Insurance, Pensions and Collective Investment

Question 1

What is meant by pooling risk?

Answer 1

Insurance relies on the concept that risk is spread across many individuals and everyone shares some of the burden.

Question 2

What is meant by the law of large numbers?

Answer 2

Repeating a random event many times makes the observed probability closer to the theoretical probability of an event happening

Question 3

Why do people buy insurances?

Answer 3

• Planned security against an adverse event
• They are risk adverse people
• For saving purposes (life insurance)

Question 4

What is underwriting (insurance)?

Answer 4

Establishing the amount the individual/company that has to be insured has to pay (the premium) and the amount the insurer has to pay if the negative event occurs.

Question 5

What is meant by asymmetric information?

Answer 5

The insured individual has different information to the insurance company. This cause adverse selection and moral hazard which lead to forecasting errors.

Question 6

What is adverse selection?

Answer 6

Those subject to higher risk are more likely to get insurance. This makes the pool of insured unrepresentative of the population

Question 7

What is moral hazard?

Answer 7

The insured changes their behaviour after taking out an insurance policy. This causes an underestimation of the risk they pose.

Question 8

What is reinsurance?

Answer 8

insurance companies buy insurance for themselves by selling part of the insurance onto another insurance company. It redistributes risk and increases the pool of insured, improving the predictability of outcomes

Question 9

What is the limitation of reinsurance?

Answer 9

It can lead to spiralling where contracts are resold and resold so many times that the original company could rebuy parts of the original contract they sold.

Question 10

What is a generational pension?

Answer 10

The current working generation pay for the pensions of the current retired generation. Doesn’t work if the population is unbalanced and causes state pensions to be insufficiently funded leading people to look for other schemes.

Question 11

What is a workplace pension?

Answer 11

Employers are required to enrol workers in pension schemes and contribute to it on the workers behalf.

Question 12

What is a private pension?

Answer 12

Sophisticated savings and investment plan

Question 13

What is an unfunded pension scheme?

Answer 13

Generational contracts. Public pensions are funded this why by the state.

Question 14

What is a funded pension scheme?

Answer 14

Workers pay into a pension pot which is invested and supposed to grow. The pension scheme must grow at least at the rate of inflation to be able to pay the pensions. Decreases in asset returns and increases in life expectancy have left large deficits in these funds

Question 15

What is a defined benefits pension scheme?

Answer 15

Workers pay into a pension pot and depending on how long they’ve been paying into it they receive a pension. (funded scheme)

Question 16

What is a defined contribution pension scheme?

Answer 16

Only the amount paid in is fixed but the amount paid out changes depending on the state of the economy. This implies pensions decrease during economic crisis. There is no obligation for the employer to guarantee a level of a pension. (funded scheme)

Question 17

What is a personal/private pension scheme?

Answer 17

They are not funded by the state and don’t benefit from employer contribution. Used by self employed people and used to top up future pensions. Usually enjoy tax reliefs

Question 18

What is a self invested personal pension?

Answer 18

Similar to a private pension but you have more choice in where the money is invested. Originally designed for people with large pension contributions.

Question 19

Where do pension funds invest the money?

Answer 19

Pension funds have the advantage of knowing when the money needs to be available so know the investment horizon, unlike insurances.
Invest 55% in equities, 35% in bonds (ensure steady cash flow) and the rest in other assets

Question 20

How are pension funds run?

Answer 20

Float= money invested but not yet paid out
Trustees= oversea that the float is misappropriated
Consultants= advise trustees on how to invest money and the risks
Portfolio managers= conduct actual investments, specialise in balancing risk and return
Pension protection fund= works as an insurance for pension funds. all are required to join by law

Question 21

What is a collective investment?

Answer 21

It is essentially a pooled fund

Question 22

What are the benefits of collective investments?

Answer 22

• diversification of risk
• smaller investors can contribute and benefit from diversification options
• professional investors can deal with large sums of money for a relatively small fee
• a portion can be dedicated to risky investments

Question 23

What are the different types of collective investments?

Answer 23

Open ended= the amount that can be invested is not capped

Closed ended= the amount that can be invested is limited, capping the amount the fund manages

Question 24

What is sovereign wealth fund?

Answer 24

Collective investment funds closed to the public where government money is invested. Countries who make a lot of money from selling raw materials use them to transfer some of the wealth gained through theses sales onto future generations and avoid Dutch Disease.

Question 25

What is meant by ‘Dutch Disease’?

Answer 25

A small county exporting lots of oil will be paid in international currency and changing revenues to local currency will mean you demand lots of domestic currency. This pushes the exchange rate up. This means businesses struggle to compete internationally and the whole economy relies on the export of oil

Question 26

How do sovereign wealth funds prevent Dutch Disease?

Answer 26

They invest abroad to avoid exchanging revenues into local currency.