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Study Guide for Test 3

I. Insurance and Risk Management

A. General Terms

Insurance is protection against financial loss.

An insurance company (or insurer) takes the transfer of risk from the policy holder (or insured). By spreading the risk of thousands of policy holders, the insurance company profits by collecting premiums in excess of claims (or loses money when claims exceed premiums).

Risk is uncertainty or lack of predictability. Risk is the chance that a peril may occur.

Peril is the cause of a possible loss, such as fire, hurricanes, accidents, or premature death.

Hazard is a condition that makes a peril more likely. For example, living in Louisiana makes the peril of hurricane damage more likely than in Arkansas. (Thus, house insurance may cost more in Louisiana than in Arkansas).

Premium – dollar payment to insurance company for policy

B. Types of Risk.

Pure Risk (insurable risk) is a risk that has only a downside (no possible benefit). These are the types of risk covered by insurance. There are three types of “insurable risks”:

1. Personal risk – risk of harm to the insured or his/her family. Examples of insurance covering this type of risk include Health Insurance and Life Insurance.
2. Property risk – risk of harm to the insured property which would cause a reduction in value of that property. Examples include Home Insurance and Collision or Comprehensive Car insurance. Renter’s insurance, also.
3. Liability risk – risk of harm to an uninsured party that is the liability of the insured (such as being at fault in a car accident). Examples include the Liability sections of both Home and Automobile insurance. Also, included a Personal Liability Umbrella to cover potential liability that exceeds normal policy provisions.

Speculative Risk (uninsurable risk) is unique in that there is a chance of gain or loss. Examples include investments. These risks are not typically insured.

Risk Management Methods – the book discusses 4 techniques for “managing risk”. Some are simply not practical. Here are the four:

1. Risk avoidance – means to avoid the behavior or action that causes the risk.
2. Risk reduction – means to engage in certain activities to reduce risk. This is a good complimentary strategy, but it’s not a total solution. But, it is helpful in reducing risk. Examples include annual physicals, using smoke detectors in your home, wearing a seatbelt.
3. Risk assumption – also called “self insurance”, i.e. accepting the risk. Examples would be not having health insurance. This is strictly NOT adequate
4. Risk shifting – transfer the risk to someone else. Example: buying insurance. When you buy insurance, you shift the risk of loss to the insurance carrier.

II. Property and Liability Insurance (namely Home Insurance and Car Insurance)

A. Homeowner’s Insurance covers both the recovery of losses due to damage to the house (and its belongings) and potential liability due to injury to an unrelated party.

1.Recovery of Losses due to Damage to the House (and its belongings)

1. Building and other structures – Insurance on the “replacement value” of the property (not the historical cost). Also, exclude the value of the land. IMPORTANT: Because housing generally appreciates in value, it is important to periodically review your coverage.
2. Additional living expenses – compensates you for living in a temporary location if your house becomes inhabitable (such as renting a house, renting an apartment, or staying in a hotel). Experts recommend that this coverage be 10-20% of your homeowner’s coverage. Also, this coverage is usually limited to 6 to 9 months
3. Personal property – usually insured up to a percentage of the house. For “luxury items” or “expensive items”, you will want to inquire about a Personal Property Floater (KNOW), which is an add-on to the policy to cover such items as jewelry, coins, antiques, guns, or other specific items of high value.

2.The second major purpose of House insurance is to cover personal liability, for example, an accident in your home resulting in injury to someone else. Again, you will want to consider supplementing this coverage with a Personal Liability Umbrella (KNOW).

3. Miscellaneous Topics

Endorsements (KNOW) to a policy are special add-ons to the policy that address various miscellaneous matters. For instance, some endorsements give discounts for having

smoke detectors or security systems.

FLOOD INSURANCE is NOT part of a standard home owner’s policy. (KNOW) You MUST purchase flood insurance separately from the Federal Government.

4. Renter’s insurance

Renter’s Insurance is similar to Home owner’s insurance, except there is no need to insure the building itself. Thus, renter’s insurance covers:

personal belongings, . living expenses, and . liability for injury to others.

