this occur, it is likely that cell owners will start to withdraw from the cell captive insurer. However this risk can be mitigated by requiring all cell owners to provide the minimum regulatory capital for the business in the cell (R1 million) and the cell captive insurer may require a minimum solvency cover requirement over-and-above the regulatory requirement. Depending on the extent of services provided by the cell owners, there could be operational risks associated with the outsourcing of key functions such as underwriting and claims management to outsourced partners / service providers. Cell captive insurers need to ensure that they have a suitable outsourcing risk framework in place with appropriate methods to monitor the outsourced functions to ensure that their exposure to this risk is properly monitored and managed. Cell captive insurers are also exposed to reputational risk arising from the impact of any actions of cell owners who are associated with the cell owner, intermediaries or outsourced partners. #### **7.6** Challenges for cell captive insurers *Figure 1.2: High level cell captive insurer regulatory balance sheet*