Features of financial products

Transcription

1 Chapter 5 Features of financial products Introduction In this chapter, you will: recognise how financial services products can help individuals to achieve realistic lifestyle aspirations; understand the key features and benefits of financial products, in terms of: payments; savings; investment; borrowing; protection. Learning outcomes In this chapter, you will: learn that you need to place aspirations in order of priority; understand that financial products can then be used to help you to reach these aspirations; recognise that products exist to fulfil each financial need. 5.1 Introduction At the end of Chapter 4, we looked at how people need to decide where they lie on their personal risk tolerance spectrum and to match this with the risk reward spectrum of financial products. In this chapter, we will look at the range of products that are on offer. Key cases will then be illustrated with case studies in Chapter 6. ifs School of Finance

2 Chapter 5 Features of financial products 5.2 Achieving realistic lifestyle aspirations The process of choosing financial products to achieve your aspirations can be split into a number of phases, which it is worth recapping here. Setting goals and objectives You will first decide on how to fulfil your needs, wants and, finally, aspirations. Ordering targets You will organise your wants and aspirations into a list of priorities. Your priorities are those things that are most important to you. Reviewing your status You will assess your current status by using budget planners and personal balance sheets. Researching possible solutions Having identified that there are certain things that you will need to do to achieve your priorities, the next stage will be to research the options. For example, if you need a product that helps manage your risk, you will need to find out what s out there and how it works. Coming up with a plan Having outlined what needs you want to satisfy and in what order, you then need to detail exactly what you are going to do. Exactly which types of financial product from the research that you have already carried out are going to help you to fulfil your needs? Which provider s products are you going to use? What are the implications of each one? Get help, if necessary. Implementing the plan You will now need to put it all into practice. You need a clear commitment to your financial plan. Monitoring and reviewing your progress This is important for two main reasons: firstly, to ensure that you remain focused on the plan and succeed; secondly, to check whether you need to amend the plan due to changing circumstances or external factors, or because you have been unable to stick to the original plan. Activity 5.1 Set yourself a short, medium and long-term goal, and go through the process outlined above. How easy is it to plan to reach each aspiration? 76 ifs School of Finance 2009

3 CeFS Unit 2 Risk and Reward in Personal Finance 5.3 Key features and benefits Financial products are closely linked to risk they are more or less risky in themselves, running the full range from almost zero risk to very high, and include products (such as insurance and pensions) that are meant to protect against risk. Financial products are designed to fulfil needs and wants, and to help you to reach aspirations by enabling you to make payments (transactional needs), to save money (savings needs, money as a store of value), to invest for the future, to borrow and to protect yourself against those risks that are outside your control. Transactional needs are those that relate to making payments Transactional needs (payments) Transactional needs are usually best met by accounts offered by banks and building societies. Many of these providers offer lots of different types of account: the one that is most suitable to transactional needs is the current account The basic features of a transactional bank account The basic features of a transactional or current account are as follows. It allows you to hold credit balances with a bank or building society and, sometimes, offers a small amount of interest on credit balances over a certain amount. It provides regular statements. It provides a means of making payments to third parties all of the banks and building societies provide either a chequebook and/or a debit card, plus the ability to set up standing orders and direct debits. If a debit card is one of the features, you will be able to draw cash from cash machines around the country outside normal banking hours. It may allow overdrafts that is, it may allow you to borrow up to a certain amount by withdrawing more than there is in the account. This will normally only be offered to customers who have established a good track record with the bank or building society and who have agreed with it an overdraft limit. There may be certain charges for example, on overdrafts or for duplicate statements and interest will be charged on borrowings. Transactional accounts such as bank current accounts are regarded as being very safe. They have little or no element of risk and usually pay little or no interest, and so offer little or no reward. What they do achieve is a low-cost (sometimes no-cost) service for accepting and making payments The need to store value (savings) Banks and building societies are most likely to have a solution to suit savings needs. A National Savings deposit account may also be a good solution for some people. ifs School of Finance

