Chapter 4 The need for financial products

To meet human need. Designing optimal ways of meeting these needs

without imperiling the safety of the system and tis component organizations
is an actuarial task.

Financial Life Cycle for Individuals

The needs of individuals for financial products at different stages through
life, affected by:
1. Income; education and age, gender, marital status
2. Expenses; education, setting up house, cost of children, medial cost, post-
retirement
3. Savings; depends on the interaction of income and expense. From
twenties -> to retirement, government usually intervene by form of
compulsory savings.
4. Different socio-economic classes; deviations from the normative are the
rich, the poor, and entrepreneurs.
a. The rich; you dont need to save when you have significant personal
assets
b. The poor; inability to save means it will have to work longer and rely
on the support of family members
c. Entrepreneurs will require capital which consume most of their
savings , exposing them to concentration risk that can bite if the
business fails.

Risks and Volatility in the life cycle

The financial risks encountered by individual in the course of the life cycle:
1. Income risks
Income can be hugely reduced by death and disability. The income
earners should be insured to protect their family. In case of disability,
need a replacement for the income.
The most important cause is unemployment. However, not everything is
insurable.
2. Expense risks
Includes:
Divorce, uninsurable
Property/liability damage insuring tangible assets
Medical expenses medical/health insurance, exposes to anti selection
risks
Frailty care
Interest changes, impact to mortgage repayment in case of
variable/floating rates
 Inflation, effects on the retirement savings
Longevity risks.
3. Saving risks
Negative real returns, fraudulent advisers, collapse of financial
institution, concentration risks, political risks, confiscation of property
by revolutionary government.

Financial Life Cycle of Business

The formation and the need for funds by raising funds; can be done by equity
or capital. E.g. Limited Company. Businesses also face risks of losing their
capital to a level it is no longer sufficient to continue trading or loss of
confidence in business due to profit fluctuations. The 3 major risks for
businesses are:
1. Insurable risks; risks of internal or external fraud/events causing loss in
revenue or additional costs. Usually insurable.
2. Hedge able risk; affected by unexpected price movements, can hedge
with derivative instruments
3. Other risks; neither insurable nor hedge able. E.g. change in business plan
that makes it irrelevant to the market, must be addressed by business
managements not outside parties.

Tax and Regulatory Arbitrage

Tax arbitrage: Change in elements of business operations that guarantees
reduction in tax
Regulatory arbitrage: Change in legal nature of business to reduce legal
restrictions.

Having discussed the financial needs of business and individuals, we now

turn to the products and services that have been developed to meet these
needs.

1. Monetary products, including money itself

a. Notes and coins issued by bank
b. Checks, debit cards, debit orders(from the service providers asking
to be paid from customers accounts), standing orders(instruction of
regular payment), internet bank option, ATM
c. Short-term savings; term deposits; money market funds or cash
management trusts
d. Borrowing instruments
i. Individual
 1. Hire purchase
2. Consumer credit or credit cards
3. Mortgage loans; dual indexed mortgage
4. Overdrafts negative accounts up to predefined limits
with higher interest than mortgage loans
ii. Business
1. Debentures, bonds
2. Selling securitized assets through SPV
2. Insurance
a. Life Insurance
i. Term insurance
ii. YRT
iii. Family Income Benefits
b. Whole Life Insurance
c. Disability Insurance; own occupation, any occupation, own or similar
occupation
Keywords: disability income insurance, lump sum benefit, waiver of
premium, managing claims
d. Unemployment Insurance; uninsurable, difficult to cover, limited to
credit insurance to cover for repayments of loans that are exposed
to unemployment risk
e. Medical Costs Insurance; Medical insurance, critical illness, hospital
cash, health maintenance organization (capitation), long term care
insurance
f. General Insurance
Three major personal lines sold to individuals: home insurance,
motor (compulsory third party), personal accident.
Business insurance: marine insurance, fire and other property,
business interruption insurance, liability insurance, credit insurance,
surety bonds, reinsurance.
Sometimes they dont buy based on the risks they are exposed to;
regulatory requirement for workers compensation, outsourcing so
they can focus on their job, tax and regulatory arbitrage whereby a
particular risk doesnt require capital as high as in other
demographics.
3. Long term savings; serves as purpose for retirement
a. Traditional Life insurance savings product
Three main forms; endowment insurances, pure endowments,
deferred annuities. Often are participating with discretionary
benefits. Can be reversionary (permanent addition to sum assured)
or terminal (only during termination of contract). Often paid in
cash(dividends) to reduce premium.
b. Superannuation funds (pension funds)
 Defined benefits and defined contribution.
Employer sponsored superannuation funds
Industry or multi-employer superannuation funds
Public offer superannuation funds
c. Investment-linked arrangements
Unit trust -> mutual funds, pools investors interest in assets
determined by its constitution. Investment profile will be one of:
diversified, index, sector, specific purpose
Investment linked life insurance policies (variable life) with choice of
several investment options and ability to change with little cost
Pooled superannuation trust -> earn net of tax
Master trust -> a unit trust that invests in other unit trusts
Wrap funds-> same effects as master trust, with investors holding
the underlying assets in their own name.
d. Other long term savings
Investment account policies like bank deposits often with GIC
Universal life unbundles the savings and insurance. Essentially an
investment contract
e. Direct Investment -> through stockbrokers
f. Derivatives; used for hedging, transferring or dividing risks
Futures contract
Option contract
Contracts for difference -> pays based on the movement without
incurring cost for buying or selling
Swap and swaptions -> fixed for floatings rates, or credit default
swaps
Exchange traded funds

4. Retirement income products

a. Term certain annuities
Fixed term of annuities for a lump sum of premium
b. Lifetime annuities
Protects against risk of living too long however, not popular due to
incomplete market (have to understand the demographics of those
with lower life expectancy), desire for control over their own money
in future, bequest motive to their children.
c. Variable annuities (Allocated annuities, allocated pensions)
Incomes are from the assets held on behalf of the policyholder. As
the asset grew with investment incomes and capital growth it also
decreases through fees and annuity payment, which eventually will
exhaust the assets. The return can be guaranteed in many ways
including:
i. Guaranteed Minimum Death Benefit
ii. Guaranteed Minimum Accumulation Benefit
 iii. Guaranteed Minimum Income Benefit
iv. Guaranteed Minimum Withdrawal Benefit

Other sources of financial security:

Families
o From parents to children until they leave home
o From children to old and frail parents
o From parents to children as loans or bequest.
Governments
o Money and banking
Last resort, providers in times of stress
o Social assistance
To prevent destitution, provide based on need not contribution,
can be based on ad hoc events, like floods, earthquakes, and so
on
o Statutory insurance schemes
Government setting up a variety of insurance schemes with
benefits that depends on compulsory contribution. Also to set up
a minimum payment by employers in certain areas -> parental
leave, unemployment, medical costs, death or injury in
workplace.
Contributions may actuarially fair but also might have to cross
subsidize the poor from the rich
o Retirement provision systems
Employers
o Group superannuation and insurance
Advantages over individual products:
Cheaper administration, without medical questions (GA) as its a
mandatory scheme for all employee, salary linked benefits that
may not be achieved in individual policies.