B. Automobile Insurance

Minimum required by state law. Must carry proof of insurance in your car. Must also carry Registration. Do NOT carry the Title – put the title in your safety deposit box.

1.Liability Insurance for your Automobile

Automobile insurance is quoted as 10/30/10. (KNOW). The first number is per person for injury. The second number is per incident. The third number is uninsured motorist insurance. For instance, 10/30/10 means a maximum coverage of $10,000 per person, $30,000 total for the accident (for all persons injured), and $10,000 coverage for uninsured motorist (if you are hurt by an uninsured motorist).

The standard protection purchased by persons with assets to protect is 100/300/100. Then, those persons purchase a Personal Liability Umbrella (for, say $2 million) to cover in excess of these limits.

2.Collision and Comprehensive coverage on your Car

Collision covers damage due to accident. Comprehensive covers all damage (for instance, your car is stolen).

GAP insurance is optional, even if you financed the car. However, it’s important to understand. Gap insurance covers you if the car is totaled and it’s worth less than you owe on the note.

3.Miscellaneous Tips about Car Insurance

a. You will need to decide on a deductible. Again, look at the higher deductibles. The deductible is how much you have to pay before the insurance company pays. For instance, if your car is damaged, and the repair bill is $1,200, and your deductible is $500, then, the insurance company will only pay $700.

III. Health and Disability Insurance

1. Health Insurance

1. General discussion

High medical costs necessitate health insurance. These costs are driven by technology, better health care, longer life expectancy, the aging of the “baby boomers”, more comprehensive treatments, fraud, and administrative costs.

2. What is health insurance?

Health insurance is the spreading of risk for health related expenses. Health insurance reduces the variance of expenses for health care. (Health insurance does NOT reduce the overall spending on health care by the entire population. It merely reallocates the expenses.)

3. Group Insurance vs. Individual Insurance

Group insurance is generally provided by the employer.

Key points:

1. Group insurance paid by the employer is a tax free employee benefit. Thus, its value to the employee is greater than the amount of the premium paid. Remember the formula from test 1:

Value of Tax Free benefit = Amount of benefit / ( 1 – marginal tax bracket)

2. Usually, most companies will pay the employee’s premium. They will allow the employee’s wife/husband and children to be covered. But, they will make a payroll deduction for the cost of these additional persons. Important: If you have step children, foster children, etc., you will need to find out the definition of “dependent”.
3. Continuation Laws – There are both state and federal laws that state that a company must offer to continue your health insurance even after you have quit or been fired. These are called “continuation laws”. (KNOW)

If the company is large, it is covered by federal law. The company must allow you to stay on their insurance plan (at YOUR EXPENSE… the company doesn’t have to provide you free insurance) for up to 18 months.

In Louisiana, the same law applies to small companies. It is referred to as the Louisiana Continuation Law. One final note:

(KNOW) There is NO law that a company must offer any type of health insurance to its employees. The laws only say that, if they do provide this benefit, they must continue to provide it after your termination (but at your expense).

3. Types of Health Insurance Coverage

Dental and Vision – generally, routine dental and vision not covered. But, dental or vision as an illness ARE. Know your policy, and, ask questions of the HR (Human Resources) department.

2. Disability Income Insurance

To provide money if you can no longer work. Key point: Definition of disabled.

1. definition of disabled (KNOW)

Make sure the policy says “can’t work at existing profession”, not “can’t work”

For example, suppose a dentist loses his hand in an accident. He can no longer perform the every day functions of a dentist. Is he disabled? Can he now draw money from his disability policy? It all depends on the definition of disabled – he certainly “can’t work at his existing profession”. But, he could teach school, i.e. he could work. The definition of “disabled” is the key variable when shopping for disability insurance.