4 Chapter 5 Features of financial products The main features of a savings account A simple savings account will not support a chequebook or debit card and cannot be overdrawn. The account earns interest at a variable rate, usually added quarterly. Any withdrawals are made over the counter at a branch. A fixed-term savings account will offer slightly higher rates of interest. The interest rates are usually tiered, so that people earn more interest on larger savings than they do on smaller ones. They also earn more interest if they agree to keep their savings in the account for a longer, or fixed, period of time. Interest rates may be quoted net of basic rate tax, with a gross rate or annual equivalent rate (AER) for comparison. This is because HM Revenue and Customs (HMRC) requires providers in the UK to deduct basic rate tax at source before paying the interest over. Usually used about deductions from earnings, at source means that payment is taken before earnings are given to you. Interest may be added to the account whenever it is due. Alternatively, some of the banks and building societies give the option to have interest paid to another account (for example, a current account). Bank deposit accounts and National Savings easy access or investment accounts are regarded as very safe. Some savings may be for a rainy day or to buy a specific item such as a holiday or car, or to pay for a wedding day. Some savings are more specific and intended to support people in old age. These are products aimed at providing pensions. An individual savings account (ISA) is a special, government-sponsored savings account. It is designed to allow people to save up to a certain amount, without paying tax on the interest. You can now hold up to 30,000 in a personal ISA Saving for a purpose the specific case of pensions Providers have developed pension products to enable people to boost their retirement income. We can divide these non-state pensions into occupational and personal pensions. Personal pensions are standalone schemes dedicated to a particular individual. All personal pensions are money-purchase schemes. Occupational pensions are operated by employers, who may also pay contributions into them for their employees. Some occupational pensions are set up as finalsalary schemes, from which you receive a pension based on how long you worked for your employer and linked to your final salary (also called defined-benefit schemes). Others operate as money-purchase schemes. 78 ifs School of Finance 2009

5 CeFS Unit 2 Risk and Reward in Personal Finance Final-salary schemes are becoming less common, because they are expensive for employers to offer. But employees often like them because they have a reasonable amount of certainty about what their pension will be worth when they retire. Some employers now offer schemes that don t relate to your final salary, but to your average salary while working for the employer, which are cheaper for the company. These are also called defined-benefits schemes Money-purchase schemes In an occupational money-purchase scheme, each employee has a dedicated pension pot to which the employer contributes over the employee s working life and into which the employee can also usually pay. Money-purchase schemes are also known as definedcontribution schemes, because there is certainty about the contributions that will be paid in, but no certainty about the level of benefit that will be paid out. In a personal money-purchase scheme, it is the individual who pays in. While you re working, part of your salary goes into your pension fund (usually monthly) to build it up and this is invested for growth. When you retire, your pension fund is used as a block of money to generate an income for you for retirement, usually paid out monthly (but sometimes annually). Your individual fund, which will be used to give you a regular pension at your retirement age, depends on the amount that has been paid into the pension scheme over the years and on how it has been invested. If it is invested well, the pot should grow quite large; if it is invested poorly, it may fall below what has been paid into it Money-purchase schemes and employment The employer and the employee may hold different views on pension products. Employers usually like offering money-purchase schemes instead of final-salary schemes, because they are cheaper to provide: the employer has not promised a certain amount of pension to you based on your salary you get a pension based only on what your pot is worth, whatever that might be. Employees may be less keen on them, because, if the investment performance is bad, the pension pot may be quite small and so the pension itself will not be worth as much as a final-salary scheme. The employee, rather than the employer, bears the risk of a fund that has done badly. In times of bad stock market returns, for example, many people have found that their personal pension won t pay out as much as they had hoped. When you reach pensionable age, a big part of your pension fund is used to provide you with an income. In many cases, this is achieved by using it to buy an annuity. An annuity is an annual payment, sometimes paid once a year, sometimes spread over a 12-month period. ifs School of Finance

6 Chapter 5 Features of financial products Annuity rates that is, how much annual income you will get for a given chunk of money change with market conditions (interest rates and so on). At some times, your pot will buy you a very high level of income and, at other times, it might not buy you much income at all. Also, some annuities pay out a set rate each year, while others will pay an amount that goes up each year to protect you from the effects of inflation. An annuity is an agreement with a life insurance company that, in exchange for a large chunk of money now, it will pay you a regular income. Some annuities pay out an income until you die and others pay it only for a set number of years. Activity 5.2 Given that your pension is intended to see you through your old age, do you think that someone should choose to have their plan invested in high-risk (but possibly high-reward) investments, or low-risk (but low-return) investments? Do you think that it might be appropriate to change the balance of investments as you get near to retirement age so that maybe you have higher risk, but possibly higher growth, investments when you are young and safer ones as you get older? Investment products There are a huge number of different investment products available and different ways of going about investing, all of which offer the possibility of a reward, but all of which carry some element of risk. Investors may be roughly divided into: retail investors, with relatively small amounts ( ,000) to invest; medium net worth investors, with larger amounts (up to 500,000) to invest; higher net worth investors, of whom there are relatively few, with more than 500,000 to invest. Features that investors should be considering, apart from the amount that they can invest, are: for how long they would like to tie up the money; what sort of growth is desired; whether they would like the product to provide income or capital; what level of risk they are willing to take; whether the investment meets their values for example, do they want it to be ethically invested? 80 ifs School of Finance 2009

