Chapter 2: How the retail consumer is served by the financial services industry Flashcards
Chapter 2: How the retail consumer is served by the financial services industry
NUMBER OF QUESTIONS 12/100
Syllabus points covered:
- Explain the obligations that the financial services industry has towards consumers
- Explain consumers’ main financial needs and how these may be prioritised and met
2.1.1 Obtaining client information
It is vital that you have obtained and understand all the essential facts about your customer before making a
are to meet identified needs.
Hence a “Know Your Customer” fact find is used
Which considers the following
The customer’s financial situation
•including income and expenditure, assets and liabilities
•establishing the budget available
Investment objectives
• the customer’s risk profile and aims for their investments
What a customer understands; their knowledge and experience to date
• the customer’s ability to understand any
recommendation complexities
The impact on customers of advice given
• taxation considerations, entitlement to DWP benefits, etc.
2.1.2: Assessing needs and circumstances
When assessing a client’s needs, before making a recommendation you should consider:
- Areas of advice and / or need
- Risk profile
- Changes in circumstances
2.1.3: Client advice
Recommendations, should:
• Capture all the ‘know your customer’ information
• Recommend within the customer’s risk profile
• Consider affordability, debt repayment, and tax
consequences of any advice
• Provide the level of service disclosed up-front
2.1.5: Client communication
This must be fair, clear and not misleading. It must serve its purpose and be informative to the customer.
2.1.6: Suitability reports
Suitability reports must meet several clear requirements:
• Personalised to the customer
• Written in Plain English, avoiding jargon
• Recommendations must be justified and show how
they meet customer aims
• Any disadvantages (as well as advantages) of the
recommendation must be explained (a balanced
approach must be taken)
• Any needs not addressed must be highlighted
2.2 Prioritising and meeting customers’ main financial needs
Hierarchy of needs
- Tax planning
- Estate planning
- Retirement planning
- Saving and Investing
- Protection
- Borrowing, including house purchase
- Managing debt
- Budgeting
Clients should consider addressing needs lower in the hierarchy before moving on to address needs higher up the list.
2.2.1 Budgeting
A budget will help your customer determine if there is any surplus income to save, invest, or use to protect their needs.
2.2 Prioritising and meeting customers’ main financial needs
Hierarchy of needs
- Tax planning
- Estate planning
- Retirement planning
- Saving and Investing
- Protection
- Borrowing, including house purchase
- Managing debt
- Budgeting
Clients should consider addressing needs lower in the hierarchy before moving on to address needs higher up the list.
Ensure you are most familiar with areas such as bankruptcy of individuals and insolvency of firms.
2.2.1 Budgeting
A budget will help your customer determine if there is any surplus income to save, invest, or use to protect their needs.
2.2.1b Managing debt
Expenditure can be categorised under 3 headings:
- Essential spending: Mortgage or rent, utilities, council tax, insurance
- Day to day spending: Groceries, essential travel, education costs
- Non-essential spending: Clothing, holidays, the pub
The person owing the money is the ‘debtor’. The body (or person) monies are owed to is the ‘creditor’
Options for individuals with debt problems
- Debt repayment plans
This is an informal, self-managed arrangement. Repayment plans are negotiated with each creditor and handled by the debtor themselves.
- Debt management plans
Involves an adviser, who must be licensed under the
Consumer Credit Act who negotiates, on behalf of the debtor, with all the creditors, and establishes acceptable repayment plans. One monthly payment is then made to the adviser who makes payments as per the plan.
- Debt consolidation
Process of negotiating a new loan or mortgage extension to repay all debts, reducing the overall monthly expense. It will almost always lead to longer repayment terms, potentially greater amounts
being repaid, and default consequences.
- Individual Voluntary Arrangements
IVAs are a way of avoiding the stigma and long-term effects of bankruptcy. In general terms, an insolvency practitioner will negotiate the repayment of loans with creditors, which usually means they accept the fact that they will get less back. Once agreed, it is legally binding. Repayments are typically made over a 5-year period to repay the new, lower, negotiated debts. This generally avoids the debtor losing their home and the application of the restrictions attached to bankruptcy. The practitioner reviews this each year and provides a report to creditors to show progress.
