Introduction to Financial Planning

The investment performance and commercial viability of investment institutions will change domestically and internationally. Many of the above macro changes are interrelated. For example, a change in interest rates in the USA will, in a globalised financial world, within a matter of minute’s impact on share markets and on currency markets around the world. Similarly, an increase in interest rates in India may likely have an effect on property, particularly residential property, as the cost of borrowing to buy or construct property investments will increase. These are just some examples of the interrelation of macro financial changes in the financial world. Micro Level Changes  At the micro level changes will occur in the following areas: wages/business income will increase and/or decline in the future; annual living expenses (cost of living) will change in the future; your client may lose his/her employment;  your client will grow older; your client will one day die;  your client may become totally and permanently/temporarily disabled; your client may divorce;  your client may suffer a financial loss through damage to, or theft of property; your client’s financial goals and objectives may change over time; and  the costs of your client’s financial goals and objectives may change over time, along with many more changes.  Can you think of any other major macro or micro changes that may impact on a financial plan? Fulfilling the Service Obligation With the background of such an environment of change, it is essential that you, as an aspiring financial planner, accept that comprehensive financial planning includes the ongoing monitoring of your clients’ financial planning situations and requirements. Not only is this an important and vital consideration for clients, it is also a sensible commercial objective. The provision of ongoing service is, for many clients, central to the relationship they seek from their financial planner, and many clients will look to you for such service. Fundamentally, the majority of clients who consult a financial planner do so because they themselves have little or no understanding of financial matters. Many will have no desire to keep themselves up to date with a constantly changing world. Many will not take the time to address, or simply will fail to recognise that, a change in their personal life may necessitate a change in their financial plan. There will be clients who do not wish to pay for such ongoing service, in the same way as there are people who don’t wish to pay for other important ongoing professional services. However, in a modern society where people are able to pay for services that range from ‘in the home’ ironing and laundry to home computer banking, many clients will look to pay someone to manage their financial affairs. That someone is a professional, competent financial planner. 101

Fostering a Long-Term Relationship with the Client The provision of ongoing monitoring services is the foundation of establishing a long term and mutually rewarding relationship with the client. Not only is that relationship of commercial benefit to both the planner and the client, successful relationships also help develop your business through referrals from satisfied clients. Many successful financial planners would agree that the most successful marketing strategy they deploy is to simply ensure that they care for their clients on an ongoing basis. Such genuine care and concern for the client’s financial well- being eventually leads to the client recommending their financial planner to family and friends. Such referrals very often lead to increased business for the financial planner. Successful financial planners derive a large portion of their business income from recurring fees paid by clients who retain the planner on an ongoing management/review basis. For planners who do not provide ongoing management/review services, it is likely that their income will be heavily dependant upon providing advice for new clients. Such a situation, it could be argued, places continued pressure on the planner to attract new clients whereas, by contrast, the planner who provides ongoing service to clients and who is paid for such service has a more stable, and predictable business. Ongoing Services Now that we have discussed the need for ongoing service, let’s now turn our attention to the types of ongoing services that you may offer. Some services are considered to be ‘core’ to any professional ongoing service, for example a strategic review of the client situation and financial plan and a review of a client’s investment portfolio. In addition, financial planning firms may offer a variety of information services to clients, ongoing consultation services, and administration services where the firm administers all aspects of the client’s financial requirements (including arranging to pay bills and receive all correspondence relating to the investments). Furthermore, some firms are able to provide online services where clients can login to the financial planning firm’s website and view their investment portfolio. Other aspects of ongoing services can include providing clients with regular investment/economic updates where keynote speakers are invited to present and address the firm’s clients. Irrespective of the services offered, it is essential that the client fully understands and agrees to the nature of the ongoing services to be provided, including the associated costs. Once the client is fully informed of the nature and costs of such ongoing services, the client is then able to decide whether or not to subscribe to them. Strategic Review Generally, the need for a strategic review — that is, monitoring the financial strategies embodied in the plan— will emanate from changes, both macro and micro, that has emerged and which will affect your client. For example, a long- term trend of falling/low interest rates (macro change) may necessitate a change of investment strategy for clients who are reliant on investment income to meet their living costs. Such a client may be a retired client, and declining interest rates would clearly mean reduced income returns from the fixed interest sector of the retired client’s portfolio. In this situation, the financial planner’s task is, if 102

possible, to identify an alternative source of investment income for the client. For example if official short- term interest rates were to fall to say 7%, the return to the investor from term deposits, debentures, and monthly income accounts would also decline. Indeed, the returns on such investments would fall to lower than the ‘official’ 7% rate. To compensate for this outcome, the financial planner may, for example, recommend an increased weighting to equity investments if the prevailing yields on such investments were attractive compared to the interest-bearing sector of the portfolio. Another macro change that would require a strategic review of a client’s situation would be if the government of the day was to announce proposed legislation that would restrict access to the superannuation fund before retirement or restrict the level of capital that superannuation members could access as a ‘lump sum’ at retirement. An announcement such as this should see the financial planner identify all clients who would be affected by such a legislation and review what impact it may have on the clients’ planning. An example of a strategic change emanating from a micro issue is if the client were to lose their job. For this client, unless new employment can be found quickly, ongoing commitments to housing loans, superannuation and insurances may be jeopardised. These commitments would need to be addressed by the financial planner with a view to, where possible, arranging with the lender for housing loan repayments to be reduced or postponed, reducing the level of contribution to superannuation, and helping the client to re- budget for the very important insurance protection. Earlier, we noted how a client’s situation never remains static but is constantly changing. In a career in financial planning, you will be confronted with numerous and regular situations that will affect your clients. Some of these situations will affect all your clients and some may only affect a limited number of clients. For example, changes to income tax legislation may likely impact on all clients, whereas a change to superannuation legislation will only impact on those clients who have investments under the superannuation umbrella. (In Module 3 - Retirement Planning and Employee Benefits, you will learn that proposed pension legislation may impact not only on those planning for retirement, but also on many clients who have investments such as annuities and allocated pensions as income sources in retirement.) In the case of a change that will affect all clients, it may necessitate advice or communication to all clients. Such communication may be in the form of a letter or, if it was deemed an urgent matter, it may necessitate telephone contact. In the case of pension legislation, if the central government were to reduce further the amount of capital that a member can withdraw as a lump sum at retirement, it would be imperative that a financial planner review the impact on clients. This is because you may have clients who have accumulated benefits in excess of the lump sum limits and it would be critical to reassess the financial planning strategy for all such clients. Some of the questions to be asked in such a situation are:  Should the client continue to contribute to pension plans at the same level?  If pension planning is now less attractive, how should our clients accumulate their savings? Looking further at strategic changes that may impact on all clients, we need to consider the general movement in investment markets. In Topics 1 and 6 we learned how a competent financial planner must have a view to general economic and investment market conditions as part of the necessary competencies of practicing as a financial planner. To this extent, it is vital that the financial planner constantly analyse the investment and economic research that he/she receives from other sources and how it may impact on clients. A prolonged increase in the price of Indian shares would necessitate a review of asset allocations in clients’ investment portfolios. This would be particularly important if the increase in share prices was not 103

driven by fundamentals such as increased profits, increased market share, and increased spending by consumers, along with other factors which can substantiate an increase in the price of a share. The financial planner and licensee must question the sustainability of such market conditions. Other questions to be addressed include:  Should clients take profits from the share sector of the portfolio and, if so, which clients?  Where will we allocate profits taken from the share market?  Are there opportunities for clients with long term investment horizons, like young superannuation members and more aggressive long term investors, to take higher exposure to shares at reduced prices if the market corrects? As you can see, these are major strategic considerations and are an essential aspect to the provision of ongoing service to clients. Portfolio Review Also critical to the ongoing professional service to clients is the need to conduct investment portfolio reviews for clients. The need to review investments is governed by many of the changes that we have already addressed in this topic. However, the primary need for portfolio reviews is to maintain a formal and methodical process of communicating to clients on the performance of the investment portfolio, along with reviewing the client’s income needs, capital growth requirements, capital expenditure requirements, pension entitlements and tax planning position. The frequency of portfolio reviews is to some extent governed by the level of capital held within the client ’s investment portfolio. Some financial planners will offer annual review services for portfolios of less than Rs.1,000,000, with more frequent reviews above that level of capital. Internationally six-monthly and quarterly portfolio reviews are common levels of service amongst financial planners. The review should detail to the client the most recent valuation of investments along with, where relevant, a review of income received from the investments. One of the reasons for limiting reviews to an annual basis for some clients is that the cost of providing more frequent service to the client may be uneconomical for the client. The point to note, however, is that there is no legislated frequency of portfolio reviews and it is at the discretion of the planner/dealer/adviser and the client. Information on New Investment Opportunities Some financial planning firms are quite active in providing clients with information on new investments. For some clients this will be an important aspect of ongoing service while for others it will be far less so. The issue of providing information about new investments has its origins in the share-broking field where, to this day, brokers will telephone clients with information about floats of new companies and stocks that have recently received a ‘buy’ recommendation from the firm. However, it is important to note that share-broking firms earn revenue through buying and selling shares for clients. Therefore, it is a transaction-driven business as opposed to comprehensive financial planning, which is hallmarked by an adoption of formal processes in dealing with clients. The opportunities to inform clients about new investments may take place at the time of the review or alternatively as they arise throughout the year. However, care must be taken to ensure compliance with the 104

regulatory requirements for giving advice. In addition, the FPSB has, under the FPSB Code of Ethics and Rules of Professional Conduct, strict requirements about how advice can be rendered to a client. This relates to the need to confirm advice in writing. Note also under Rule 710 of the Code that you have a duty to explain clearly to the client the reasons for moving from one investment to another. Ongoing Consultation While competent financial planners will formalise the timing of reviews for clients, most planners will be happy for clients to consult with them at times other than review meetings. Such consultations may be by telephone, email, fax or very often in person. The provision of such consultations may likely impact on the fees charged by the planner for the review services. As such it is important for the client to be made fully aware of the availability of the financial planner at times other than review meetings and, where applicable, the associated costs. In the early years of financial planning internationally, many firms and planners offered clients an ‘investment monitoring’ service as a means of providing both ongoing service to clients and recurring income to the firm/planner. The offer of monitoring services was based upon a commitment from the firm/planner to monitor investment portfolios with a subsequent commitment to contact the client in the event that it was deemed that a client should redeem from an investment or, indeed, make new investments. Such offers were founded, from the client’s perspective, on the assumption that the firm/planner was ‘looking after ’ the investments and would ensure that nothing went wrong in the portfolio. Consider the following comments: We provide an investment monitoring service which ensures that your capital will always be invested in the best performing funds. Our investment monitoring service provides you with the comfort that someone is always looking over your investments. While these comments are of a generic nature, they nevertheless provide you with an indication of the sort of offers that have been made to investors in the past and even today. In Topic 1, we stressed the need to be very careful about the written word of your financial planning for clients, as the expectations that your writing creates in the client’s mind may one day be used against you if the client believes those expectations have not been met. Against this background, consider what expectations your client may have if such comments as the above were included in a financial plan prepared by you. Now, consider how your client may feel if one of the share investments you had recommended decreased in value by 30% within one week as a result of unforeseen impact of international commodity prices on the industry and an unfortunately high allocation to aluminium stocks. Would your client expect that your ‘monitoring’ service should have been active enough to foresee this situation eventuating, and recommended a withdrawal before the downturn? Now, just for a moment imagine that you work for the most insightful financial planning firm in India which, because of their high level and standard of investment research, was able to foresee the downturn in aluminium industry shares. 105

