Chapter 4-Introduction to financial products and customer needs Flashcards
- List five categories of benefits that an individual may seek to obtain via financial products.
A whole range of benefits is available, which can be categorised into:
• benefits on events unpredictable in time - both whether and when they might occur
• benefits on events certain to occur but unpredictable in time
• benefits for immediate consumption
• benefits on events predictable in time
• benefits from the accumulation of disposable income and capital.
- Explain the idea behind means testing carried out by the State and how this may impact individuals.
States vary considerably in terms of the type of benefits they offer to citizens, the amount of benefits offered, and whether or not the benefits are means tested. A means test is an assessment to determine eligibility for benefits, for example, an individual may only be eligible for a specific benefit if they earn less than a certain level of income per year.
Where means testing applies, there may be a financial disincentive to individuals to make alternative private provision. Citizens may or may not be required to contribute towards the costs of social security benefits. These benefits are subject to the political risk that the State may change or withdraw benefits in the future.
- List the five main possible types of social securities benefits offered by the State.
The main possible types of benefits offered are:
• retirement pensions including survivor benefits
• medical care, for example, the National Health Service in the UK
• income support due to unemployment, illness, or disability
• housing support due to low income
• long-term care support.
- Describe the main cashflows exchanged under an insurance contract.
Under insurance contracts, 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.
- What can insurance companies do to reduce their uncertainty in relation to the risks accepted from individuals and companies?
Providers of insurance products can pass some of the risks that they take on to third parties through reinsurance contracts. Risk transfer is covered in detail later in the course.
- Define what is meant by the term ‘pension scheme’.
A pension scheme involves the accumulation of funds, which are paid out on a later event; usually retirement, but the event may also be death or early withdrawal from the pension scheme.
- Describe the main cashflows exchanged under an investment scheme.
Investment schemes involve 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 at a later date.
- Define a derivative.
A derivative is a financial instrument whose value depends on the value of other investments (eg shares, bonds) or variables (eg interest rates, exchange rates).
- Explain what is meant by ‘the existence of an insurable interest’ as an insurance principle.
In most countries, an insurance contract is only valid if the person taking out the contract has a financial interest in the insured event.
This is primarily to prevent moral hazard, fraud, and other crime.
For example, if an individual could insure a building in which they had no interest against fire, then they could raise money from the insurance company by setting fire to the building.
Individuals are generally assumed to have unlimited financial interest in their own l ives, and the lives of spouses and dependent children, but other financial interests are limited in amount to prevent overinsurance.
- Explain what is meant by ‘pre-funding of the risk’ as an insurance principle.
The key principle of insurance and pensions is that individuals or corporate bodies put money aside in advance of the occurrence of an uncertain risk event The uncertainty might relate to:
• whether the event will happen at all, such as the risk of fire or flood
• the timing of a certain risk event, such as life expectancy
• the cost of an event that is certainly going to occur.
The key issue for the individual or corporation is how much money is needed to provide a given level of benefit with the desired probability.
This will depend on:
• the probability of the risk event occurring
• the amount that the risk event will cost, and
• the return that can be earned on the pre-funded money before the risk event occurs.
The individual will also have a risk tolerance - how comfortable they are with the probability of their desired outcome not being achieved.
- Explain what is meant by ‘pooling of risk’ as an insurance principle.
As an alternative to financing benefits directly for themselves, individuals may group together and pool their finances. This approach will help to protect the individuals against some of the uncertainties that may exist in the cost of financing the benefits. It may also lead to more cost-effective provision than if each individual made their own financial provision.
- Provide an example of a market where insurance companies pool large volumes of risk.
Various microinsurance examples exist, for example basic l ife and health insurance in deprived communities in developing countries.
- Distinguish between logical and emotional customer needs.
It is important to differentiate between the emotional needs and the logical needs of the customer. If the customers’emotional needs are
met, they may get what they want rather than what they really need.
For example, an individual may believe they have a need to generate additional income in retirement from investment capital. However, this
may be an emotional need. On analysis it may be that the customer’s expenditure levels will fall on retirement and that the level of additional income required may be very much lower than perceived.
The logical needs approach involves finding out what a customer’s needs are, analysing them, prioritising them and then fitting the benefits or products provided to those needs. Thus there is
reconciliation between the products and the needs.
- Give four categories into which a customer’s logical needs can be analysed.
- maintaining a current lifestyle
- protection, eg against death, loss, illness, accident
- accumulation for a purpose, eg an income in retirement, repayment of a mortgage
- accumulation for a purpose as yet unknown out of any remaining disposable income or capital.
- Distinguish between current and future customer needs.
A current need is one that will have an immediate effect on the customer’s circumstances. For example, what would happen if they developed a condition that meant they were unlikely to work again?
A future need may be one that relates to a customer’s future aspirations, for example to retire at age 55 or to pay off a mortgage at a particular date.
Some needs may be both current and future. For example, for someone in retirement, the need to maximise returns earned on capital to provide income while at the same time protecting the value of the capital from the effects of inflation over time is both a current and future need.
