Section 6 Economic and Business Environments
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Objectives
- Describe economic and business environments.
- Describe economic and business applications across and within areas of actuarial practice.
- Explain the effects of economic and business environments on the Define the Problem and Design the Solution stages of the Control Cycle.
Definition and exmaples
- The economic environment is the collection of forces that affect the overall economic activity in an economic system, be it local, national or global. Economic forces can include productivity, income, wealth, credit, employment, investment markets and interest rates. In other words, it is the totality of the economic surroundings that affect a company’s markets and its opportunities.
- The business environment reflects the conditions under which businesses operate within the economic environment.
- Key economic forces that affect actuarial work include:
- Economic cycles.
- Inflation and deflation.
- Wages, wage trends and employment levels.
- Investment markets and investment returns.
- The major business environmental factors include:
- Business structure.
- Industry structure including ownership and stakeholders.
- Competition including the effects of consolidation and integration.
- Globalization of business.
- Compensation and employee benefits.
- Business ethics.
- Many actuarial solutions are aimed at reducing the undesirable effects of economic forces such as price change and employment change. Other actuarial solutions depend on the economic benefit of investment returns to provide protection from risks. Thus, an understanding of economics is essential to the work of the actuary. Read Economic Environment: Introduction to Economic Forces (m2s6-00_EconomicForces.pdf).
- Economic cycles include 4 phases: expansion, prosperity, contraction and recession.
- Business forces work within the economic environment. They may be economy-wide, industry-wide or local. These forces describe how business is conducted and how businesses interact among themselves and with their customers and owners. An example is the structure of the business involved; “Structure” refers to the type of ownership and governance of a business. Read Business Structures (m2s6-01_BusStructure.pdf) to learn about the business structure of insurance companies and employers.
- Types of structures in insurance companies:
- Mutual insurance companies and Stock insurance companies - Net income belongs to the owners
- Lloyds organization - Owners have personal liability
- Fraternal insurance companies - Not-for-profit corporations
- Types of corporations and some characteristics:
- Public corporate - tend to emphasize shareholder value
- Privately held - take a more paternalistic attitude toward their employees; emphasize the owners’ interests in the design of employee benefits
- Not for profit corporations - also take a more paternalistic attitude toward their employees
- In addition to its owners, every business has many other stakeholders. The U.S. Government Accountability Office uses this definition of stakeholder: “An individual or group with an interest in the success of an organization in delivering intended results and maintaining the viability of the organization’s products and services. Stakeholders influence programs, products, and services.”
- Stakeholders include employees, customers, creditors and governments. Business managers need to be aware of the stakeholders and consider their demands when making decisions, including the design of the goods and services. Actuaries must also be aware of stakeholder interests when designing solutions.
- In setting out 10 criteria for risk management, Segal looks at the roles of three stakeholders: regulators, rating agencies and shareholders. Read pages 48-49 of Corporate Value of Enterprise Risk Management (2011) about the "Primary Stakeholder Focus." Segal thinks the shareholder’s interests are primary. The cost of maintaining a high rating or of retaining a large amount of capital may limit opportunities.
- Competition: Sellers try to gain market share by attempting to distinguish his product from his competitors’ in one or more ways. Differentiating factors might include price, service and flexibility. Insurers may differentiate their products based on unique underwriting standards. Read Section 5.7.5, pages 124–125 in Understanding Actuarial Management (2010) for an overview of competition as an external force important to actuaries.
- Lack of credible data may lead to pressure to reduce cost estimates (and therefore prices) to meet competitive pressures. When data are not credible, it is easier for others in the company to make the claim that the true cost may be lower than the actuary’s estimate.
- Consolidation within an industry can decrease competition, but it can also improve efficiency, lowering the price of a product or increasing the company’s profits. Insurance company consolidation is no different.
- Integration: Integration of industries or products leads to other challenges. As the distinctions between insurance companies, banks and other financial institutions blur, all find themselves faced with new competitors. Actuaries must understand and incorporate risk management tools from other disciplines, such as financial engineering, when developing new products and solutions. And since financial institutions—and insurance companies in particular—are major employers of actuaries, it is important that actuaries understand financial services integration and some of its effects.
- From the customer’s perspective, there are different arrangements that can be referred to as integrated financial services that offer varying degrees of integration. Integration occurs so that organizations can recognize economies in their costs, enhance their revenues, or both. Note also the significant number of management issues inherent in integrating dissimilar organizations, including organizational structure, organizational complexity, corporate culture, need for expertise, marketing and financial management.
- Globalization: The economies of individual countries are now closely linked through trade, movement of capital and labor across borders, the movement of work to other countries where labor is less expensive, etc. Large businesses have operations in multiple countries and are attempting to operate as single global entities rather than a collection of national entities. For more about globalization, read the following:
- In Understanding Actuarial Management (2010), read Section 5.7.9, pages 128–129. This reading provides an overview of globalization.
