Topic 4 - Dealing w Long-term Risks Flashcards
What is the relationship between risk and reward?
- the greater the risk, the greater the possible reward
What are examples of risk associated w possibility that something harmful or damaging could occur if things go wrong?
- physical injury or death
- loss of or damage to possessions
- a legal liability
- a financial loss
Why is risk associated w uncertainty?
- bc future can’t be predicted accurately
What does risk associated w probability mean?
- risk of an adverse event is higher when a situation makes it more likely that something will go wrong
What is speculative risk?
- risk associates w chance, where outcome could be either favourable or adverse
When does risk also arise? (Not associated w probability or taking a chance)
- when the actual outcome of an event or situation differs from what someone expected or planned for
What is the consequence of the risk/reward relationship?
- someone wanting potentially high rewards must accept a higher level of risk of loss
- someone keen to dec. or avoid risk must accept they’ll earn a lower return
What is the ‘trade-off’ between risk + reward?
- when deciding what combo of risk + reward to accept, a saver or investor pays for the chance of earning a higher reward by accepting more risk
What motivates ppl into taking a higher risk?
- earning a higher return on savings (regardless to their attitude to risk)
What are some examples of savings + investment products that have diff levels of risk?
- premium bonds: no risk bc 100% backed by gov but have no guaranteed reward
- a banks savings account: little risk but pays low interest rate
- unit trusts: more risk as value can go up + down, according to stock market movements
- shares in an established company: risk as no diversification but chance of dividends
- shares in newly quoted company: higher risk as company is unknown but if in an innovated sector, return could be high
Who earns a stated rate of interest + when may it be set?
- ppl who saves in a normal notice account, cash ISA or bond
- may be set in advance or may vary w changes in general lvl of interest rates in country
What are the 2 ways someone who buys an investment product hoping to be rewarded?
- to earn a return
- to make a capital gain
What does interest rates in the UK being very low in recent yrs mean?
- v. low rates are paid on saving accounts + causing some savers to choose a riskier product to earn a higher return
- financial regulators concerned: as unsuitable for many small savers who may lose money
Why has the Bank of England kept its interest rates v. low?
- to make it easier for ppl to borrow + for economy to come out of its low lvl of activity
When ppl borrow money, what does the interest rate reflect?
- risk to lender
- e.g. rate charged on mortgage (secured) is cheaper than rate quoted on personal loan (unsecured)
What risk does a person who borrows for a medium or long period of time take?
- may be unable to keep up w repayments + may lose their property
- accept risk in return for reward of being able to buy consumer products
What does a person’s attitude to risk have implications for?
- kinds of financial product they’re willing to buy
- financial plans they make
What does having a certain amount of risk acceptance/tolerance mean?
- willing to accept risk but probs set a limit to risk + take steps to manage it so can minimise risk
What does being risk adverse mean?
- cautious + always try to avoid risk in any way they can
- give up higher reward to dec. risk
What is a good way of managing risk?
- to transfer it (risk transfer)
What does a risk transfer mean?
- person facing risk decides to spend money on passing risk to someone else, who accepts financial responsibility
What does an insurance company do?
- collects premium from ppl who insured risk + pays out compensation who suffer the loss
- company calculates premiums carefully so high enough to cover losses + make profit
What are the 2 main dimensions of risk?
- impact of risk
- probability of risk occurring
What are the aspects to the impact of a risk?
- amount of money involved
- effect on lifestyle
- timing of event
- frequency of event
How is the amount of money involved an impact of risk?
- more money lost, greater the impact of someone’s situation
- amount needs to be compared w a person’s income + wealth
- longer it takes to replenish money, more sig. the loss
How is the effect of lifestyle an impact of risk?
- can change someone’s life
- e.g. if injured in accident, may means yrs of medical treatment: may affect person’s family + social life
How is the timing of an event an impact of risk?
- e.g. if younger person loses savings, have rest of life to save up again, if older, wouldn’t have a change to make money again
How is the frequency of a risk an impact of risk?
- if event is frequent, accumulated impact much worse than if event happens once
How is it possible for someone to have an idea of the likelihood of an event happening?
- if they have some control over event
- able to take some risk reduction measures
How do you calculate the significance of a risk?
- probability x impact = degree of risk
- greater number = higher risk
How can a saver reduce risk of losing their money?
- choose a safer firm of saving
- avoid high risk by keeping away from v. risky financial products
What is 1 method ppl can use to manage LT risks?
- insurance
What are the diff types of LT insurance products?
- life assurance
- critical illness insurance
- income protection insurance
- accident, sickness + unemployment (ASU) insurance
Why is the term ‘assurance’ used instead of insurance in life assurance?
- bc dying is inevitable
What are the 2 types of policy life assurance protection is provided primarily by?
- whole-of-life assurance
- term assurance
What are the characteristics inc. in whole-of-life assurance?