2. Disability Insurance Trade offs.

1. Waiting Period – typically 6 – 9 months. You can get coverage for this time frame with “supplemental insurance”.
2. Duration of benefits – Check the policy, is it for a set number of years, or until 65, or until death. Obviously, no restrictions is better (payments until death).
3. Amount of benefit – the idea is to replace your income so that you can maintain your standard of living. Experts advise disability insurance equal to 70% of your pre-tax income.
4. Accident and Sickness coverage – you definitely want to be covered for your disability regardless if its due to an accident or sickness (not one or the other).
5. Guaranteed Renewability – also a key concern for life insurance – make sure policy can’t be terminated due to age or health (or any reason). Guaranteed Renewability means: If you pay the premium, you can’t be canceled. Thus, make sure you pay the premium.
6. If you don’t pay the premium, a common quotation in both disability and life insurance policies states, “Reinstatement requires evidence of insurability”. i.e. they can cancel your policy if a. you fail to pay the premium on time, and b. there has been a change in your age or health.

3.Sources of Disability Insurance

1. Employer – group plans, just like health coverage. Again, there is a tax savings for the employee.
2. Social Security – “OASDI” “Old Age Survivors and Disability Income” ßDon’t memorize, just thought you may want to know it. Started by Roosevelt during the New Deal (1930’s). Problem: Baby boomers. Ratio of workers to retirees continues to reduce. (as more people draw benefits, live longer, and the baby boomers retire).
3. Worker’s Compensation – employers are required to carry this insurance at no cost to the employee. If the employee is hurt on the job, he/she is entitled to worker’s compensation.
4. Individual policies

IV. Life Insurance Overview (Chapter 12)

Life insurance protects your spouse and dependents in the event of your untimely death.

How much life insurance to carry?

Theoretically, life insurance should provide sufficient benefits so that your family can maintain the same standard of living even without your income. (i.e. the Present Value of your future earnings, adjusted for inflation.)

You pay a premium to a life insurance company. This premium is determined by Mortality Tables based on age and other health risks, such as your sex (M or F) or whether you smoke or not.

General Tips:

1. Insurability clause – Many life insurance policies require “proof of insurability”, and, may require you to take a physical (usually if the policy is for a large amount, i.e., several million dollars).

2. Thus, in some circumstances, you may want to get “guaranteed renewability” life insurance “before you need it”.

3. Guaranteed renewability means that the insurance company cannot cancel you because you have entered a higher risk class (i.e. perhaps due to illness). They can still cancel you if you don’t pay your premium. Then, “reinstatement will require proof of insurability”.

4. Two general types of life insurance: (1) Term and (2) Whole Life or Universal

Be very familiar with the chart on the next page.

	TERM	WHOLE LIFE
Coverage:	Covers you for one year	Covers you throughout your
	then you renew if alive.	life.
Premiums:	Lower	Higher
Value of Policy After
Year is Over:	Worthless	Builds value as you age.
Age Adjustments:	Insurance company can	Policy actually increases in
	decrease coverage as you	value as you get older and
	get older.	"death benefit" remains the same.
Guaranteed Renewability:	Check policy.	Check policy.
	Strongly recommend not	Strongly recommend not
	buying policy that does not	buying policy that does not
	have guaranteed renewability.	have guaranteed renewability.
Ability to Draw Cash
from Policy:	None	Can draw cash while living or
		can borrow from cash value of
		policy.
Incontestability Clause:	Typically, two years.	Typically, two years.
Beneficiary:	Must name beneficiary.	Must name beneficiary.
	Can change beneficiary at	Can change beneficiary at
	any time.	any time.
	But if you don't change, no	But if you don't change, no
	change is assumed.	change is assumed.
Insurance Company
Ratings:	Every insurance company is rated by A. M. Best. Make sure you
	buy your policy from a highly rated company. You're counting on
	that company to pay your dependents, perhaps 30 to 70 years from
	now. Therefore, you want a strong company protecting your family.

V. Investments – An Overview (chapter 13)

A. First step: (KNOW) Emergency Fund – 3 months of living expenses. Put in interest bearing savings account. You must have a separate emergency fund BEFORE you take up investment strategies for the long term.