They send an urgent memorandum to you to advise you to take your clients out of the fund. Further, fortunately for you, by the time you receive your memorandum your clients had received a mail merge letter from the firm recommending withdrawal and that the client contacts you urgently. As a successful financial planner you now have over 150 clients, almost all of who have invested in the recommended share. Can you contemplate the logistical issues associated with such event? Do you think you could arrange to meet/ speak with 75 clients in one week? Do you think you could arrange the administrative processes to deal with such a large and timely issue? It is likely that many financial planners could not deliver on such an issue for clients so affected. In reality, some clients will be away or sick or not able to be contacted and so may not receive the advice until well after the event. The point is that the creation of monitoring expectations in the client’s mind may be dangerous to the financial planner from a litigation perspective. A second problem relates to the interpretations that a client may make. What expectations does your client derive from the words ‘investment monitoring service’? Does your client perceive such service to mean that you will look at every detail of every investment for every client every day? If your client perceives that you will be monitoring their investments every day and you, for whatever reason, fail to have the client withdraw in time from a collapsing investment, you may well be sued for non- delivery of a service. In more recent years, some financial planners and firms have been offering ‘portfolio review services ’ or ‘portfolio management services’ and other such terms. The word ‘monitoring’ needs to be used very carefully. As you progress to the point where you are practising as a financial planner, you should carefully consider the type of services that you offer to clients. Formalising the Ongoing Service It is very important, both from a professional and legal perspective, that financial planners offering ongoing service to clients document such arrangements with the client. Some financial planning firms require the client to sign a formal agreement that details the level and scope of service being subscribed to by the client. It may also detail the fee schedule that will apply to the client and may be a legally binding document on both parties. However, some financial planners will prepare a ‘Letter of Engagement‘, which is less formal and less legalised. Indeed, it may be argued that such a letter is somewhat like a Memorandum of Understanding between the client and the firm. The Review Process The review process is essentially a reassessment and re-evaluation of all the major steps in the financial planning process. The review process itself is best carried out by following an orderly, step-by-step set of procedures, and the following suggested steps incorporate both the strategic review and the portfolio review. 106

Steps in the Review Process Step 1 The first step in any review process is to review the client’s needs and objectives. As with a new client, consider the client’s position with respect to matters such as liquidity, flexibility, health, comfort with existing investments, insurance needs, estate needs and the like. Have the client’s needs (or indeed objectives) substantially changed? Step 2 The second step is to review the financial and investment strategies. What changes (both micro and macro) have taken place that impact on existing strategies, and how can those strategies be modified to cater for the changed situation? This essentially completes the strategic review component of the review exercise; the next steps move on to the portfolio review. Step 3 The third step is to assess the current worth and performance of the investment portfolio. Has the portfolio per-formed to expectations? If not, why not? What level of income (if applicable) has been generated? Is the income sufficient? If not, what can be done to amend the shortfall? Step 4 Step 4 involves looking closely at management of the investments. Is the fund manager managing the investments in the manner envisaged (e.g. in terms of asset allocation)? Step 5 Step 5 is to consider whether the current portfolio is, in fact, the most appropriate portfolio for the client. Ignoring where the money is currently invested, ask yourself the question: If the funds were in cash today, where would I recommend the client invest the money? If there are major differences to the current portfolio, this is a clear signal that a reappraisal of the investment portfolio is necessary. Step 6 The next step in the portfolio review is to assess the current health of the investments. Are there ‘symptoms’ of weakness, such as a developing pattern of poor performance or a significant withdrawal of funds by other investors? Such symptoms of weakness are cause for close investigation, not necessarily redemption. Weaknesses can occur through problems with the investment product itself, the manager; the strategies employed by the manager, or changed market conditions. It is important for you to recognise that past performance is not in itself a guide to future performance — there is no ‘crystal ball’. Hence the need for close research before any decisions are taken. Step 7 Based on your analysis of any material differences between the current, and ‘best’ portfolio and any investment weaknesses identified, Step 7 is to decide what to do! You need to take into consideration any transaction costs (for example, taxation, redemption penalties and so on), diversification requirements, and the client’s changed circumstances before making any decisions. 107

Step 8 The final step is, of course, implementing any changes that are deemed necessary and agreed to by the client. The recommendations you make to your client (for change or status quo) should be clearly explained and substantiated, and procedures for taking action made as streamlined and as simple as possible. For example, it will assist the client considerably if part of your process for client redemptions includes preparation of investment redemption letters from an appropriate proforma. Check that the Plan is Being Followed One last aspect of the review process is to check that the client is indeed following the agreed plan, as many people fail to stick to one. For example, they may buy or sell a certain share as a result of contact by a broker, or they may buy an insurance policy without reference to the plan. As soon as such arbitrary decisions are made, a plan tends to unravel. Part of the review process may very well be educating the client about the necessity of sticking to the plan, and the need for them to always ask the question before buying or selling any product of financial significance (whether it be shares or a car): ‘How does this fit into the plan?’ Hopefully, you will also have ‘trained’ them to seek your advice before they commit themselves. Frequency of Reviews The frequency of reviews for any one client is dependant on a host of factors, including:  the level of capital; as mentioned earlier, clients with a higher level of capital tend to need more frequent portfolio reviews than clients with a low-capital base;  the type of investment portfolio;’ active’ portfolios may require more frequent review;  the ‘pace of change’ in the client’s circumstances and financial situation, for example, clients approaching or entering retirement may need to be more frequently reviewed than clients in a more stable financial position; and the level of service you as a financial planner are prepared to offer. The frequency of reviews thus varies from an annual event to more frequent six-monthly or quarterly reviews. What is important is that the frequency chosen clearly adds value in terms of benefit for the client. Tools to Aid Plan Review There are a number of tools available to the financial planner to aid in the review process. They include suitable computer-based portfolio management systems and the research services of commercial companies. Portfolio Management Systems For any financial planner/firm offering ongoing services to clients, it is critical that portfolio management systems be available. Such systems include computerised database and reporting software. The computer database of a competent financial planner should hold up-to- date information on all clients including details of full names, addresses and telephone numbers, dates of birth and investments held. The details on investments must include name of the investment, amount invested and when, current number of units held where applicable, and any transactions on the investments apart from the initial placement. 108

The investment reporting/review service, which may or may not be linked to the database software, should report on all investments held and withdrawn. Information also provided should cover the income history of the investments, and the asset allocation (weighting to shares; fixed interest/cash and property) of the portfolio. In a world driven by technology, it is a reality that the competent financial planner must be computer literate. You should be able to acquire skills in word processing software and spreadsheets. Some computerised portfolio management systems commercially available to financial planners/firms provide integrated packages of data-bases/portfolio reviews and proposal development software. Reverting to the earlier example of the financial planning firm sending a letter of recommendation to all clients in a particular investment, logistically, such an action can only be facilitated through comprehensive computer hardware and software capabilities. Clearly, in a business environment heavily dependant upon computer hardware and software, it is vital that a financial planner/firm adopt the practice of regularly backing up computer files to disks or tapes with, at any one time, a recent full back up being stored offsite. Investment Research One important aspect of portfolio review services is the provision of up-to-date research on investments within the client’s portfolio. Such research should include the investment performance history, the level (rupee value) of funds under management within the investment, and the most recent available details on asset allocation of the fund. For financial planners/firms who subscribe to commercially available portfolio management systems, the provision of investment research may also be included. For planners who are employed by large national dealers/ advisers and for whom portfolio reviews are prepared by a head office, investment research may accompany the report sent to the planner. However, one of the most important aspects of the research is for the planner to consider the continued suitability of investments in the client’s portfolio. Questions to be asked by the planner/firm include:  Is the client’s investment still recommended by the dealer/advisory firm?  If it is, how does it compare with similarly recommended funds of the same type?  Would there be any benefits in recommending a change to the client?  While the investment is still recommended, is there any need to reduce exposure to a particular asset class (like shares) due to prevailing economic and market conditions? If a change is recommended, what costs will the client incur? If, for example, as a result of the portfolio review meeting with the client, it was evident that the client has higher income requirements, how can the portfolio be adjusted to meet the income requirements? In this situation, the planner must use the available research to identify suitable alternative investments to produce, if possible, the required level of income. 109