7 CeFS Unit 2 Risk and Reward in Personal Finance There are many types of investment: some are financial investments and others are nonfinancial, such as property, gold, silver, and art and antiques. Some people even invest in fine wines. The main point to remember is that, although some of these investments offer the potential for very high rewards, they are only for the experienced or wealthy investor, because they also involve very high risks of incurring losses. There are so many investment products that it is possible to look only at a limited number here, so we will focus on three types of product: funds; bonds; shares Funds or collective investment schemes Unit trusts, open-ended investment companies (OEICs) and endowment policies (a kind of insurance policy) all offer a way in which an investor with only a few thousand pounds (and sometimes even less) can invest in a wide range of investments. They allow people to pool their money together in one large pot, which is then invested in a range of shares, bonds, or other assets. The risk to each investor of any one investment going wrong is reduced because their pool of money is spread across a large number of holdings. This risk-spreading technique is called diversification. Funds can: carry varying amounts of risk depending on in what the fund invests the risks should be clearly set out in the marketing literature. In most cases, funds can fall in value as well as rise so there is usually some investment risk; offer the potential for investment rewards of different kinds, because most collective investment schemes are invested with a specific objective in mind that is, capital growth, income, or a mix of the two. See Factsheet 6 for more details about how funds work Bonds Bonds are investments issued by companies or governments (UK gilt-edged securities or gilts are an example of a bond issued by the UK government). Bonds are a way in which the issuer can borrow money, so someone who invests in a gilt is effectively lending money to the government. Bonds pay interest, usually at a fixed rate, and a set amount of capital is paid out on the loan repayment date. They can be bought and sold on the stock market before the repayment date. If you hold a bond issued by a safe borrower, such as the UK government, you can be very sure that you will get regular income (interest payments); you also know that you will get a set amount of capital back at the end of the bond s life, when the loan is due for repayment. If you buy a bond issued by a less safe borrower for example, a company that cannot pay its debts your income and capital may be less secure, but it will still be safer than if you were to hold shares in that company. So most bonds can be said to have a low risk profile (although some are higher than others). Because most bonds pay you a fixed rate of interest every year and your capital back at the end, if you hold them through to their repayment date, they offer low to medium rewards. If you sell a bond before its repayment date, however, it s possible to make higher profits (or a loss). ifs School of Finance

8 Chapter 5 Features of financial products Activity 5.3 What sort of investor do you think might benefit from holding bonds? Shares Companies issue shares. If you own shares in a company, you effectively own a share of the business. People who hold shares in a company may benefit from that company s business growth in two ways: they usually get income, through distributions of the business s profits, called dividends and paid out to shareholders regularly usually twice a year; they also have the potential for capital growth if the price of the shares goes up. Given this possible combination of income and capital growth, shares offer potentially quite a high reward, with a correspondingly high risk. If the company does badly and has no profit to distribute in a year, there may be no dividends; in addition, the share price can also fall so the investor may make a capital loss Providing for saving and investment National Savings and Investments (NS&I) products are suitable for more cautious investors. They include products that will meet both saving and investment needs. They have the benefit of being backed by the UK government s Treasury, so are regarded as very safe and, in some cases, give guaranteed returns. On the other hand, they are unlikely to give you very high returns so there will be times when other investments will do much better. This means that they re not attractive to investors looking for something with the potential for big rewards. National Savings products provide a reasonably wide range of options, which include the following: individual savings accounts (ISAs); easy access savings accounts; fixed-interest savings certificates and fixed-rate savings bonds; index-linked savings certificates; premium bonds; children s bonus bonds; investment accounts; capital bonds; income bonds; pensioners guaranteed income bonds; guaranteed equity bonds Borrowing People need to be able to buy some things now to fulfil wants and aspirations, even though they don t necessarily have the money. They may also not be in a position to save enough in order to buy, so, instead, need to borrow money. 82 ifs School of Finance 2009