B. The goals of investment management: (KNOW)

Maximize Return (KNOW)

Minimize Risk (KNOW)

Each of these goals is almost always in conflict with the other.

The investment advisor (and you) must determine the “risk level” that is appropriate for each investor (you). (The amount of “risk tolerance” will depend on personal choice, “stage of life”, other factors such as married/single, children, job security, goals, etc.)

Stage of Life examples:

Young Adult, Middle-aged Adult, Retirement. Each stage of life has different return/risk tradeoffs.

C. Calculating Returns

There are two returns on an investment: 1. any periodic payment (such as a dividend or interest payment, and 2. the capital gain or loss (when the asset, such as a stock or bond, goes up or down in value). (KNOW)

a. Return for a single period:

Return on Investment = ((P1 – P0) + D1) / P0

Example: Joe buys Sears stock for $85 per share.. He receives a dividend of $8, then sells the stock for $91. What was Joe’s return on investment in Sears?

Return on Investment = (91-85) + 8 / 85 = 14/85 = .165 or 16.5%

b. Calculating Annualized Returns

So that we can compare returns for different time periods, we often “annualize” returns – i.e. find out how much we made “per year” on a stock or other investment.

There are two different ways to calculate annualized returns, one (arithmetic) is easy, the other (geometric) is a bit harder.

1. Arithmetic returns are simply the “arithmetic average” (which is what most people think of as simply the average).

Example: Assume Anna held Dell stock for 4 years. In those 4 years, she earned 9%, 22%, 11% and -6% (in the 4^th year, she lost money).

Her arithmetic average return would be (9+22+11-6)/4 = 9%

2. Geometric returns are the average compound returns.

3. The arithmetic return can be deceiving. (KNOW)

Example: Suppose you made 50% the first year, then lost 50% the second year.

The arithmetic return will be zero. (which implies you have not gained or lost money).

But, you have lost money. Let’s say you started with $100.

Year 1: $100 * .50 = profit of $50. You now have $150

Year 2: $150 * -.50 = loss of $75. You now have $75.

Overall, you lost $25 (from $100 down to $75), but the arithmetic average return of zero implies you broke even.

D. Measuring Risk

A. In finance, “risk” is defined as the “variability of returns”. (KNOW)

If you hold only one stock, risk is measured as the “standard deviation” of the stock’s historical returns.

If you hold 30 or more stocks, you are diversified (KNOW). And the measure of risk becomes BETA (KNOW).

E. Historical Performance of Different Types of Assets

(Don’t memorize chart, just know that when return is higher, so is risk! Also know that Stocks have historically done better than bonds. Both stocks and bonds have beaten inflation.)

F. The Efficient Market Hypothesis (KNOW)

In simple terms, “there are no bargains in the stock market”. In finance jargon, “the market has already discounted all available information. This information is already fully reflected in the stock’s price”.

The EMH has many implications: You can’t beat the market. You should diversify, and, not try to time the market.

VI. Investing in Stocks – (Chapter 14)

A. Trivia:

The two most common stock markets, the NYSE and the NASDAQ (see below) compete to have companies list their stock on one of these two exchanges.

You can tell on which exchange a stock is listed by the number of letters in their “symbol”.

NYSE stocks have “symbols” of 1,2, or 3 letters. For instance, Ford’s symbol is “F”.

NASDAQ stocks have 4 letters or more.

B. Stocks – What are they?

Stocks represent an ownership interest in the company.

For instance, Yahoo (YHOO) has 1,300,000,000 shares outstanding (that’s 1.3 billion).

If you own 100,000 shares of Yahoo, then you own:

100,000 / 1,300,000,000 of the company.

To the company: Stocks are part of the Capital Structure. The company can sell more stock to raise money; or it can issue more debt. This would be a Capital Structure decision.

To the individual: Stocks are an investment. The individual buys stocks for the (1) dividend income, and (2) the capital gain or loss (hoping the stock will go up in value).