- Bankruptcy
Bankruptcy is the most far reaching for the debtor, even though bankruptcy typically is discharged after 12 months. For a creditor to file for bankruptcy of a debtor, the debt must be for at least £5,000. If the petition is accepted, an official receiver/trustee in bankruptcy takes control of the debtor’s assets. There is a set order in which creditors are repaid and most unsecured, non preferential creditors will not get their full amount repaid. The bankrupt individual could lose their home and other fundamental possessions, depending on their personal circumstances (such as having dependants).
2.2.1c Borrowing
A mortgage
• Is secured by a legal charge on a UK property.
•This means that, if the borrower ‘defaults’ on the mortgage, the lender can force a sale in order to recover any monies owed.
A loan
• Can be either secured or unsecured on assets of the borrower.
• Secured loans tend to be lower-risk, so rates are more competitive.
• Unsecured loans are riskier for the lender, and therefore more expensive for the borrower.
A ‘mortgage’ is the security offered to the lender in exchange for the loan, rather than the loan itself.
Interest rate options
Refer to pg 46
2.2.2e: Alternative home finance options
Equity-release
There are two types of scheme, a lifetime mortgage or a home reversion scheme.
Lifetime Mortgage:
• ‘Roll-up’ mortgage
Loan interest is added through the term, and the loan is repaid on property sale
• Fixed repayment lifetime mortgage
No loan interest is paid, but a pre-agreed premium is added and repaid on sale
• Interest-only mortgage
Interest is paid monthly, and the loan is repaid when the house is sold
• Home income plan
The loan buys an annuity which provides an income for life. The loan is repaid when
the house is sold
• Shared-appreciation
The lender buys a share of the property and receives the equivalent percentage of the proceeds when the house is sold.
Lifetime mortgages provide either a lump sum up-front or offer a drawdown facility to suit the client’s needs. Often such arrangements offer a ‘no negative equity’ guarantee which provides assurance that the loan will be repaid on sale.
Home Reversion Scheme:
Rather like shared-appreciation lifetime mortgages, a percentage of the house is ‘sold to the lender. This is generally between 20% and 60% of market value.
The original owner can live in the property for life, under a lease agreement. A nominal rent is paid by the original owner, often known as a ‘peppercorn’ rent.
Key Fact
A financial adviser cannot give a client advice on long-term care planning without the required specialist qualifications.
Another option for homeowners struggling financially, is a sale and rent back arrangement.
Home reversion schemes are used by older individuals, who are releasing equity from their
property, usually to improve their lifestyle or pay for long-term care costs.
A sale and rent back scheme is usually used by younger individuals, who have got into financial difficulty and want to avoid having their property repossessed by a lender.
‘Home purchase plans’ another alternative to a traditional mortgage, and comply with Islamic Law
There are two main scheme types available:
• Ijara
The monthly repayments are held by the firm that is facilitating the arrangement, and used to buy the house at the end of the term
• Diminishing musharaka
The firm facilitating the arrangement buys the property and each repayment transfers a share of the property to the purchaser
Key fact
Loans to individuals who are Muslims must not involve the payment of interest.
The two options covered above are acceptable to Islamic law scholars.
2.2.2f: Loans
Unstructured loans:
• These are the most common arrangement
• Mortgages, loans for commercial property, overdrafts and most personal loans are all
examples of unstructured loans.
• These loans offer flexibility in repayment. Over-payments, term reductions, etc. can be
negotiated and help to reduce interest
Structured loans:
- These add the interest to the loan up-front, and therefore the term and interest payable are fixed. There is often no advantage in early repayment. In fact, penalties usually apply.
- Structured loans tend to be more expensive than unstructured loans. Examples include car loans and hire purchase agreements.
2.2.3 Protection
Protection is a basic requirement of financial planning
Life cycles
3 stages Vulnerable years, the relaxed years and the anxious years
Vulnerable years:
• Early years of a marriage, registered civil partnership or relationship
• Children or other dependants
• Income and affordability is likely to be low, due to high expenses
• Financial protection needs are likely to be at their highest
• Death or disability would have a major impact on the family unit
• Low-cost financial protection policies are usually the most suitable, as they will provide the cover required, for the lowest premiums
Relaxed years:
- Entering their 40s
- Increased income, more of which is disposable
- Children are becoming more independent (allegedly!)
- Priorities in financial planning may change
- Investments and pensions become more important
- More ‘sophisticated protection products can be recommended
Anxious years:
- Entering their 50s
- Their mortgage has probably been repaid
- Their earning capacity has probably reached its peak
- Children are likely to finally be financially independent
- More people they know are ill or dying, leading to increased anxiety
- Individuals become more concerned about inheritance tax planning
- Possible long-term care cover becomes more of a worry
- Costs of policies will be increasing, as the risk of illness or death increases (mortality and morbidity risk)
One life event that can interfere with all the above life cycle stages is divorce.