9 CeFS Unit 2 Risk and Reward in Personal Finance Generally, banks and building societies offer cost-effective and flexible ways in which individuals can borrow. Credit card lenders can offer very flexible options, but borrowers have to be careful how they use cards, because they can be expensive. For much of their lending activity, lenders have to take account of the Consumer Credit Act 1974, as amended, which controls regulated agreements. Loans made by banks and building societies can take various forms, some of which we have looked at already. They include overdrafts, personal loans and mortgages Loans and risk It is possible to grade borrowing products according to risk criteria but the risks are not, as with the products listed above, about your losing some, or all, of your money. Rather, they are associated with your ability to keep up repayments and the consequences for you if you don t. A mortgage loan with a variable rate of interest carries interest rate risk because, if interest rates increase, the borrower will have to make higher monthly repayments. Some mortgage loan products have built-in caps, which mean that interest and therefore monthly repayments cannot rise above a certain level. There is a small price to pay for this, but the borrower has the benefit of much greater certainty. Some loans carry significant penalties if you want to repay them early so if you come into a windfall that would allow you to pay your debts off, or if you want to move your loan to a cheaper lender, it could actually cost you quite a lot to do so. These risks relate more to changes in your circumstances and to the inflexibility built into the product that can stop you adapting to these changes, than to anything else Managing the lender s risk credit scoring When banks and building societies lend to individuals, they are keen to ensure that these borrowers are likely to repay. Lenders go through a number of processes to manage their risk in this regard. One of the common risk management techniques for personal loans is credit scoring. Credit scoring has been defined as the measurement of the statistical probability that credit will be repaid that is, a process that works out how likely you are to repay the loan, based on your answers to a set of standard questions. It can t tell the lender who will definitely repay their loan and who won t, but it gives them a strong indication of the risk of non-repayment. Credit scoring is a method of ascertaining the creditworthiness of a loan applicant. Credit scoring involves awarding points to the possible answers that you might give, for a range of questions that have been shown to have a statistical relationship to the likelihood of default. Experience and testing have shown that people giving a particular answer are more or less likely to repay the loan. The kinds of questions you might be asked relate to: marital status; number of dependants; ifs School of Finance

10 Chapter 5 Features of financial products age; number of years at present address; whether the property in which you live is owned or rented; occupation; previous credit experience, including a past failure to repay a loan; length of time with present employer. There is a score for each possible response to a question and your total for the whole questionnaire is then compared with credit control guidelines. People who score above a certain level may be automatically approved (or will at least pass to the next stage). Those scoring below a certain number will have their loans automatically declined. Not everyone thinks credit scoring is a good thing, but it helps those lenders that have many applications to look at (particularly online lenders). Providers tend to use computer programs to score applications; bank staff review those applications that are borderline. Lenders also base their lending decisions on other things for example: the amount that you want to borrow; for what you want it; for how long you want to borrow it; from where you plan to get the money to repay the loan; whether you have any additional security that is, whether you will agree that the lender will take possession of your house or some other asset if you don t repay, so that the provider can get its money back; your track record, in terms of integrity and reliability Overdrafts One of the most flexible sources of borrowing to fund short-term day-to-day needs is the bank overdraft. This allows you to continue making withdrawals even if you don t have any money in your account, up to a pre-agreed limit. They are generally provided to cover short-term needs. You should always seek bank approval before going overdrawn. Providers charge interest on an overdrawn account and, on top of this, may also apply various administration charges for example, a monthly fixed administration fee or a per transaction fee. The interest rate may depend on whether the overdraft is authorised or unauthorised that is, on whether the account holder agreed in advance with the bank that they could overdraw their account (and by how much) Credit cards A credit card account provides you with a card and an agreed credit limit. Card issuers have to tell you their interest rates as an annual percentage rate (APR). This gives you a measure of the overall cost of borrowing, because it takes account of the interest rate applied and any other charges applicable. If you use a credit card to get a cash advance by drawing money on it from a cash machine, for example there may also be a charge of around 1.5 per cent of the amount you take out (a cash advance charge). Interest may also be levied on the cash amount from the day of the advance that is, without any interest-free period. Credit cards are very flexible, but they don t suit large amounts borrowed for a long time. 84 ifs School of Finance 2009