Caveat: Common Law Duty of Care/Professional Responsibility: Ongoing Services Financial planners must be extremely careful not to simply rely on a computer- generated investment report when conducting a review with a client. By now you should be aware that financial planning is not simply about investing but, rather, is a holistic approach to the management of a client’s current and future financial position. The making of investments is simply one aspect of the process, and review meetings should encompass an assessment of the client’s financial welfare in areas other than investments. Some financial planners will use a ‘checklist’ of questions when meeting with clients for reviews. The questions will seek confirmation that the client continues to maintain the appropriate insurances and that the client’s estate planning remains appropriate. Indeed, under common law, planners are expected to continue to exercise a duty of care/professional responsibility to the client. Any review process that did not seek to elicit confirmation that, for example, appropriate insurances are held, may see the financial planner face litigation for failing to exercise a duty of care if the client’s house burned to the ground and the client held insufficient insurance on the home and contents. Fostering a Professional Service To this point, we have described what is involved in providing a professional ongoing service. In this, the last section for discussion in the unit, we cap off the theme of professionalism that has run through this unit. First, we review the FPSB’s Code of Ethics and Rules of Professional Conduct. Secondly, we address one vital aspect of providing a professional service — provision for complaints resolution. Finally, we turn to your development as a professional and how that can be facilitated. Professionally Resolving Client Disputes/Complaints Despite the integrity and professionalism of a financial planner, disputes may arise. Disputes most commonly involve alleged financial loss as a result of claimed negligence or misleading conduct on the part of the planner/ adviser; less common complaints relate to misunderstanding of some aspect of the client- adviser relationship (for example, remuneration, services offered, and so on). Irrespective of the nature of the complaint, disputes need to be resolved in a professional manner, that is dealt with fairly and objectively, with understanding (but not necessarily acceptance) of the client’s perspective, and in accordance with established procedures within the organisation and within the industry. If you are an authorised representative within your organisation, it is important that you seek counsel within the firm and involve others in resolving the dispute. You must thoroughly familiarise yourself with your organisation’s internal complaints-handling procedures. These procedures give the firm the opportunity to resolve disputes swiftly before any damage is done to its reputation, and also the opportunity to remedy any failure of service delivery or any shortcomings. If a dispute cannot be resolved internally within a reasonable time frame, it must be made known to the complain-ant that they have the right to refer the matter to an external complaints resolution scheme approved by the regulators. 110

Developing Professionally As your financial planning career progresses, from time to time you will be dealing with your client’s accountant and solicitor in relation to your client’s situation. As such, over time, you get to know a range of professionals who may become accustomed to the manner in which you conduct your practice and the way in which you care for your clients. Reverting to Topic 1, where we discussed the community’s expectations of you as a professional, it is vital that you recognise that as members of the ‘traditional’ professions, accountants and solicitors themselves are well aware of what is required to be recognised as a professional. As such, in your early dealings with your client’s accountant and solicitor, be aware that you are being measured and assessed by the other professional. The other professional will be assessing your professional demeanour or lack thereof and will be looking for evidence that you are sufficiently competent to provide services to their client. Most importantly, the other professional will be wanting to see that you have placed the client’s considerations ahead of your own. On this latter point, of vital importance is the fact that, by providing a very professional and competent service to the accountant’s or solicitor’s client (and now, your client), over time you may benefit through referrals from these professionals. Financial planners are specialist providers of financial planning service. Financial planners pro- vide a service which no other professional pursuit, in isolation, can provide. As such, in these early years of financial planning in India, planners have a wonderful opportunity to benefit through referrals in the same way as medical specialists benefit from referrals from general practitioners. To take this analogy further, medical specialists rely on referrals of patients from general practitioners (GPs) to earn an income. No referrals lead to a financially failing medical specialist. However, the GP should only make such a referral if he/she is confident of the competencies of the specialist. An interesting point to note about the relation- ship between GPs and medical specialists is that, as part of aiding the ongoing care of the patient and fostering the referral relationship, the specialist will always reply in writing to the GP upon meeting with the referred patient. This is an aspect that can be easily mirrored in the financial planning profession. For example: Dear Ms. Accountant Thank you for referring Mr. and Mrs. Client to us for financial planning advice. We recently met with Mr. and Mrs. Client to gain an understanding of their current situation and their financial objectives and requirements. Shortly we shall meet with them to present our written recommendations and we invite you to contact us if you feel that you can assist us with further information about Mr. and Mrs. Client ’s situation. Once again thank you for this referral. Yours sincerely ABC Planning Pvt Ltd Meenakshi Practitioner Authorised Representative Such an approach is greatly appreciated by the referrer and conveys an air of professionalism and sincerity that is most important in building professional relationships. It is also important to consider referring clients to other professionals for tax or legal advice if the client does not have a current adviser in the particular field. However, such cross-referrals should only be made if you are sufficiently satisfied as to the other adviser ’s competencies and professionalism. 111

You should not expect to receive referrals from accountants and solicitors from the day you commence practising. Such referrals may take years to develop through an accumulation of trust and confidence in you by the other professional. Nevertheless, it is one aspect of professional financial planning practice, which will continue to grow as the awareness of financial planning grows further. Continuing Professional Development Earlier in this topic we discussed the reality that financial planners deal with changes at both a macro and micro level. We listed a large number of macro events that can necessitate changes to a client’s situation. On this basis therefore, it is very important that you as a financial planner recognise the need for continuing professional development that focuses on ongoing education. Simply stated, your studies in the CFPCM education programme will be but the beginning of a career of constant learning that will keep you up to date with the many changes that will confront you in day-to -day practice. For example, whenever there is a change to taxation legislation or superannuation legislation, you will need to learn about the changes and the potential impact on your clients. As we have already discussed, you have a duty of care to your client, and part of this duty is to maintain your knowledge and skills in a world of constant change. Indeed, the FPSB has recognised the very real need for continuing education (CE) by demanding that all practitioner members meet a minimum number of CE credits biennially. Practitioner members are required to maintain records of all CE credits as a means of substantiating compliance with this requirement. The FPSB intends to conduct an annual random audit of 5% of practitioner members to measure that compliance. Building Personal Competencies/Capabilities You have almost completed Introduction to Financial Planning as the first stage in developing your competencies and capabilities as a financial planner. From Introduction to Financial Planning, you now progress to Module 1- Risk Management and Insurance Planning in which you learn how insurance planning provides a major foundation of financial plans for most clients. In Module 5 - Advanced Financial Planning and Review, you will become familiar with the skills required to develop and review a comprehensive financial plan. Module 5 is the final and unifying unit of the CFPCM education programme and in this unit you will be asked to substantiate the knowledge you have gained over the first five modules by preparing an assignment based upon a case study. From the case study you will be required to develop a comprehensive financial plan for assessment. Important Your financial planning education must be adequately complemented by practical experience through training and mentoring by your professional colleagues. Indeed, the financial planning profession is like the traditional professions wherein there is much emphasis on the four ‘Es’ of Education, Examination, Experience and Ethics. You should take every opportunity to learn from competent, experienced colleagues. 112

Summary As one of the most rapidly developing service industries in India and aided by a world of economic and social change, the role of financial planning is increasingly important in the Indian community. While the role of financial planning is ‘increasingly important in the Indian community’, it can only maintain such an important role as long as the competencies and professionalism of financial planning practitioners are demonstrated and maintained at a high level. As an aspiring financial planner you have a duty of care to your client and also a ‘duty of care’ to your fellow financial planning practitioners. While we discussed in Topic 1 your duty of care/professional responsibility to your client under common law obligations, your duty of care to your fellow practitioners is that of a commitment to high ethical and technical standards. Your duty of care to your fellow practitioners also involves a commitment, at all times, to place the interests of your client ahead of the interests of yourself and your employer. Adherence to such standards of excellence and commitment will ensure that increased community acceptance of financial planning will one day see financial planning regarded as one of the traditional professions in the eyes of the Indian community. As you conclude this book, we hope that you have enjoyed your introduction into the professional world of financial planning. We wish you well in your examination and continued studies. In this topic we began by explaining that there is a very real need for financial plans to be monitored and reviewed. We learned how your client will be affected by macro and micro changes that will impact on the success of the financial plan. We learned how change is a constant in the life of every financial planning strategy. Against this background, we detailed the difference between a strategic review and a portfolio review and how they can often be conducted simultaneously with the client. We detailed the process of conducting a review with a client and also the tools that will aid the financial planner in preparing for, and conducting the review. We have again emphasised the need for you to observe the highest of professional standards when dealing with your clients and fellow professionals such as accountants and solicitors. One important aspect of professional conduct dealt with in this topic has been that of complaints resolution, and we have seen the active role that the FPSB plays in this arena. Finally, we addressed the need for you to develop professionally throughout your career. You learned about the FPSB’s ongoing continuing professional development requirements of members and the some of the methods through which you can access such CPD. Performa Review Agreement The following pro-forma letter may serve as a basis of a legal agreement between the planner and the client for ongoing services. I/we [name of client(s)] of [address of client(s)], accept the need for ongoing service and wish to implement the review service offered by [name of planner] through its Authorised Representative [name of proper authority holder ] and described in the financial plan issued to me/us. 113

I/we understand that you will provide me/us with the following services: [synopsis of services] I/we acknowledge that a fee of [Rs. amount or however calculated, plus period] will apply. It is understood that I/we may terminate this service agreement at any time in writing, subject to payment of fees accrued, and that you may terminate this service agreement upon giving one month ’s notice in writing to me/us at the above address. It is understood that should it be necessary to alter the terms of this service agreement (including the fee structure), you will provide me/us with one month ’s notice in writing at the address above, and after that time you can apply the altered conditions to this agreement and my/our accounts. I/we further understand that in the event that I/we cease to pay for the ongoing service, [name of authorised representative] and [name of planner] will be relieved of any responsibility for the review of my/our financial plan. I agree to be bound by the terms and conditions of this letter of agreement. Client:___________________ Witness:_______________________ Client:___________________ Witness:_______________________ Accepted for [name of planner] by: Authorised Representative:_______________ Date:___________ The Common Seal of [name of planner] was hereunto affixed in accordance with its Articles of Association In the presence of: Witness:__________________________ 114