- sum assured is payable on death of life assured (whenever death occurs)
- no fixed time limit + remains until policyholder dies/surrenders it
- more expensive: certain sum will be paid out in future
- less common
What are the characteristics inc. in term assurance?
- sum assured is payable only if person dies before end of a specified term
- if person survives term: cover ceases + no payment or refund of premiums is made
- suitable as mortgage protection
- if they have a repayment mortgages, sum assured dec. /yr to reflect reductions in amount own on loan
What is mortgage protection?
- where borrower wishes to insure their life for term of loan, so if they die before loan is repaid, loan can still be paid off w/o property being sold
What’s are the reasons for buying life assurance?
- family protection
- debt protection
- managing a tax liability
- cover for older ppl
How does buying life assurance protect family?
- death of a breadwinner can leave family large debts + no income to support standard of living
How does buying life assurance protect debt?
- when someone pays a mortgage/loan, their death can result in failure to make repayments: may lead to loss of property used as security as loan
How does buying life assurance manage a tax liability?
- if expecting to inherit money: may take out life policy to cover inheritance tax that needs paying when person dies
How is buying life assurance a cover for older ppl?
- ppl >50 may want to provide for grandchildren or cover costs of funeral/any unpaid bills
What is critical insurance?
- pays out guaranteed cash lump if person insured is diagnosed w a critical illness (that’s listed)
- may be combined w a life insurance policy
What are income protection policies?
- pays out monthly income to insured ppl suffering an accidental injury or a LT illness + so are unable to work
What does income protection insurance allow ppl to manage?
- LT risk of loss of earnings + being unable to pay mortgage, debts + household bills
What are the characteristics of ASU insurance?
- provides cover to insured party if accident or sickness prevents them from working or if they become involuntarily unemployed
- pays out for max of 12 or 24 months
- lower cost
What is PPI?
- type of ASU linked to e.g. loan or credit card rather than amount of cover being based on income
Why is any savings product seen as a form of risk management?
- it’s a result of ppl making a deliberate decision not to spend all their income + to put it away to cover future needs
Why is it important for ppl to have some knowledge of savings + investment products?
- in case of a positive future event (e.g. promotion at work bringing a higher salary or winning money)
- to know how to invest xtra money safely + wisely
What is the Financial Services Compensation Scheme (FSCS)?
- a type of insurance that helps ppl manage their LT risks
What does the FSCS’s do and what was its aim?
- set up to protect ppl’s savings up to a certain limit
- gives savers peace of mind + promotes confidence in financial institutions as ppl know they won’t lose all their money
What does the FSCS offer max. protection on?
- deposits on banks, building societies + credit unions (must be authorised by PRA)
- investments
- home finance
- LT insurance
- compulsory insurance
- non-compulsory insurance
- general insurance advice + arranging
What are the main ways of dealing w the LT risk of providing for others after death?
- making a will
- providing for inheritance tax
What does making a will allow?
- someone to make provision for their property after their death
What are the advantages to making a will?
- a person can decide what happens to their money, property + possessions after death
- can provide for a partner where no marriage or civil partnership
- can make arrangements for children in event of death of 1 or both parents
- can minimise amount of inheritance tax they pay
What’s are the main items ppl include in their will?
- details of their assets
- names + details of all beneficiaries
- arrangement for guardianship of any children < 18
- named of executors
What are the requirements for a will to be valid?
- must be made by a person 18 or over
- who’s of sound, mind + aware of what it contains
- who is making it voluntarily
- w/o pressure from anyone else
- must be made in writing + signed by person in presence of 2 witnesses
- witnesses must also sign, in presence of person making will
What is the nil rate band?
- when inheritance tax is paid on an estate when somebody dies if value of estate exceeds a certain amount
What happens to the inheritance tax if a partner in a marriage or civil partnership dies?
- the surviving partner can use any unused portion of deceased partner’s nil rate band to inc. their own
What is the inheritance tax usually paid from?
- funds in estate by executor of a will or by deceased’s personal representative
Why do some ppl like to make provision for the payment of inheritance tax before they die?
- so that the beneficiaries can inherit estate w/o having is value dec. by tax
What is a good way to make a provision for the payment of inheritance tax?
- for person making will to calculate approximate amount of inheritance tax that will be levied on state + take out a life insurance policy for this amount
- could save an annual sum in a savings account or investment fund: runs risk of being insufficient
What is a trust?
- a financial relationship where property is held by 1 party for benefit of another
What is the Child Trust Find (CTF)?
- a LT tax-free savings account aimed to ensure every child living in country has savings at age of 18
What are junior ISAs?
- LT tax-free savings accounts for children, + a child is eligible to have 1 if <18, live in UK + we’re not entitled to a CTF
What did junior ISAs replace?
- Child Trust Funds
What are the 2 types of junior ISAs?
- a cash junior ISA (interest tax free)
- a stocks + shares junior ISA (cash is invested + child doesn’t pay tax on any capital growth or dividends)
What is a legal guardian?
- person who has legal authority + a corresponding duty to care for the person + property of another person (ward)