11 CeFS Unit 2 Risk and Reward in Personal Finance Loans for capital purchases Loans to buy something of a capital nature (anything from a car to property, which you will own as an asset as a result of the purchase) are often best arranged as fixed-term loans, to be repaid within an agreed time period. Most high-street banks will offer personal loans on this basis. They provide a more structured form of borrowing than overdrafts and are generally for a fixed amount. (Further details on overdrafts and loans were discussed in Chapter 3.) Loans for house purchase The most common long-term loan is the mortgage, in which the property that is bought with the loan acts as the lender s security. There are numerous different products on the market at any one time, because banks and building societies compete fiercely for customers. Some have fixed interest, some are variable and some feature an opening period of fixed interest. Some offer payment holidays ; others have products, such as endowments, attached to them. It is essential that a person takes professional advice before taking out a mortgage Repayment Most people expect to pay off their borrowings from future income. For example, the bank may take its monthly loan repayments on a personal loan out of the account into which the customer s salary is paid. This is why a bank, when assessing a loan proposition, will usually want to make a detailed assessment of your earnings and outgoings, to check that you have enough spare income to meet the required schedule of repayments. Most high-street banks have standard budget planners that borrowers can complete before applying for a loan, to see for themselves what their excess of income over outgoings is. These are similar to the budget planner that you completed for yourself in Chapter Protection People will want, and aspire to, protect themselves, their dependants and their belongings from disaster. They could rely on non-financial services solutions such as should they fall ill and be unable to work state benefits or sick pay. But many people decide that they need more than this, so take out other protection instruments, called insurance. In addition, some protection may be a legal requirement (car insurance, for example) Income replacement insurance Various types of insurance policy are designed to protect people from the effects of being unable to earn an income for various reasons. Some policies provide a set level of income if a certain event occurs for example, redundancy or illness and that income can be used for whatever the policyholder wants. Others, such as mortgage payment protection insurance, cover specific debts and can be seen as protecting the lender as much as the borrower. ifs School of Finance

12 Chapter 5 Features of financial products Family income benefit policies (FIBs) These are an example of the former type they provide an income that can be spent on whatever the person receiving it wants. They are a version of term assurance the simplest kind of life assurance policy, with no additional investment element. Premiums are paid to a life company, usually monthly, but they could be by a single lump sum. In return, the life company promises to make payments if a certain life assured dies (usually the breadwinner of the family). Whereas with traditional life assurance, the payment would be a single lump sum, with a FIB, the full sum is paid out in stages from when the death happens, until the policy expires. These staggered payments may be made annually, but are more likely to be made monthly. Accident, sickness and unemployment (ASU) policies These policies provide an income if you have an accident, if you are too sick to work, or if you lose your job. They are usually attached to a specific debt, so that if you can t earn an income because you are sick, your mortgage or personal loan is paid off. Because of this, they re often known as payment protection plans. Mortgage payment protection insurance Also known as mortgage payment insurance, or repayment protection insurance, this is a version of ASU policy designed specifically to cover a borrower s monthly mortgage repayments, if they are made redundant or can t work through accident or illness. There are usually some restrictions for example: you will not be able to buy a policy protecting you from unemployment if you are already unemployed; your health will be assessed before the insurance company decides whether to offer you a policy and how much to charge for it; you may not be able to claim any money within a set time after starting the policy; you may have to have been in full employment for a whole year before making any claim. Credit cards often incorporate an option to buy insurance to protect you if you lose your earnings because of accident, sickness or unemployment. In these events, the insurance company pays the card repayments, either for a set period, or until you are back in work or the balance is paid off whichever comes the sooner. This is another form of ASU policy. The card company usually debits the premiums that you pay for this to your card account every month Motor insurance If you drive a car, the law requires that you hold a certain amount of motor insurance. The law states that you must have insurance to cover any legal liabilities that you might incur due to injury or damage that you cause to people or property. This is called third- 86 ifs School of Finance 2009