Reading 1 Credentials of a good Financial Planner By Madhu Sinha (CFPCM, Certified International Wealth Manager (CIWM) Terms such as Wealth Managers, Financial Consultants, Financial Advisors and Financial Planners are used interchangeably. A lot of advisors, financial distributors and banks call themselves Financial Planners. This word is used generously by many. Consumers are confused about the various terminologies used and hence do not actually question what a particular designation means. A Certified Financial Planner will follow financial planning process to make a comprehensive financial plan. First of all, he will gather detailed and comprehensive data and also interview the client. He will also make note of the information that client did not have and ask him to get back with the information. He will take in information about the client, his family, his aspirations, goals, income, expenses, cash flows, assets, liabilities, insurances, investments, powers of attorneys and information that might be relevant. He will also take information about his client’s behavior towards risks and how he reacts in bullish & bearish situations? He will understand the mistakes that his client has committed in the past and how were they committed? A good financial planner would take anywhere between 4-6 hours (including open questions followed by social chat) over 1 or 2 sessions to complete this data gathering process. Secondly, the planner should discuss risks and returns with his client. He will never promise the moon and will tell how good he is and that he has provided the highest returns. No good financial planner in his right mind will ever do so and this is the kind of person you should look at working with. He will take his client through a proper risk profiling exercise, and will tell that the long-term return of the stock market in the past say 30 years is around 14%. In this way he is talking about past returns without making any commitments for future returns. A Certified Financial Planner will take his clients through estate planning matters, retirement planning, children’s education planning. He will also identify insurance needs of his clients. He is well versed with financial markets and the numerous products available. He will recommend those products which will meet the requirements of his clients. He will see that the right amount of money is available to his clients at right time. He will also see the financial position of his clients becoming better than where they were when they met him. After implementation of the financial plan will start the process of review and revision of the plan. Any plan which is not reviewed at least six monthly is futile. To summarize, the success of the plan depends on how the plan has been prepared, implemented and reviewed. Different professionals are expert in different fields as given below: Professionals Expertise Financial Planners Cash Flow Planning, Insurance Planning , Chartered Accountants Investment Planning , Tax Planning, Retirement Planning, Estate Planning Insurance Advisors Accounts, Audit, Tax Planning Wealth Managers Insurance Planning Stock Brokers Stock market Investment Planning Lawyers Estate Planning 115

Reading 2 Working with Clients Lovaii Navlakhi, CFPCM When a new client approaches you, try to understand his concerns and try to find out why he needs you now. Go beyond financial needs to get a holistic view of the person, his/her hopes and aspirations and the goals he is looking to achieve. Then endeavaur to win his/her confidence and work towords a mutually beneficial and lasting relationship. A Financial Planner has to build a relationship with the client where he will be able to confide in the planner and has the confidence in the abilities of the Planner to be able to help him. This might lead to some discomfort from the client, as he might have to delve into topics that he is not comfortable with. The Planner has to therefore make sure that the client is comfortable with him even while discussing such issues. How a planner handles this challenge has more to do with his ultimate success or failure than any other aspect of the planning process. This makes working with clients the toughest part of planning. Someone who is good with numbers can master the art of planning. But not every mathematician is good with people, and there lies the difference between the two. This also sets the Planner apart from Sales, where The Planner is looking at the larger picture and identifies the client’s needs and fears and recommends products that are in line with the financial planning, whereas a Sales person would look at his interest and try to push a particular product. The Planner is more - nay, only concerned with the client’s interests. The satisfaction got from the feeling that you are helping people achieve their goals is so motivating that though you might be doing the same thing for a thousand people, every person is a new challenge. The key to success is to understand the responsibility associated with money. It is a person’s hard earned money that is at stake and you’ve got to manage it as if it was your own. The fact that their future goals depend on the very money you manage is a huge task, a huge responsibility. It is the duty of the Planner to build a social relationship, at a personal level so that the client trusts him and is comfortable talking to him about his current position, his aims and his aspirations. “I started by making friends my clients, at a later date clients who came to me became friends. Now I do not have any clients who are not friends. If I don’t understand them, I will not be able to do justice to my job.” Getting the client to be comfortable with the Planner, getting him to trust him with his dreams is the most difficult task at times. It takes years to build a relationship where the client and the Planner have reached a level of comfort. “If we do not have expertise in a particular field, we do not depend on estimates or vague beliefs; we look for an expert in that field and refer the person to them so that the client’s goals are fulfilled whether or not our expertise lies in that particular field.” 116

A Planner must not only be a good analyst, but a very good listener, an empathetic and a people’s person. The qualities required for a successful planner would be a combination of analytical skills, educational requirements and all people skills along with good branding skills, because he would have to position himself differently than the others, to have an edge over the others. When and whom not to Make a Client: When a prospective client does not match the criteria of the Planner or if the two of them don’t click, it is best not to try and change the mindset of the client, but to refer him to someone who would be able to meet the requirements of the client. Types of Clients: There are Typically 5 Types of Clients: 1. Who want to join the bandwagon and make a quick buck - with eyes only on the short term: They are people who do not understand the concept of Financial Planning or refuse to understand it. They are only interested in making quick money without any clue whether the money they are accumulating would be sufficient to even meet half their expectations. They only invest when there is hype about the markets doing well and get out of it as the bear run begins or see even a minor correction thus buying at highs and selling at lows. They would end up burning their fingers and blaming everyone else for their losses but themselves. 2. Who look at the long term and are patient to withstand the short-term uncertainties: These are typically people who look at financial planning in its true sense. They set goals (long-term and short- term) and work towards their goals by having an asset allocation plan, which would help them achieve their goals and also suit their risk appetite. They also review the same as and when need arises or periodically. They understand the risks involved and take responsibility for their decisions. They do not blame the Financial Planner for any of their decisions (if they backfire) but take corrective action with the Planner’s help. 3. Trusting clients - who leave everything in the hands of the planner: These are people who trust the Financial Planner completely and give him the power to take decisions on their behalf. The Planner is aware of the huge responsibility placed on him and tries time and again to explain the course of action to the clients. The trust they place in him is both a huge reward and a huge responsibility. 4. Clients who want to learn: These are people who are willing to learn and experiment with their money. They are first to try any new concept/ product that comes into the market and are also willing to take extra risks. The rewards may or may not match the risks taken by them. They spend considerable amount of time understand- ing the logic of the planner’s decisions, though they do not interfere with them. 5. People who are scared of investing: These are typically clients who are not willing to take any risks on their money; they generally prefer options where the returns are fixed even though they may be way below the returns which could be got by taking little amount of risk. They are more concerned with the safety of the principal than returns. Convincing such people to invest in riskier instruments (like equity or even mutual funds) may be a tough task for the Planner, but can be achieved by 117

educating them about the various investment options and moving slowly from fixed return products to riskier ones. Most of the clients come to me because of the comfort that their money is being handled by me, they refer friends and relatives because of the trust they have in me as well as my capabilities. The people who come through these referrals are again very trusting as they know people who are convinced of my qualities and hence I do not have to prove them of my abilities/ about my genuineness. Working with clients is the toughest part of planning and also the best part of planning; because it enables you to see people achieve their dreams and you know they could not have done it without your guidance and advice; and this is the best reward that keeps you going. People come to you for various reasons, and they have a past that you have to deal with. You have to learn why certain things have not worked out in the past for the person and why you have to deal with this differently. Since each person is different, you have to understand things from their perspective and provide advice accordingly. E.g.: For somebody who has never invested in equities before, you cannot suggest a 50% equity portfolio when he comes to you even if the Goals demand this kind of asset allocation; you have to then be careful and build that equity portfolio in a staggered manner. For such a person, rather than suggesting to put a lump sum aside for investment, we suggest an SIP (Systematic Investment Plan) where the equity portion is built with time. Once the client sees that Equity has almost zero risk over longer periods of time (say 3-5 years+), the client himself would be willing to increase his allocation to equity. We do suggest an SIP to everyone who has regular inflows, as this is the best way to save money and make it grow. For most planners, the first meeting with a client is about getting to know each other. The Planner is trying to learn who the client is and what is it that he wants. This is a session which eventually determines whether the Planner would take the person as a client or not and also if the Client is comfortable with the Planner; because this gives the Planner an idea of how the client’s mindset is; whether the planner would be able to meet his expectations and if he would be able to do justice to the task assigned to him. To understand how the person’s mindset is, the Planner has to ask various questions. Some of these questions could be as below:  What brings you here? - There must be a reason why the Person needs a Financial Planner and it is important for the Planner to know and understand it as there may be various reasons why the client comes to a Planner- To help him set long term goals, to help him make a quick buck, to help him reduce expenses etc.  Tell me about yourself - This will help in learning about the client, as he will talk about himself, his goals, his needs and what he expects from the Planner. This helps the client become open and friendly with the Planner and makes him more comfortable to discuss issues, which might be bothering him and would have brought him to the Planner in the first place.  What do you expect from us? - This will help in the client frankly telling the Planner what he expects and helps the Planner decide if he will be able to meet the expectations or not.  Where would you like to be in the next 5 years? 118

 How will you be involved in the process? - This will help identify your client’s profile and understand how they learn  Have you ever worked with a Financial Planner before? - This will help in understanding what went wrong in that relationship that the client had to leave him. If the client has been moving from Planner to Planner looking for better performance — that should be a clue that you might never make him happy.  What do you want out of this relationship?  Are you willing to commit to it for the long term? Some prospective clients do not make it past this first meeting, and the most common reason being that their expectations are out of line. The comfort factor is then missing out of the relationship (which actually makes the relationship work in the long term) and so when this factor is missing, we then realize it is time to bid good-bye. Mr. Lovaii Navlakhi, Certified Financial Planner, is a Practicing Financial Planner and Managing Director - International Money Matters Pvt. Ltd., Bangalore. 119

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Part - II Financial Management - General Principles and Behavioral Finance 121