C. How are stocks traded?

1. Primary Market (KNOW) – “Initial Public Offerings” or, more commonly, “IPO’s”. The company sells stock directly to the public. (Note: the company is the seller).

2. Secondary Market (know) – Stocks are bought and sold by individual investors. This is where the vast majority of stocks change hands. (Note: the seller is not the company. The seller is an investor. The buyer is a different investor.). Examples are NASDAQ and New York Stock Exchange.

D. Why invest in stocks?

Investors buy stocks for two future benefits – KNOW

Dividends

Capital gains (or losses)

E. Features of Common Stock

Voting:

1. Cumulative voting vs. straight voting

The best way to demonstrate is an example. Suppose a company is electing 5 directors to their Board of Directors. You own 100 shares.

With “cumulative voting”, you can cast 500 votes for 1 person.

With “straight voting”, you must cast 100 votes each for 5 different people.

You can see that with cumulative voting, if you own more than 20% of the stock of the company, you are assured of being able to elect one director. With straight voting, you are not..

2. Proxy voting

Proxy voting refers to the assigning of your rights to someone else (your “proxy”), who can, in turn, vote your shares on any matter that comes up at the annual meeting.

F. Building a Portfolio of Stocks

1. Portfolio: a combination of assets designed to suit the investor’s return/risk profile. The portfolio will hold assets in varying percentages so as to maximize the “expected return” for a given “risk tolerance”.

2. Expected Return:

Yyou use a “weighted average” to calculate the expected return.

Example: An investor decides to diversify. He puts 20% of his money in small cap stocks, which he expects to return 15%. He puts 40% of his money in large cap stocks, which he expects to return 10%. Finally, he puts 40 of his money into long term govt. bonds which he expects to return 5%. What is the expected return of his entire portfolio?

E(R) = (.2*.15) + (.4*.10) + (.4*.05) = .03 + .04 + .02 = .09 or 9%

Quick question: Why not just put all of his money into small cap stocks? Because, as we learned earlier, they are riskier.

Other General Tips

Know these different classifications of stocks:

Income Stock – stable, dividend paying stock. Less risky.

Growth Stock – usually, no dividend. Company is growing. Risky.

Large Cap Stock – large stock, literally “large capitalization stock”

Small Cap Stock – small company, literally “small capitalization stock”

Know these terms and how to calculate them:

Earnings per Share = After-tax income / Number of shares outstanding

Price-earnings (PE) ratio = Price per share / Earnings per share

Dividend Payout Ratio = Dividend per share / Earnings per share

Chapter 16 – Investing in Mutual Funds

I. Mutual Funds – General Overview

A. Mutual funds have become very popular in the United States.

B. A mutual fund. What is it? (KNOW these 3 terms highlighted below).

A “mutual fund” is an investment that pools money to buy stocks, bonds, or other investments.

The mutual fund is managed by an “investment company” that buys and sells stocks, bonds, etc, and charges a fee for managing the fund.

A “family of funds” is run by the same investment company (such as Merrill Lynch).

C. Why so popular?

Mutual funds are popular for two reasons: (KNOW) diversification and professional management.

Diversification: While it may be difficult for an individual to adequately diversify his/her portfolio, this person can “instantly diversify” by buying into a mutual fund that holds a basket of stocks.

Professional Management: Mutual funds are usually managed by investment experts.

II. Types of Mutual Funds

There are three types of mutual funds that you will need to remember.

1. Closed End Fund

A mutual fund whose shares are issued only when the fund is organized. These shares trade on an exchange, and, can be bought or sold throughout the trading day.

As a basic investor, do not invest in closed end funds. (KNOW).

2. Exchange Traded Funds

Exchange traded funds are relatively new, and, increasingly popular. An ETF invests in the stocks that are contained in a specific index, such as the S&P 500 (the ETF’s symbol is SPY) or the Nasdaq 100 (QQQQ), or the Dow Jones Industrial Average (the Dow “DIA”).

The ETF can also be traded anytime during the trading day. The number of shares is not limited. ETF’s have (KNOW) “passive management” (management makes no buy/sell decisions. Management merely buys the stock index.)