13 CeFS Unit 2 Risk and Reward in Personal Finance party insurance. It exists because if people were to drive without insurance, they could cause other people very serious injury or their cars damage but not have enough money to pay appropriate compensation. Third-party insurance provides cover for the third party in an accident: you are the first party; your insurance company is the second; anything else involved is the third. Third-party insurance will pay out for things such as: damage to someone else s car, or property, if you have a crash; compensation for injuries, should you hit someone or injure someone who is a passenger in your car. Fully comprehensive cover goes further and is not compulsory in law. It also protects the policyholder. So for example, it will pay out for: damage to your own vehicle; injury to yourself from an accident; theft of the vehicle. Some policies provide a basic level of cover the legal minimum, plus an amount to pay off any car loan you might have but they won t pay out if you dent the car. For example, a common policy is called third-party, fire and theft cover. This is cheaper than fully comprehensive cover. Choosing which level of cover to buy will depend on whether you are concerned about protecting yourself from all losses or only want to comply with the law and on the level of cover that you can afford Life assurance Assurance is different from insurance because it refers to an event that will happen, rather than to one that might happen. Life assurance is therefore based on the fact that death will, at some point, occur. The aspiration that people are trying to achieve when they look at taking out life assurance is to guarantee an income for dependants should they die and be unable to provide for them. People can also take out life policies on the lives of other people (for example, their husband or wife) Term assurance The simplest type of life protection product is term assurance that is, the type of policy that pays out a certain amount only if the life assured dies within a certain time period. These policies have no residual or investment value if the assured survives the term. Most policies can be set up on a single-life basis, which pays out if the individual dies, or as joint-life, which pays out on the death of either of the joint holders. If, for example, a married couple were to buy a joint-life policy to protect a joint mortgage, they would usually set it up to pay out on the death of whoever was first to die (called a joint-life, first-death basis). The payout would ensure there was enough money to pay off the mortgage, so that the survivor wouldn t have the stress of trying to pay it off alone. ifs School of Finance

14 Chapter 5 Features of financial products There are various types of term assurance, some of which are very complex. Two common types are as follows. Level term assurance is the simplest. The payout (the sum assured) is paid out only on death. The policy continues for a set time for example, 25 years. Premiums are level and stay the same throughout the term, and are guaranteed not to change. Convertible term assurance is a kind of level term assurance policy that lets the holder convert it, later on, into a whole-of-life or endowment policy. It will cost a bit more than a straight level term policy, because of the flexibility of the conversion option. If you do convert it, you shouldn t need to go through a new medical for the new policy so this could be a big plus if you had actually become uninsurable during the initial period because your health had worsened Endowments Endowment products are designed to meet both protection and investment needs, and they pay out on death, on surrender that is, early withdrawal or on a given maturity date. Endowment policies pay out benefits in the following circumstances: if a certain event happens for example, the death of a named individual and this is the protection element; if the policy has a maturity date, it will pay out its current value to the policy owner on that date this is the investment element. After that date, the policy ceases to exist. Not all policies have a maturity date: some called whole-of-life policies continue indefinitely unless the life assured dies, or the owner decides to take his money out. Some policies also let their owner withdraw their benefits earlier than the maturity date, in part, or in full. The amount that endowment policies pay out will depend on a number of things, including: the cost of the policy that is, how much the policy owner has paid in (the premium); the investments linked to the policy some policies let the policyholder choose to have premiums invested in a particular underlying investment, such as a unit trust. The amount that the policy will pay out depends on how the unit trust has performed: it may have gone up, or it may have gone down; any agreed minimum guaranteed death benefit many policies have an in-built guarantee of the minimum amount that they will pay out, while others only have a guaranteed minimum payout when the payment happens because the life assured has died. In this case, there is no guarantee for encashments before death and they could be less than the amount originally paid in. Activity 5.4 From an investment perspective, where do you think you d put an endowment policy on our risk reward spectrum? 88 ifs School of Finance 2009