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Part – II Financial Management General Principles and Behavioral Finance Learning Outcomes  After reading this topic, you will be able to know:  Functions and role of Capital markets, type of indices  Derivative Market  Foreign Exchange Market  Life and Non-Life Insurance  Debt Management  Cash flow management and various personal financial ratios  Concept of Behavior Finance and Investor psychology  Economic environment 2.1 Brief Overview to Financial Markets Capital Markets-Primary and Secondary: Capital Market is one of the significant aspects of every financial market. Hence it is necessary to study its correct meaning. Broadly speaking the capital market is a market for financial assets which have a long or indefinite maturity. Unlike money market instruments the capital market instruments become mature for the period above one year. It is an institutional arrangement to borrow and lend money for a longer period of time. It consists of financial institutions like IDBI, ICICI, UTI, LIC, etc. These institutions play the role of lenders in the capital market. Business units and corporate are the borrowers in the capital market. Capital market involves various instruments which can be used for financial transactions. Capital market provides long term debt and equity finance for the government and the corporate sector. Capital market can be classified into primary and secondary markets. The primary market is a market for new shares, whereas in the secondary market the existing securities are traded. Capital market institutions provide rupee loans, foreign exchange loans, consultancy services and underwriting. A capital market is a market for securities (debt or equity), where business enterprises companies and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year. The capital market includes the stock market (equity securities) and the bond market (debt). Money markets and capital markets are parts of financial markets. Securities and Exchange Board of India (SEBI), oversee the capital markets in their designated jurisdictions to ensure that investors are protected against fraud, among other duties. Functions and role of the Capital Market 1. Mobilization of Savings: Capital market is an important source for mobilizing idle savings from the economy. It mobilizes funds from people for further investments in the productive channels of an economy. In that sense it activates the ideal monetary resources and puts them in proper investments. 2. Capital Formation: Capital market helps in capital formation. Capital formation is net addition to the existing stock of capital in the economy. Through mobilization of ideal resources it generates 123

savings; the mobilized savings are made available to various segments such as agriculture, industry, etc. This helps in increasing capital formation. 3. Provision of Investment Avenue: Capital market raises resources for longer periods of time. Thus it provides an investment avenue for people who wish to invest resources for a long period of time. It provides suitable interest rate returns also to investors. Instruments such as bonds, equities, units of mutual funds, insurance policies, etc. definitely provides diverse investment avenue for the public. 4. Speed up Economic Growth and Development: Capital market enhances production and productivity in the national economy. As it makes funds available for long period of time, the financial requirements of business houses are met by the capital market. It helps in research and development. This helps in, increasing production and productivity in economy by generation of employment and development of infrastructure. 5. Proper Regulation of Funds: Capital markets not only helps in fund mobilization, but it also helps in proper allocation of these resources. It can have regulation over the resources so that it can direct funds in a qualitative manner. 6. Service Provision: As an important financial set up capital market provides various types of services. It includes long term and medium term loans to industry, underwriting services, consultancy services, export finance, etc. These services help the manufacturing sector in a large spectrum. 7. Continuous Availability of Funds: Capital market is place where the investment avenue is continuously available for long term investment. This is a liquid market as it makes fund available on continuous basis. Both buyers and seller can easily buy and sell securities as they are continuously available. Basically capital market transactions are related to the stock exchanges. Thus marketability in the capital market becomes easy. Capital markets may be classified as: Primary markets Secondary markets. Primary Market: Primary market is a market to raise money from public through IPOs (Initial Public Offerings). Companied need money to expand their businesses and public helps the company by subscribing in the shares offered by the company. By investing in the share capital of the company, investors become part owners of the company. They get right to vote and participate in the profits of the company. Governments and other groups obtain financing through debt or equity based securities. Primary markets are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors. Primary market is also known as “new issue market” (NIM). The primary markets are where investors can get first crack at a new security issuance. The issuing company or group receives cash proceeds from the sale, which is then used to fund operations or expand the business. Exchanges have varying levels of requirements which must be met before a security can be sold. 124

Features of Primary Markets This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM). In a primary issue, the securities are issued by the company directly to investors. The company receives the money and issues new security certificates to the investors. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business. The primary market performs the crucial function of facilitating capital formation in the economy. The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as “going public.” The financial assets sold can only be redeemed by the original holder. Methods of Issuing Securities in the Primary Market 1. Public issuance, including initial public offering; 2. Rights issue (for existing companies); 3. Preferential issue. Secondary Market: Once the initial sale is complete, further trading is said to conduct on the secondary market, which is where the bulk of exchange trading occurs each day. Primary markets can see increased volatility over secondary markets because it is difficult to accurately gauge investor demand for a new security until several days of trading have occurred. Secondary marketing is vital to an efficient and modern capital market.[citation needed] In the secondary market, securities are sold by and transferred from one investor or speculator to another. It is therefore important that the secondary market be highly liquid (originally, the only way to create this liquidity was for investors and speculators to meet at a fixed place regularly; this is how stock exchanges originated, see History of the Stock Exchange). As a general rule, the greater the number of investors that participate in a given marketplace, and the greater the centralization of that marketplace, the more liquid the market. When an interested investor wants to buy a share, which has already been issued by the company, he will have to engage in a secondary stock market transaction. The secondary market is simply a place where existing securities are bought and sold. Also referred to as the dealer market or the auction market, this is the place where most of the stock investment takes place. Some key characteristics of trades in this market are:  Securities are bought and sold at ‘market value’ or the value at which they are currently available, which may be higher or lower than the ‘face value’ at which the share was originally issued by the company.  The issuing company bases many management decisions on the performance of its stock in the secondary market. This market functions as a barometer of public opinion about the company and its 125

prospects. Any crucial decision taken by the company, senior management changes, and market dynamics can affect the company’s share values drastically.  The secondary market is further divided into equity and debt markets. Stocks are traded in the equity market, while corporate bonds are traded in the debt market. Both the primary and secondary markets discussed in this stock market guide are essential parts of the investment world, but most investors refer to their transactions in the secondary market when they talk about stock market trading. When the secondary market is active and remains steady without major fluctuations, it demonstrates that the country’s economy is doing well. The stock markets thus function as an indicator of the industrial activity and investor confidence in a country. Indices and Parameters Stock indexes (or indices) are created to provide investors with the information regarding the average share price on the stock market. Since shares of thousands of companies are traded on any given day in the stock market, it is impossible to keep track of all the price movements and discern the direction in which the market is going. A stock index represents the average price of shares trading on a stock exchange. The average in computed using the prices of only a handful of stocks that are deemed to be the most representative of the market as a whole. The Uses of Stock Indexes The first and foremost use of a stock index is as a measure of performance of the market. Since the index is based on representative stocks, an increase in the index signifies an increase in prices of a majority of stocks. Investment analysts find the stock index a useful tool in determining the factors underlying stock price movements. Historical information about the index and macro-economic variables can be correlated to analyze factors related to share price movements. A number of analysts (“Technical analysts”) believe that historical share price movements can help one to predict future price movements. These analysts use the stock index data to forecast the direction of the market. Stock indexes have been very useful in portfolio management. A broad-based stock index is normally used as a proxy for the “market” portfolio and used in determining the systematic risk of portfolio being managed. This helps portfolio managers make investment decision. Free market economies are subject to business cycles; thus, the economic growth varies from one period to another. It is extremely important for businesses to predict when the economy will start expanding or when it will slide into a recession. Stock prices have been found to be leading indicators (i.e., stock prices rise/fall before the economic expansion/recession) of the economy. Thus, the change in stock indexes can be used as an indicator of the direction of the economy. 126

How Stock Indexes are Calculated There are two important factors in determining the utility of a stock index: the number of stocks to be included in the index and the method of calculating the average price. Number of Stocks in an Index Ideally, a stock index should be based on as many stocks in a given market as possible. This index will then be truly representative of the market. However, in the past, the cost of calculating such an index on a continuous basis was found to be too much. Thus, most stock indexes created prior to the computer age included very few stocks. BSE has 30 stocks included in SENSEX and NSE has 50 stocks in index called NIFTY 50. Method of Calculating an Index Stock indexes are calculated using different methods of determining the average price of shares. The two most widely used methods are: 1. Price-weighting 2. Value-weighting Price-Weighted Indexes Price-weighted indexes are calculated simply as the average share price of stocks included in the index on a given day. Thus, on the very first day the index was calculated, the share prices of all the stocks were added and then divided by number of stocks (called the divisor) to calculate the value of the index. Over the long run, however, this calculation method will introduce errors in the value of the index due to stock splits and stock dividends. To eliminate these errors, the divisor has to be continuously adjusted.. Value-Weighted Indexes/Market Capitalization Weighted Index The alternative method of index calculation is the value-weighting scheme. Here the market values of all the firms included in the index are added and divided by the market value of the firms on the day the index was firs calculated. SENSEX, first compiled in 1986, was calculated on a “Market Capitalization-Weighted” methodology of 30 component stocks representing large, well- established and financially sound companies across key sectors. The base year of SENSEX was taken as 1978-79. SENSEX today is widely reported in both domestic and international markets through print as well as electronic media. It is scientifically designed and is based on globally accepted construction and review methodology. Since September 1, 2003, SENSEX is being calculated on a free-float market capitalization methodology. The “free-float market capitalization- weighted” methodology is a widely followed index construction methodology on which majority of global equity indices are based; all major index providers like MSCI, FTSE, STOXX, S&P and Dow Jones use the free- float methodology. The growth of the equity market in India has been phenomenal in the present decade. Right from early nineties, the stock market witnessed heightened activity in terms of various bull and bear runs. In the late nineties, the Indian market witnessed a huge frenzy in the ‘TMT’ sectors. More recently, real estate caught the fancy of the investors. SENSEX has captured all these happenings in the most judicious manner. One can 127

identify the booms and busts of the Indian equity market through SENSEX. As the oldest index in the country, it provides the time series data over a fairly long period of time (from 1979 onwards). Small wonder, the SENSEX has become one of the most prominent brands in the country. This method of calculation eliminates some problems inherent in the price- weighting method. Stock splits and stock dividends do not affect the index as the index accounts for the market value of equity rather than the price of a share. High-priced stocks do not necessarily have a bigger impact on the index. It is market value that matters. Large market value firms will affect the index more than small market value firms. Finally, as it is based on a sample of 500 stocks, S&P 500 is more broad-based and thus more representative of the market as a whole. Money Market Is a segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of negotiable certificates of deposit (CDs), banker’s acceptances, Treasury bills, commercial paper and repurchase agreements (repos). Types of Money Market instruments in India - Money market instruments take care of the borrowers’ short-term needs and render the required liquidity to the lenders. The varied types of India money market instruments are treasury bills, repurchase agreements, commercial papers, certificate of deposit, and banker’s acceptance. Treasury Bills (T-Bills) - Treasury bills were first issued by the Indian government in 1917. Treasury bills are short-term financial instruments that are issued by the Central Bank of the country. It is one of the safest money market instruments as it is void of market risks, though the return on investments is not that huge. Treasury bills are circulated by the primary as well as the secondary markets. The maturity periods for treasury bills are respectively 3- month, 6-month and 1-year. The price with which treasury bills are issued comes separate from that of the face value, and the face value is achieved upon maturity. On maturity, one gets the interest on the buy value as well. To be specific, the buy value is determined by a bidding process, that too in auctions. Repurchase Agreements - Repurchase agreements are also called repos. Repos are short-term loans that buyers and sellers agree upon for selling and repurchasing. Repo transactions are allowed only among RBI- approved securities like state and central government securities, T-bills, PSU bonds, FI bonds and corporate bonds. Repurchase agreements, on the other hand, are sold off by sellers, held back with a promise to purchase them back at a certain price and that too would happen on a specific date. The same is the procedure with that of the buyer, who purchases the securities and other instruments and promises to sell them back to the seller at the same time. Commercial Papers - Commercial papers are usually known as promissory notes which are unsecured and are generally issued by companies and financial institutions, at a discounted rate from their face value. The fixed maturity for commercial papers is 7 days – 1 year. The purposes with which they are issued are - for financing of inventories, accounts receivables, and settling short- term liabilities or loans. The return on commercial papers is always higher than that of T-bills. Companies which have a strong credit rating, usually issue CPs as they are not backed by collateral securities. Corporations issue CPs for raising working capital 128