ETF’s are popular for many reasons: The main two are: (KNOW)(1) very low management fees, (2) very broad diversification.

3. Open End Funds – “active management” – (KNOW)

These are the funds you think of when you think “mutual fund”. For example, the Fidelity Magellan Fund, the American Funds’ “Investment Company of America.”

Open End Funds are generally Actively Managed. Open end funds can only be bought or sold at the end of the trading day. There is no preset number of shares. Open End funds’ shares are issued and redeemed by the investment company at the option of the shareholder.

(KNOW) “Net Asset Value” or “NAV” is the value of the fund’s net assets divided by the number of shares outstanding.

NAV is the “price” of the mutual fund.

III. Expenses Associated with Mutual Fund Investing

1. “Load Funds” (one time charge) (KNOW)

A “Load Fund” charges the commission upfront. A “load fund” is a mutual fund in which investors pay a commission upon the purchase of shares. This commission typically ranges between 3% and 6%.

This “load” reduces the net amount of your original investment. For example, if you invest $1,000 in a fund that has a 5% load, then you will buy only $950 of the mutual fund’s shares. (your tax basis is still $10,000).

Load funds are typically bought through a stock broker, and, the “load” serves as the commission for the broker.

2. “No Load Funds” (KNOW) – no one time charge

3. Contingent Deferred Sales Loads – one time charge if you sell too early.

4. Management Fees (RECURRING every year) (KNOW)

There are two ongoing fees (charged annually against your account):

1. Management Fees – the fees charged for the professional management (pays the salaries of the investment professionals and support staff). This fee is on an annual basis (it’s ongoing) and varies between funds from 0.25% to 2% of your investment (usually about 1%).

2. 12b-1 Fees – the fees charged for marketing the fund. Named for the provision of the SEC law that allowed this fee to be charged. This fee varies between 0.5% and 2%.

5. New Ways to Market the Mutual Fund – Different Share “Classes”

Mutual Funds have come up with hybrids of the one-time fee and the annual fees (different combinations) to create a new way of marketing mutual funds.

(KNOW the difference between Class A, B, and C)

1. Class A – the traditional upfront load. You pay a “load” on the initial investment (and the management fee, and, a reduced 12b-1 fee).
2. Class B – the traditional “contingent deferred” charge. If you sell the shares before the time limit (usually 5 years), you pay a “load” as you sell. You also pay the management fee, and, a reduced 12b-1 fee).
3. Class C – a “no load” class for the mutual fund. You do not pay a front “load” when buying the fund. Nor do you pay any contingent fee regardless of when you sell. But, you do pay the management fee, and, a HIGHER 12b-1 fee.

IV. Classifications of Mutual Funds (according to the types of their investments)

1. Stock Funds (don’t memorize this list, be able to give definition if given the term).

1. Growth Funds – buys stocks in growth companies. Ex. Google, Apple
2. Income Funds – stresses more conservative, dividend paying stocks.
3. Global Funds – invests throughout the world, including the USA.
4. International Funds – invests in foreign stocks only (no investment in USA stocks).
5. Index Funds – “buying the index”. The mutual fund buys the contents of a stock index. Much like an ETF. Usually No Load with very small management and 12b-1 recurring fees.

General Definitions

1. Family of Funds – a group of funds (of different types) offered by the same investment company.
2. Automatic Reinvestment Plan – your dividends and capital gains from the fund are automatically used to purchase additional shares in the mutual fund.
3. Dollar Cost Averaging – an investment technique where you put up the same amount of money each month (say $200) regardless of the price of the shares.

V. How to Pick the Right Funds for You

1. Your Goals (risk tolerance, time frame, and diversification).

2. Return and Risk Profile of the Fund

1. Type of investments in the fund and historical return.
2. Historical return and risk of the fund (track record)

VI. Information on Mutual Funds (objective information!)

1. Morningstar.com (know)

Free to register. Best source of information on mutual funds.