- In The Global Actuary (m2s6-02_266Hansen.pdf), Carl Hansen, the executive director of Milliman Global discusses the effect globalization has on the actuarial profession. As he states, globalization also represents opportunities for actuaries who can work across borders.
- In The Solvency II Actuary (m2s6-10_morgan_olesen_paper_final.pdf), read about how Solvency II requirements will create new opportunities for actuaries.
- Compensation and Employee Benefits: In many countries, employers provide insurance benefits to their employees as part of the overall compensation arrangement. This is often done for beneficial tax reasons. Other times the benefits are provided to attract and retain employees. In some benefit arrangements, employers simply provide workers with an opportunity to purchase benefit plans at a lower cost, while other employers pay for some or all of the cost of the benefit.
- Employers offer employee benefits for other reasons, including:
- To contribute to the employee’s welfare.
- To maintain or to improve employees’ efficiency.
- To attract and retain qualified employees.
- To meet demands in collective bargaining.
- To satisfy societal or governmental pressures.
- To take advantage of group purchasing efficiencies.
- Business Ethics: Actuaries must have a very strong commitment to ethics and adhere to a professional code of conduct. The topic of business ethics has received increased scrutiny due to numerous examples of inappropriate activity and/or inadequate risk controls that led to business failures in some cases. Enron, Worldcom and others have raised doubts about the ethical standards of business. Read Business Ethics (m2s6-03_BusEthics.pdf) to learn more. Read “Could the Enron Collapse Help Level the Playing Field?” (m2s6-04_267enron.pdf). Read Actuary in the Hot Seat (m2s6-05_Foster.pdf) to learn how Richard S. Foster, actuary for the U.S. Medicare system, was placed in a difficult situation and worked hard to grant his employer’s wishes without violating his responsibility under the Code of Professional Conduct.
Control Cycle
- Read (m2s6-06_F_I_ERM_Apps.pdf) for comments on about consolidation/convergence and outsourcing jobs.
- Read Section 14.3 of Understanding Actuarial Practice (2012) to learn about how economic and business factors affect the work of the life actuary.
- Actuarial assumptions, such as lapse and surrender rates, can be influenced by alternative investment opportunities, such as disintermediation. Policyowners may be more likely to lapse their policies if the company doesn’t maintain a competitive interest crediting policy.
- Possible benefits of merging include:
- Better risk distribution.
- Enhanced distribution channels.
- Operational expense savings via synergies.
- Stronger financial position.
- Tax benefits.
- The following reading reviews the business and economic influences on problems faced by actuaries working with U.S. retirement plans. The reading explains the connection between retirement plans and the private business sector in the United States. Review Section 21.1.3 in Understanding Actuarial Practice (2012).
- Casualty insurance is often split into two major areas of practice: personal lines and commercial lines. Personal lines refers to insurance that is purchased by individuals, such as home-buyers and automobile owners, to protect them from damage to their property or from legal liability resulting from an accident. Commercial lines of insurance protect businesses from damage to their properties or from liability or loss of income resulting from accidents or other occurrences. Read (m2s6-09_AskExpertP_C.pdf) for comments on how the economic environment affects a casualty actuary.
- Learn about portfolio management, asset allocation, fixed income portfolios and globalization, which are all factors when developing solutions in Section 5.2.4 of Understanding Actuarial Practice (2012).
- Economic and business forces have a significant effect on health care and health care solutions. Review Sections 28.4 and 28.5 of Understanding Actuarial Practice (2012) to learn how the following areas influence the work of health actuaries.
- Effects of cost increases on employee benefit design.
- Changes in benefit plan design and the impact on expenses.
- Funding issues and the pressure of cost escalation relative to economic capacity (GDP).
- Cost shifting and the effect of consolidation.
- Access and quality of care.
- Effects of cost increases on disability and long-term care benefits.
- Recently, employers have developed plans based on defined company contributions rather than defined health care benefits in an attempt to reduce their costs. Click the next arrow to continue.
- Flexible benefits were designed, at least in part, to contain costs. Allowing benefits to be tailored to the specific needs of an employee allows for a better-perceived value for those benefits.
- Consider some examples of how business and economic influences affect solutions within the U.S. retirement system by reviewing Section 21.1.4 of Understanding Actuarial Practice (2012).
- In summary, financial markets and investments are significant factors in most actuarial solutions, regardless of practice area. Some forces impact certain practice areas more than others. For example, health care cost trends have the greatest effect on health actuaries, but also affect retirement actuaries who work with retiree medical products and casualty actuaries who deal with workers’ compensation.
- Business and economic forces are closely linked to other types of forces. Business structure reflects cultural values. Businesses and economies must exist within the realm of government regulations and policies. Government policies directly affect inflation and interest rates. This includes tax and fiscal policies, as well as the actions of central banks. Regulators place requirements on businesses that influence their operations greatly.