and they participate in active trade in the secondary market. It was in 1990 that Commercial papers were first issued in the Indian money market. Certificate of Deposit - A certificate of deposit is a borrowing note for the short-term just similar to that of a promissory note. The bearer of a certificate of deposit receives interest. The maturity date, fixed rate of interest and a fixed value - are the three components of a certificate of deposit. The term is generally in bank between 7 days-1 year, FI’s 1 year to 3 years. The funds cannot be withdrawn instantaneously on demand, but has the facility of being liquidated, if a certain amount of penalty is paid. The risk associated with certificate of deposit is higher and so is the return (compared to T-bills). It was in 1989 that the certificate of deposit was first brought into the Indian money market. Banker’s Acceptance - A banker’s acceptance is also a short-term investment plan that comes from a company or a firm backed by a guarantee from the bank. This guarantee states that the buyer will pay the seller at a future date. One who draws the bill should have a sound credit rating. 90 days is the usual term for these instruments. The term for these instruments can also vary between 1 to 180 days. It is used as time draft to finance imports, exports. It depends on the economic trends and market situation that RBI takes a step forward to ease out the disparities in the market. Whenever there is a liquidity crunch, the RBI opts either to reduce the Cash Reserve Ratio (CRR) or infuse more money in the economic system. Derivative Market The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. A security whose price is dependant upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. The term “Derivative” indicates that it has no independant value, i.e. its value is entirely “derived” from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act, 1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:- A Derivative includes: - 129

Security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; Contract which derives its value from the prices, or index of prices, of underlying securities; Futures Contract Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre- specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash. Option Contract Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option purchase the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. Under Securities Contracts (Regulations) Act,1956 options on securities has been defined as “option in securities” meaning a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities. An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price. Therefore, in the case of American options the buyer has the right to exercise the option at any time on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame. As in the case of futures contracts, option contracts can be also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract. Index Futures and Index Option Contracts Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index. 130

Similarly, the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date. An index in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectorial indices. In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently, sectorial indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the index have begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be discontinued. By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry. Structure of Derivative Markets in India Derivative trading in India can place either on a separate and independant Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self- Regulatory Organization (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/ Segment would have to be through a Clearing Corporation/House, which is independant in governance and membership from the Derivative Exchange/Segment. The various types of membership in the derivatives market are as follows:  Trading Member (TM) – A TM is a member of the derivatives exchange and can trade on his own behalf and on behalf of his clients.  Clearing Member (CM) –These members are permitted to settle their own trades as well as the trades of the other non-clearing members known as Trading Members who have agreed to settle the trades through them.  Self-clearing Member (SCM) – A SCM are those clearing members who can clear and settle their own trades only. Eligibility Criteria for Stocks on which Derivatives Trading may be permitted A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria:- 131

 The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalization and average daily traded value in the previous six month on a rolling basis.  The stock’s median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock’s quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.  The market wide position limit in the stock shall not be less than Rs.50 crores. A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued. Foreign Exchange Market The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Eurozone members and pay Euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of  Its huge trading volume representing the largest asset class in the world leading to high liquidity;  Its geographical dispersion;  Its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday;  The variety of factors that affect exchange rates;  The low margins of relative profit compared with other markets of fixed income; and  The use of leverage to enhance profit and loss margins and with respect to account size. As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, 132

average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.[4] Commodities Market Commodity markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold in standardized contracts. India commodity market consists of both the retail and the wholesale market in the country. The commodity market in India facilitates multi commodity exchange within and outside the country based on requirements. Commodity trading is one facility that investors can explore for investing their money. The India Commodity market has undergone lots of changes due to the changing global economic scenario; thus throwing up many opportunities in the process. Demand for commodities both in the domestic and global market is estimated to grow by four times than the demand currently is by the next five years. Commodity Trading Commodity trading is an interesting option for those who wish to diversify from the traditional options like shares, bonds and portfolios. The Government has made almost all commodities entitled for futures trading. Three multi commodity exchanges have been set up in the country to facilitate this for the retail investors. The three national exchanges in India are: Multi Commodity Exchange (MCX) National Commodity and Derivatives Exchange (NCDEX) National Multi-Commodity Exchange (NMCE) Commodity trading in India is still at its early days and thus requires an aggressive growth plan with innovative ideas. Liberal policies in commodity trading will definitely boost the commodity trading. The commodities and future market in the country is regulated by Forward Markets commission (FMC). Wholesale Market The wholesale market in India, an important component of the India commodity market, traditionally dealt with framers and manufacturers of goods. However, in the present scenario, their roles have changed to a large extent due to the enormous growth that the economy has witnessed. The lengthy process of wholesalers buying from manufacturers; then selling it to retailers who in turn sold it to consumers does not seem feasible today. An improvement in the transport facility has made the interaction between the retailer and manufacturer easier; the need for a wholesale market is gradually diminishing. Retail Market The retail market in India is currently witnessing a boom. The growth in the India commodity market is largely attributed to this boom in the retail market. Policy reforms and liberal government policies have ensured that this sector is growing at a good pace. Some of the reasons attributed to the growth of retail sector in India include the large population of the country who has an increased purchasing power in their hand. Another factor is the heavy inflow of foreign direct investment in this sector. More than 80% of the retail industry in the country is concentrated in large cities. 133

India Commodity Market - Global Scenario Despite having a robust economy, India’s share in the global commodity market is not as big as estimated. Except gold the share in other sectors of the commodity market is not very significant. India accounts for 3% of the global oil demands and 2% of global copper demands. In agriculture India’s contribution to international trade volume is rather less compared to the huge production base available. Various infrastructure development projects that are being undertaken in India are being seen as a key growth driver in the coming days. Services-Life and Non-Life Insurance Central to an understanding of insurance needs is the concept of pure risk and, in this section, we look at the various risks people may be exposed to, and introduce you to life and general insurance, strategies considered further in Topic 5. Risk in the Context of Insurance There are uncertainties in an average life which is exposed to many types of dangers or risks which may damage or destroy an asset, property or human life. The need for insurance arises out of the existence of these risks. However, risk in this sense is not the investment risk discussed earlier, but encompasses other types of financial risk, such as the loss of property, loss of income-earning capacity through illness or disability, or liability for damages. We, therefore need to distinguish between these two major categories of risk. For the purposes of risk management, one of the important considerations in a financial plan, we will use the following classification. Meaning of Risk Risk in insurance only means that there is a possibility of loss or damage which may or may not happen. The peril may sometimes be avoided through better safety and damage control management. Thus insurance is relevant only if there are uncertainties about the happening of events which may bring about loss or damage. The occurrence of the events insured against has to be random, accidental and not a deliberate act or creation of the insured person. Mechanism of Insurance People facing common risks come together or they are brought together by insurers and make their small contributions to the common fund. When risk occurs, the loss is made good out of this common fund. Thus the risks are pooled and losses are shared. Types of Risks 1. Pure risk refers to those situations where the consequences of the risk will be either a loss or no loss. It involves situations such as a house burning down, a car being damaged in an accident or loss of a limb due to an accident. These are instances where there is either a loss or no loss; a house may burn down or it may not. Insurance relates to this form of risk. 134

2. Speculative risk refers to those situations where the consequences of the risk can result in either a loss or a gain. Investing money as described earlier is a form of speculative risk. Managing Risk Risk management is a new managerial discipline which has become a part of business management in many corporate firms. Risk management may be defined as a managerial function concerned with the protection of the firm’s assets, earning or profits, legal liabilities and personnel against financial loss that may result from fortuitous events or accidental happenings. The process involves the following steps: 1. Risk identification, 2. Risk evaluation, 3. Selection of risk management techniques - these are risk avoidance and loss prevention and reduction, 4. Risk retention, 5. Risk transfer. Pure risk can be managed in a number of ways, and we can categorise these means in the following manner:  Risk control: here, steps are taken to minimise risk (for example, putting locks on the windows partly controls burglary risk);  Risk avoidance: risk is eliminated by avoiding the risk altogether; for example, deciding not build a house on a flood plain;  Risk retention, where a person decides simply to accept and pay for any loss himself. Examples include window replacement, where one agrees to pay an excess on a car insurance policy, or accept a certain waiting period on an income protection policy — all for a reduced premium. Many people accept the risk associated with medical and dental expenses. Effectively, risk retention is self-insurance. Decisions to self-insure are based on a cost-benefit analysis — the cost of the premiums against the value of the possible loss. In situations where the premium is disproportionately high relative to the risk for possible transfer, risk retention is the more appropriate risk strategy.  Risk transfer, where through contract, the risk is transferred to another party. For example, if property is leased, it may contractually transfer the risk of fire insurance to the lessee.  The most common form of risk transfer is through insurance, where through payment of a premium the risk is effectively transferred to the insurance company. (Technically, some would argue that the risk is not transferred per se, but rather shifted to, or shared among all the insured in the insurance pool. But the effect is the same – the insured is protected from the loss.) We are concerned primarily with risk transfer through insurance. To be insurable, there is one very important attribute of pure risk that we need to keep in mind: the occurrence of that risk needs to be mathematically predict-able, using the law of probability. For example, we can investigate the occurrence of a type of pure risk in the past and use that to predict the occurrence of this type of risk in the future. 135