15 CeFS Unit 2 Risk and Reward in Personal Finance Illness and disability These can be placed into three categories, as follows. Permanent health insurance (PHI) This is mainly bought by people who work for companies with no, or little, sick pay in their contracts. If you hold PHI and you can t work because of illness, the policy will pay out a regular income of (usually) per cent of your usual earnings. This income is tax-free but you only get it until retirement age. Insurers only pay out per cent or so because, if they were to replace all of your lost income, you would have no incentive to go back to work. There are many different versions of PHI depending mainly on the premium that you want to pay. For example, you will pay much less for a contract that starts paying out only after 26 weeks of sickness, rather than 13 weeks. Critical illness insurance (CII) This will pay a one-off lump sum (not a regular income) on the diagnosis of certain conditions. Usually, these include illnesses such as cancer, stroke, heart attack, kidney failure, paralysis, or multiple sclerosis. Different insurers cover different diseases, so it s important to read the small print. The payout is made regardless of whether the person covered can work after the particular illness is diagnosed. The main benefit is that it will cover certain medical expenses for example, if private health care becomes necessary or it may provide a lump sum to let you convert your house if you need to for example, if you need to install a lift. Medical insurance This covers certain medical bills only for example, your policy may allow you to go into one of a list of named private hospitals (which may be important if the National Health Service cannot fit you in within a reasonable time). This contrasts with CII and PHI, under which you can spend the money on whatever you want. Premiums for all of the above will depend on your age, family medical history, occupation and so on, and some illnesses are specifically excluded Home insurance With home insurance, you can insure both the building itself, and its contents, against various eventualities. Even if you didn t want home and contents insurance yourself, you may find that your bank requires that you get buildings insurance before it will give you a mortgage. This is because your home represents the bank s security. Often, you can buy both buildings and contents insurance under a single, combined policy, but separate policies are also available. Buildings insurance generally insures the property itself against damage caused by things such as fire, storm damage, flooding, or subsidence and falling trees. In addition, you may be able to add in cover for accidental damage. Most policies pay for repairs if the above things happen. Some also pay for things such as temporary accommodation should you have to move into a hotel after such an event. Contents insurance insures the contents of your home for loss or damage caused by things such as fire, flood, or theft. In addition, you may also be able to build in cover for accidental damage or loss, or things such as the loss of freezer contents (if there is a power cut), damage in the garden and replacement of locks following the theft of your keys. Some contents policies even cover items when they are away ifs School of Finance

16 Chapter 5 Features of financial products from the home. Some policies automatically increase the level of your cover annually to allow for inflation. Others also increase cover for one month before and one month after a wedding because of the increase in possessions that is, the gifts that will be in the house for these periods Liability insurance Liability insurance covers people for the payout that they may have to make if they cause someone else injury or loss. In this context, liability means responsibility usually used in a negative sense. Personal liability insurance could pay out compensation to someone because of your house, your pet, or your activities: for example, if a slate falls from your roof and injures someone, or if a pet that you own bites someone, you are liable. Employers must hold employee liability insurance to cover injuries to employees. Businesses (such as shops) that invite people onto their premises must hold public liability insurance. Activity 5.5 List the kinds of situation in which you might be liable to someone else for damages. 5.4 Conclusion Each person will set themselves realistic life aspirations, which they hope to be able to plan to reach. The financial services industry provides a complete range of products to help to fulfil any of these needs. Chapter summary In this chapter, you have: learned that aspirations can be met with the help of financial products; seen that all financial products are designed for a purpose and carry a certain amount of risk; understood that all financial products have key features of which you should be aware. Key words: priorities; transactional needs; at source; annuity; credit scoring; third-party insurance; liability 90 ifs School of Finance 2009

17 CeFS Unit 2 Risk and Reward in Personal Finance Suggested answers to activities Activity 5.1 The answer to this question will differ from person to person. Activity 5.2 The mixture of high-risk, potentially high-reward investments and low-risk, lower-reward investments in a pension plan is likely to change the nearer the holder gets to retirement age. The ideal situation is for the pension to have some higher-risk investments when a person is young, so that the pension pot grows well. Then, as the investor grows older, the money can be transferred into lower-risk investments to maintain the pension pot s value. Activity 5.3 Bonds appeal to investors who want a known rate of return at a known future date. Investors who are risk-averse will benefit from buying gilts, because they are very low risk. Activity 5.4 The underlying investment determines where endowments sit on the risk reward spectrum. The value of the endowment at the end of the term depends on how this investment has performed. Therefore endowments based on high-risk stock market investments are more risky, but potentially more rewarding than endowments that are based on low-risk, lower-reward gilts. The protection element of an endowment is low risk. Activity 5.5 You will have listed any situation in which it is either your action that has caused damage. For example, if you kick a football through a window, or run across the road and cause an accident, you are liable for the resulting damage. If, by your inaction, you fail to do something, you will also be liable: for example, if you fail to report a small fire, which then grows into a large one. ifs School of Finance