Chapter 4: Introduction to financial products and customer needs

Question 1

Summarize the three main principles of insurance and pensions that impact the design of financial products and the benefits that can be provided from such products

Answer 1

1. Insurable interest - in most countries, an insurance contract is only valid if the person taking out the contract has a financial interest in the insured event, to prevent moral hazard, fraud and other crime
2. Pre-funding - individuals or corporate bodies put money aside in advance of the occurance a risk event, which is uncertain in terms of whether it will happen, its timing and amount. The amount of money put aside depends on the probability of the risk event occuring, the amount the risk event will cost, and the return that can be earned on the pre-funded money before the risk event occurs
3. Pooling of risk - protects a group of individuals who pool their finances, against uncertainty in financial costs, which then leads to more cost-efficient provision than if each individual made their own financial provision

Question 2

Insurance contract

Answer 2

In return for a single payment (or a series of payments), the provider will pay an individual or any heirs an agreed amount (or series of amounts) that start or end on a pre-specified event.

This event may happen to the individual, the individual’s property or a third party.

Question 3

Reinsurance contract

Answer 3

An insurance contract for providers of insurance, which allows the transfer of risk they take on to third parties through reinsurance contracts.

Question 4

Pension scheme

Answer 4

A vehicle that involves the accumulation of funds, which are paid out on a later date, usually retirement. The event may also be death, withdrawal, or illness

Pension schemes meet the need:

• to accumulate assets to provide an income in retirement
• to increase this income in real terms in order to maintain a standard of living
• to protect against the financial impact of the death of the member, both before retirement (eg lump sum death benefits) and after retirement (eg spouse’s pension)
• to accumulate assets for other reasons (eg lump sum at retirement to contribute to paying off mortgage loans)

Question 5

Investment scheme

Answer 5

A vehicle that involves an individual paying a single payment or a series of payments to a provider with the expectation that a higher amount will be paid back on a later date

Includes

• saving products offered by insurance companies
• CIS’s, such as investment trust companies and unit trusts

Question 6

Derivative

Answer 6

A financial instrument whose value depends on the value of underlying investments (eg shares/bonds) or variables (interest rates, exchange rates)

Question 7

How can an investor holding shares in a big supermarket chain protect themselves against the fall in the value of these shares, using derivatives?

Answer 7

• Sell futures on the supermarket shares, ie enter into an agreement to sell shares on a specifies futures date at a price agreed now
• Buy a put option on the supermarket shares, ie give himself the right, but not the obligation to sell the shares on a specifies future date at a price agreed upon now

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Question 8

Explain how attitude to risk affects an individual’s financial decisions

Answer 8

A risk-averse individual will prefer protection against future events even at the expense of a worse immediate lifestyle.

A high-risk individual will prefer to work on the assumption that rare events will not happen to them, and will prefer to address such events when they occur. In the meantime they will use the money saved by bot making provision to enhance their immediate lifestyle.

Question 9

Current needs

Answer 9

A current need is one that has an immediate effect on an individual’s circumstances.

For example:
- Protection, e.g. against death, loss, illness, accident

Question 10

Future needs

Answer 10

Future needs relate to future aspirations.

For example:

• Accumulation for a known purpose, e.g. retirement income, mortgage repayment
• Accumulation for a purpose yet unknown out of any remaining disposable income or capital

Question 11

How can logical needs be identified?

Answer 11

Logical needs are determined after a careful analysis and prioritization, followed by fitting products to those needs.

The needs may be identified as:

• Maintaining a current lifestyle
• Protection
• Accumulation for a known purpose
• Accumulation for a purpose as yet unknown from remaining disposable income or capital

This may involve taking advantage of tax-efficient arrangements.

Question 12

How can emotional needs be identified?

Answer 12

Emotional needs are identified by considering an individual’s feelings. This may result in an individual getting what they want rather than what they truly need.

For example:

• to generate more income in retirement than is actually needed
• to avoid the guilt if not protecting dependents

Question 13

List the main types of social security benefits that may be offered by the State

Answer 13

1. Retirement pensions including survivor benefits
2. Medical care
3. Income support due to unemployment, illness or disability
4. Housing support due to low income
5. Long-term care support

Question 14

Microinsurance

Answer 14

Refers to insurance products that offer coverage to low-income households

A microinsurance plan provides protection to individuals who have little savings and is tailored specifically for lower valued assets and compensation for illness, injury or death