This may involve new liabilities, relying on a sole income, less pension provision because of pension sharing
KEY FACT
The RO1 exam will expect you to be able to identify key need areas for a client in different life cycle stages, and match these to the ‘right’ policy type.
What is life assurance
It is a contact between the assured who is the policy owner and the life office that takes on the risk, in exchange for the payment of premiums
The policy will pay out on the death of the life assured
Mortality is the length you are expected to live for
3 types of term assurance covered:
Term Assurance, Endowment and Whole of Life policies
Variations of Term Assurance
Level term Assurance:
- Has a set term and sum assured
- Payment of the sum assured is made if death occurs within the set term
- Used primarily for family protection
- Also used with an interest-only mortgage, as the mortgage outstanding is unlikely to reduce until the end of the term, when the aim is that any associated investment policy matures and repays the mortgage
Decreasing term assurance
• Has a set term
• The sum assured reduces gradually over time on a pre-
calculated basis
• Used primarily for mortgage protection in conjunction with a capital and interest mortgage where the mortgage balance decreases over time
Variations of Term Assurance cont..:
Family income benefit:
•Has a set term, Pays out a regular income for the
remaining term of the policy after death
• The sum assured reduces in stages. The longer you survive, the less will be paid out in total income
• Is a form of decreasing term assurance policy
• Used for low-cost family protection, where the need for protection is at its highest, but disposable income and
affordability present the biggest challenges
• Look out for young families and squeezed budgets and affordability in any exam questions!
Increasing Term Assurance:
• Allows the sum assured to increase regularly, without health evidence
• This is a form of ‘guaranteed insurability
• Suitable for individuals who are concerned about the possible future buying-power of the sum assured, and
want to combat the effects of inflation
Convertible term assurance:
- Gives the individual the option to convert the policy into a more permanent one, such as an endowment or a whole of life policy, without health evidence
- Again, this is a form of guaranteed insurability
- Suitable for individuals who are concerned about future underwriting decisions
Renewable term assurance
- Gives the individual the option to renew the policy at the end of its original term, for an additional term, without health evidence
- Again, this is a form of guaranteed insurability
- Suitable for individuals concerned about future underwriting decisions
Endowment Assurance
A ‘pure’ endowment policy is a savings plan, which aims to pay a lump sum at the end of a pre-agreed term and a specified lump sum death benefit, if the assured dies during the policy term.
The main characteristics are:
- Provides an element of life assurance, in a similar way to level term assurance
- Provides an investment element
- The investment element can be unit-linked or with-profits
- Monthly premiums pay for life assurance and the investment element
- Set term agreed at inception
- Surrender values are likely to be low or nothing in the early years of a policy
Historically, endowments were often used to repay interest-only mortgages.
KEYFACT:
Critical illness cover is most commonly included on term assurance and whole of life policies.
Whole of life assurance
Whole of life policies provide a pre-agreed sum assured with no end date.
The main characteristics are:
• Costs tend to be higher than term assurance for the same level of cover, as the plan has no set term. The
policy is guaranteed to pay out at some point and can provide some investment as well as life cover
• Possible to pay higher premiums, in order to include critical illness cover
• The policies can be non-profit, with-profit, or unit-linked
• Policies with an investment element tend to use the customer’s premiums to buy investments, then cash
some of them in, to pay for mortality and other costs
• Customers can opt for a type of policy called a ‘flexible whole of life policy’, commonly known as a
universal or unit-linked whole of life plan, where:
- The individual can choose the life cover amount
from a range, between a minimum and a maximum
amount, depending on their needs. The level of
cover can be changed throughout the policy term
- This allows them, for example, to opt for higher
cover if protection needs are paramount (maximum cover), or a higher investment element if this is more important (standard cover)
• Other features are available to help tailor cover to changing needs, such as ‘special-events’ options,
which allow cover to be increased within set limits in the event of major life events
• WOL policies are often used to pay for funeral expenses and inheritance tax planning.
Sickness and health policies
Cover risk of illness known as morbidity risk.