Pure Risks that People Face Any analysis of insurance needs is predicated upon an understanding of the risks with which people may be confronted. These risks include: Personal Risks  Risk of early death (premature natural death or accidental death);  Risk of injury or debilitating illness (short or long term); and  Risk of loss of income through incapacity to work for some extended period. Other risks related to insurance include the risk of leaving an inadequate estate for dependants or other beneficiaries, or the risk of outliving retirement benefits. Property Risks  Risk of loss or damage to one’s own property (house, car).  Loss of use of property. Liability Risks  Risk of causing injury to other persons or the damage or loss of others’ property through one’s actions or inactions, for example, failure of any person in performing one’s duty  For professionals in the financial services field: risk of causing financial loss as a result of inadequate, inappropriate or otherwise negligent advice.  Loss/damage arising from negligence of third party. From recognition of these risks we can then establish the various needs that people have, needs that can be met by insurance. However, it is important to recognise that personal insurance is not the only mechanism available to handle aspects of risk. Depending on personal circumstances, there may be alternatives such as employer-pro-vided benefits (like accumulated sick leave, superannuation and others). Similarly, both central and state governments make insurance compulsory in transport (compulsory third party motor vehicle insurance). It is the task of the financial planner to ascertain which risk-related needs are not at present covered or not sufficiently covered, and to make recommendations to fill these gaps. Risk-Related Needs Having identified the risks to which people are exposed, we can now turn to a consideration of needs. Using the categories of pure risk cited above, the more common needs include: Personal Protection  To provide a lump sum and/or income for any dependants in case of premature death;  To provide for oneself and any dependants in the case of total and permanent disability (including the cost of care); 136

 To provide for oneself and any dependants in the case of serious injury, accident or illness (i.e.trauma); and a lump sum to cover major medical/hospital costs, or an income stream whilst unable to work; to provide a lump sum upon death to meet all liabilities and debts (like mortgage, personal loans). Property Protection To provide sufficient funds to replace that which has been lost or damaged through fire, flood, theft, accidents including loss or damage to house, home contents, motor vehicles, and other vehicles. Liability Protection To meet any liabilities associated with damage to another ’s property (like a motor vehicle), or with injury to another (to somebody you employ as a part-time gardener), or with other ‘damage’ like a financial loss. The Client Life Cycle While the needs listed in Figure 4.5 on the next page are common for most clients, clients’ specific needs will vary according to individual personal circumstances. Of particular relevance in this regard is the client’s stage of life, as illustrated in the Figure 4.5 given on page 195. Of course, this is very much a traditional, stereotyped life cycle, and you may find that many of your clients will not conform to this pattern. However, Figure 3.3 does illustrate the principle that clients’ needs change over time, and that it is important to clearly identify all aspects of the clients ’ circumstances in the analysis of insurance needs. Costing Needs The financial planner needs to ascertain the costs associated with any of the identified risks materialising as an event. For example, in the case of early death, costs might include: The cost of meeting commitments: repayment of loans, mortgages; and the provision for any dependants: lump sum (cash reserve)and/or ongoing income required to support the spouse/family in the lifestyle desired; coverage of future expenses such as children’s education. In the case of total and permanent disability or short term critical illness, costs include immediate healthcare costs, as well as the amount needed in ongoing income to support the client and his/her family. In the case of property damage or loss, how much, in money terms, would this represent to the client? What would be the replacement value? 137

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Matching Needs Against Insurances in Place A whole raft of insurance products has evolved to meet the many risk-related needs identified in the previous section. As a planner, you need to identify the types of insurance policies that the client already has in place, the premium costs, the rupee-value coverage, and any significant conditions attached to those policies before you can develop a set of insurance recommendations that will meet the client’s overall insurance needs. Insurance products can be simplistically classified into two main areas, life insurance and general insurance, and it is these two areas of insurance that are normally differentiated on a data collection form. Life Insurance This type of insurance relates to insurances that can be taken out over a human lifetime, whether it be insurance for death, disability, or serious illness. In addition to insurance against premature death, illness or disability, life insurance may also have a savings, or investment component. There are two key elements to a life insurance policy: A life insurance policy requires an owner of the policy. This is the person, company or trustee who receives the benefit if one of the specified events of the policy occurs. Secondly, a policy must have a life insured. This is the individual to which the life insurance policy relates. Types of Life Insurance There are various types of life insurance, but they generally fall under the following categories: Figure 4.6: Forms of Life Insurance Description Owner Comments Life insurance with no investment component Term life insurance Individual, company or trustee • Contract cover the event of death within a specified (superannuation fund) period (hence, often referred to as temporary insurance). • Pays on agreed lumpsum on death. No surrender value. Total and permanent As for term insurance above • Usually attached to life insurance cover and pays a disability (TPD)* Individual lumpsum on specified total and permanent disability conditions. Trauma insurance* • There is some variation in definition between companies (with life cover) and policy owners need to read contracts carefully Stand-alone trauma insurance Pays out a lump sum on satisfying a covered life threatening medical condition Terminal illness’ As for term insurance Pays out a percentage of death benefit when terminal illness diagnosed. Accidental death benefits As for term insurance Pays out on death accident only. Income Protection* Life insured individual Pays out a percentage of life insured’s regular income for Whole of life and As for term insurance illness or injury for a specified period after a set waiting endowment period • Collectively called permanent life insurance policies; pays out when the insured dies (see further below) • Has surrender value. *Usually extensions or ‘riders’ to life insurance contracts, but may be ‘standalone’; hence, not strictly life insurance (death protection) policies as such. However all of the above could be considered ‘personal protection’ policies. 139

A life insurance policy may specify certain events where cover is not provided. For example, cover may not be provided when a person injures him-or herself intentionally or commits suicide. These events are known as exclusions and the nature and type of exclusions will vary from company to company. The amount paid by the policy owner to provide the cover is referred to as the insurance premium. The level of premium for a given risk is determined by a number of factors including:  age of the life insured;  health;  habits;  family medical history;  exclusions (HIV being a major exclusion);  the sum or amount being insured;  any existing insurance in place or being applied for; and profitability and marketing objectives of the insurer. Whole of Life and Endowment Policies Many life insurance policies may deal not only with the pure risks described, but may also provide some form of investment or savings component. These types of policies are sometimes referred to as life assurance policies. Historically, these types of life insurance policies fall into two main types: Endowment policies generally have a specified maturity date where the cover ceases and the accrued investment is repaid. (The sum insured is also usually paid out on the earlier death of the insured.) These policies can thus be used as a means of saving for retirement while protecting dependants from the financial effects of the insured person’s premature death; and Whole life policies generally mature when the life insured is very old (100 years), and thus the maturity date of a whole of life policy is the same for each person insured. In practice, most policies therefore never mature before the death of the insured life. These types of policies generally have a low level of investment component and, as such, the investment value, relative to an endowment policy, is less. Conversely, the sum insured or life insurance value is greater. Convertible Whole Life Policies: Some companies permit the whole life policy to be converted to an endowment policy by the policy owner and specify an earlier maturity date. This ability to convert is a feature exploited by players in the secondary insurance policy market. As the premiums are paid, funds are gradually built up to pay the claim when it inevitably occurs. This accumulation in funds generates equity in the policy — otherwise known as the surrender (or cash) value. This equity or surrender value is not the value of the premiums paid, but the residue, after taking expenses and other costs into account. Policy Loans: Lastly, these ‘traditional’ types of life insurance policies generally allow the policy owner to borrow against the policy, at interest rates generally lower than prevailing market rates. This can be one source of cash in the event that a client needs to access funds in an emergency situation but does not wish to cash out his or her life insurance policy. 140

General Insurance General insurance is insurance that relates to risk financing of property. Property can take many forms and it need not specifically relate to tangible goods or items; it may relate to loss suffered by another party because of a person’s action or inaction. Loss can thus be tangible (as in damage to property) or intangible (such as the loss of future earnings due to receiving negligent advice). Note the distinction between this form of insurance and the ‘personal protection’ insurance discussed previously, which relates purely to coverage of risk to the individual person, who is the subject of the policy. Once again, the policy owner enters into a contract of insurance with a product provider that provides coverage for specific events in exchange for a premium. Underlying Principles and Features As with life insurance, the purpose of general insurance is to indemnify the insured against loss, or to ensure they are no worse off after the specified event(s) occurs. This is an important concept, as an insurer will not better the insured’s position after the event. This reduces the ‘moral risk’ on the part of the insurer and prevents the insured causing the event to effectively enhance their position. This underlying principle of indemnification lies at the heart of all general insurance contracts. Generally speaking, an insurer will not reimburse for a value greater than that which was lost. Whilst you may insure your home for Rs.100,000, if is subsequently destroyed and was valued at Rs. 80,000, this is the amount which will be paid out (if covered under a normal indemnity value policy — see below). However, insurance companies have recognised that the indemnity value of, for example, a home or its contents may not be sufficient to cover the replacement of those items should they be lost/stolen or destroyed. Hence two types of policies have evolved:  An indemnity value policy, where the insurer simply pays the value of the property or contents at the time of the loss;  A replacement value policy, where the sum provided is more in keeping with what is needed in the event of a loss. While the insured has only lost an amount equal to the indemnity value, it may well cost more to replace the property/contents with something equivalent; i.e. there is often a gap between the indemnity and replacement values. A replacement value policy leaves the insured in the same financial position after the loss as before. Of course, as the replacement value is normally higher than the indemnity value, the insurance premium is correspondingly higher. In your general insurance needs analysis, you should consider the type of policy that is in place, or to be recommended. The insured is required, to fully disclose all matters which might materially affect the risk on the part of the insurer. This is normally dealt with in the application for insurance, which provides a number of questions relating to the items to be insured and the individual or company applying for insurance. In your data collection process, you need to discuss the real value of particular assets and their insured values. One common error is to include the land value in determining house insurance cover levels, rather 141

than the building itself and valuable items of furniture or equipment. Another error is to use the current value of the property instead of the replacement value of the home and contents. Terms of the Contract In some cases, an insurer may be prepared to specify the value of cover if sufficient in-depth information is pro-vided at the time the contract is prepared. Similarly, the term of the general contract specifies dates and times at which cover will cease. Prior to the expiry of the contract, the insurer may decide to offer a new contract to renew the policy. There is no compulsion on the part of a general insurer to renew the policy and the insurer may decide to alter the terms offered to the insured. This is quite different from life insurance, where the insurer is required to provide ongoing cover, provided the premiums are paid. This allows companies to increase premiums and alter the terms of the contract based on general or specific claims experience of the insured. Insurers may also offer payment terms for annual premiums. Usually, the price includes a financing component and with a higher number of instalments, the finance component can be relatively high. For example, Company XYZ charges Rs.550 per annum for a contract paid annually, but charges Rs. 49.28 if paid monthly. 12 x 49.28 = Rs.591.36 This shows the annual finance cost is Rs. 41.36 per annum or 7.52%p.a. General insurance contracts usually provide for a degree of self insurance by including a deductible amount or excess on any claim. Whilst in the fiercely competitive domestic insurance market these can be reduced or waived, they are a means to prevent petty claims clogging up a claims department. Similarly, excesses are sometimes used to limit ‘risky’ activities on the part of the insured. For example, your client’s motor vehicle excess may be Rs. 100 on a claim. Yet, if their 18- year- old son is driving, the excess increases to Rs.1,000. This ‘penalty’ acts as a deterrent to having the 18- year- old use the car. Insurance contracts usually specify those events, or perils, which are covered in what is known as the ‘operative clause’ of the contract. In addition, the contract will specify perils that are not covered as exclusions to the policy. Exclusions are often the source of dispute between insurers and the insured. One of your responsibilities as a financial planner is to identify these problems before they occur and highlight these to you client so that action may be taken. Categories of General Insurance General insurance is usually separated into commercial and personal type contracts. Whilst there are many similarities, there are differences in the types of cover offered. One other difference is the nature of obtaining cover. Whilst in the personal market there are a number of players all vying for similar types of business, commercial insurance can sometimes present specific insurance needs which are difficult to ‘place’ or find takers for. This need is often served by a general insurance broker who specialises in obtaining cover for these specific needs and, indeed, is able to obtain the 142