Guaranteed premiums are higher from the start, but less likely to increase
Reviewable premiums are cheaper to start but are likely to increase after the first policy review
Income Protection Insurance (IP)
- This replaces income if the individual is unable to work, after a specified time
- The time before payments commence is known as the ‘deferred period
- The shorter the deferred period, the more expensive the cover
- Benefits are paid after the deferred period, until the earliest of; return to work, expiry of the policy, or death, so are ‘long-term cover’
- The term is pre-determined, and it is often linked to expected retirement age
- There is an upper limit of benefit; typically, 60% of earnings, paid tax-free
- The cover is permanent and will continue even after a claim, with premiums not needing to be paid during a claim
- The policy usually has no cash-in value, nor investment content
- The policy cost will be influenced by age, occupation, and health, but will tend to have relatively high premiums, because they provide long-term cover
- These policies are also referred to as ‘Permanent Health Insurance’ (PHI) as they cannot be cancelled by an insurer once accepted, as long as the requested premiums are paid
Personal Accident and Sickness (PAS) protection
- A short-term, and therefore cheaper, version of income protection insurance
- Pays out a regular benefit, typically for just 12 or 24 months
- Policies usually pay out a fixed agreed amount
- Can also pay out a lump sum in the event of a significant event, such as losing a limb or permanent blindness
- Benefits and premiums are not as dependent upon age, health, and occupation as IPI, due to the relatively smaller amounts payable in the event of a claim
- Unlike an income protection policy, which cannot be cancelled if premiums are maintained, personal accident and sickness policies can be cancelled by an insurer as they are classed as an ‘annual contract’
- These policies are often found as a ‘rider’ to another type of policy, such as travel, or buildings and contents insurance
Sickness and health policies Cont…
Accident, Sickness and Unemployment cover (ASU)
- Another short-term, and therefore cheaper, version of income protection insurance
- Pays out a regular benefit, typically for just 12 or 24 months
- Again, based on an individual’s earnings
- If they are sick, have an accident or are made redundant
- Certain redundancy types are excluded such as ‘voluntary’
- Benefits and premiums are not as dependent upon age, health, and occupation as IPI, due to the relatively smaller amounts payable in the event of a claim
- Again, unlike an income protection policy, which cannot be cancelled if premiums are maintained, ASU policies can be cancelled by an insurer as they are classed as an ‘annual contract
Critical Illness cover (CIC)
- Pays a pre-determined lump sum on the diagnosis of a specified serious/critical illness, permanent total disability or terminal illness
- Designed to ease the financial burden of being diagnosed with any of certain specified illnesses, such as cancer or suffering a heart attack
- Each insurance company will have their own list of illnesses that are covered, and the policy usually has no investment content
- The insured often needs to have ‘suffered the illness for several days in order for a claim to be deemed valid.
- This is often called a ‘survival period’ and is typically between 14 to 30 days, so, dying instantly of a heart attack will not constitute a valid CIC claim
- For this reason, it is often added to whole of life or term assurance policies, so that, in such cases, an ‘accelerated claim’ can be made on the death benefits, meaning that dying instantly of a heart attack would constitute a valid claim
- Critical Illness can be taken out as a stand-alone policy
Private Medical Insurance (PMI)
• Gives people the option of private medical attention
• A range of levels of cover are available, the more comprehensive and expensive the plan, the higher the amount of claim that will be covered
• Generally underwritten at inception, and any pre-existing conditions can be excluded from cover. The benefit of underwriting, in this instance, is that this
will be disclosed up-front
• Generally, provides treatment for acute, short term medical conditions; not those needing long-term, regular or periodic treatment
• Usually excludes dental care, routine health checks, accident & emergencies and any pre-existing conditions
• Can include quite a lot of exclusions, for things such as mental-health issues, fertility treatment, and HIV
• Can be fully medically-underwritten at policy application stage
•Or issued subject to a moratorium, which means any conditions suffered in the last 5 years will be excluded from cover for the first two policy years
Long-Term Care (LTC) insurance
• Pays towards the long-term care of individuals who are typically, but not exclusively, the elderly
• Payment of benefits is usually based on an individual’s inability to carry out certain ‘activities of daily living’ such as washing, dressing, and continence
• Two types of cover are available
- Immediate care is taken out at the time that a medical care requirement has been diagnosed. It is paid for by a lump sum. The money is invested, and the
resulting income used to fund towards the care costs
- Pre-funded is bought ‘just in case’, like most other forms of insurance. An
insurance plan is bought, which provides the income for the care costs, if
needed
• These products are highly regulated, and require specialist advice from a suitably-trained adviser