‘best deal’ for their clients.. The following list identifies some of the more common forms of insurance contract. The list is by no means exhaustive and many insurers may provide features and options not listed. Many insurance policies are ‘bundled’ into packages. In some cases, insurers may be reluctant to offer one type of policy if others are not included. For example, public liability may only be offered if other policies are included. Similarly, many insurers provide for minimum sums insured or minimum premiums. This ensures that insurance contracts accepted are commercially viable. Forms of General Insurance Name Type Description Home building Personal Provides cover for a number of listed perils. Fire, storm, water, burglary, impact are the principal ones but not Home contents Personal the only ones. Public liability (home) Personal Provides cover for a number of listed perils, plus theft and, sometimes, accidental damage. Domestic workers’ Personal compensation Commercial Covers the owner’s legal liability to those who may Building Commercial sustain bodily injury or damage to property whilst on Contents the insured’s property Commercial Covers the legal liability in relation to those employed Public liability at the house for injury they sustain As for home building Product liability Commercial Provides cover similar to home contents against a Professional indemnity Commercial similar range of perils. Crop insurance Commercial Provides cover for the legal liability of the insured in Comprehensive Commercial / Private relation to bodily injury or property damage to others arising out of the business. Third party accident Commercial / Private Similar to public liability except it applies in relation to liability arising out of products Covers legal liability for wrongful advice on the part of a professional to a client. Provide cover for damage to crops as a result of fire or hail Provides cover for collision, fire, theft and third party accident motor vehicle Private (see below). Covers legal liability for damages to third party property arising from Private the use of the motor vehicle. Health Insurance In India, most people who have health insurance are covered under the Mediclaim policy for individuals. There are certain other health insurance policies also. Mediclaim Policy (Individual) This policy provides for reimbursement of hospitalisation/domiciliary hospitalisation expenses for illness/dis- ease or accidental injury sustained during the policy period. 143

The liability in respect of all claims for expenses incurred in hospital/nursing home - boarding, nursing, doctors’ fees, operation charges, diagnostics and anaesthesia, blood, oxygen, medicines and so on, shall not exceed the sum assured for the person during the period of insurance. Domiciliary treatment means medical treatment for a period exceeding three days for such illness/injury which in the normal course would require treatment at the hospital but actually taken whilst confined at home in India under any of the following circumstances namely: 1. Condition of the patient is such that he/she cannot be removed to the hospital, 2. The patient cannot be moved to the hospital for lack of accommodation therein. But expenses incurred for pre and post hospital treatment are not covered and certain ailments are also excluded. The insured is entitled to cost of health check-up not exceeding 1% of sum assured once in every four years subject to no-claim preferred during this period. Group Mediclaim Policy It is available to any group/association/institution/corporate body subject to a minimum number of persons to be covered. The coverage under this policy is same as under individual mediclaim policy but health check- up expenses are not payable and there are some other minor differences. Jan Arogya Bima Policy This is also similar to individual mediclaim policy and is available to individuals and family members with age limit (five to 70 years). However, children between age of three months and five years can be covered provided one or both parents are covered concurrently. The sum assured per person is restricted to Rs. 5,000 only. Cancer Policy for Members of: a. Indian cancer society - the insured member and his/her spouse are covered and if any of them contracts cancer, the cost of diagnosis, biopsy, surgery, chemotherapy, radiotherapy, hospitalisation and rehabilitation to the extent of Rs. 50,000 only for each claim. Two dependant children can also be covered for nominal premium of Rs. 50 per child. b. Cancer Patients Aid Association (CPAA) - In 1994, CPAA introduced the Cancer Insurance Policy in collaboration with New India Assurance Company. The policy is available to healthy individuals who have not suffered from cancer in the past. There is a 20-year comprehensive scheme and a full life scheme for various sums assured. Under these schemes, the policyholder has the benefit of a fresh limit every year to take care of his treatment expenses. The policy also covers free annual check-up at CPAA facilities. There is also a corporate policy in which 6,500 individual members are participating. Bhavishya Arogya Policy This is a deferred mediclaim policy for persons aged between 25 to 55 years. The retirement age to be selected may be between 55 to 60 years. 144

Overseas Medical Policy Overseas medical schemes are available under different plans (A to H) Videsh Yatra Mitra Policy This policy is another overseas mediclaim scheme with benefits comparable with those offered by foreign insurance companies like personal accident, illness, accident, loss of checked baggage or delay in its arrival, loss of passport and so on. Managed Health Care This is a new and innovative concept in health insurance. The services made available include wide network of hospitals/nursing homes where a policy holder can avail of cashless services i.e. admission to these hospitals without payment of admission fees or deposits and other expenses which are reimbursed to the hospital concerned by the insurer. 2.2 Debt Management Why do people borrow? There are various reasons which prompt people to borrow or avail of credit. Some of them are as follows: (a) (a). Consumerism If you do not have the cash to pay for your consumption requirements, naturally you will avail of credit. Increasing consumerism is making, people consume now and pay later. With credit, goods and services are available now, rather than later. (b). Contingency At times, the emergency fund may prove inadequate or lacking and one may have to borrow to meet these requirements. However, this option should be reserved for extreme emergencies as borrowing carries interest. (c). To buy a house - Everybody needs a house to live in and will have to borrow in most cases to fulfil this requirement unless there is an ancestral home to fall back upon. Even in such a case, one may borrow for repairs and maintenance. Details of such loans are provided under the section on types of loans in Topic 4. (d) Children’s education - Education loans are common nowadays and parents may act as guarantors or co-borrowers of the loan. (e) Children’s marriage - Marriage of children is a matter of pride in society and parents may not like to spare any expense. A personal loan may conveniently tide over the situation. However, along with advantages, borrowing also has its limitations: 145

a) One should borrow only as much as one can pay easily when repayments start. A detailed discussion on the ideal levels of borrowing is addressed in the section on Financial Statement Analysis in Topic 4. b) Debt is not free, it costs money in the form of interest. A debt trap should be avoided where one needs to borrow just to be able to repay old debts and interest. How to manage debt? a) Different individuals will have different debt tolerance levels. For example, a salaried person who is risk averse, may avail of lower debt even though his income is more regular than that of a businessman who is more risk-tolerant. b) Families where both spouses are working may be able to afford higher level of debt than families where just one spouse is working. c) It is best to repay debt taken at higher rates of interest with surplus funds, which may be earning lower interest. d) Though, most credit has limits on the overall borrowing from the side of the lender, we may impose our own limits on the level of borrowing as a percentage of annual income. Additional limits may be imposed to keep total equated monthly instalments below a certain level each month. Long Term Debt vs Short Term Debt Corporate and government bonds are issued by companies and agencies in need of money to carry out their daily operations. These debt instruments vary most importantly by their term to maturity. Maturity means the term of the bond or the date on which a loan must be repaid in full. The issuer of the bond or loan granter sets the maturity date, and in some cases the interest rate payable on the bond or loan. Short-term debt is that with a maturity of one year or less. This usually takes the form of bank loans, which carry a relatively low interest rate. Long-term debt consists of loans and bonds that have a maturity longer than a year. These bonds and loans generally carry a higher interest rate, as lenders demand a higher return in exchange for taking on the greater risk of loaning money over a long period of time. Short term debt financing is a source of ‘quick’ liquidity for the business, in particular SMEs, who do not have large pool of reserve funds for emergency uses. Small enterprises are more prone to short term shocks from their operating environment such as a large debtor declaring bankrupt, or an abruptly ceased partnership with a major supplier. Hence, short term debt financing provides almost immediate funds to tide over such difficult situations that could otherwise impact the going concern of SMEs. 146

Short term debt financing is usually easier to negotiate (compared to long term debts and equity financing), as the financier faces relatively lower credit risk. Due to the ease of negotiation, short term debt financing can be used to free up funds in the business for good investment opportunities that would otherwise have been foregone. Most short term debt financing instruments can be obtained without having to pledge a considerable amount of collateral, as long as the borrowing company has relatively stable operations and turnover rate (i.e. moderate business risk). The cost of servicing short-term credit is less taxing on the company. Short-term loans usually offer lower interest charges, and most suppliers do not charge interest at all until the credit allowance period is breached. But Short term debt financing has to be monitored closely to avoid bad relationships with suppliers and bankers, or a bad reputation in the industry for not paying debts on time. Short-term debts only meet working capital or immediate business needs. They are not useful for servicing any long term plans with larger capital requirements, higher risk, and longer payback horizons. In contrast to short-term borrowings, long-term debt is used to finance business investments that have longer payback periods. For example, the purchases of machinery, which may help the company, produce goods over a 5-year period. There are 2 main types of long term debt financing options: Basically, term loan is a loan with a repayment period of more than one year. It is usually taken by companies with longer investment or payback horizons, such as building of a new factory or purchase of new production equipment. Mortgage is basically a long-term loan, secured by collateral of some specified real estate property. The loan is normally amortized and the borrower is obligated to make periodic installments to repay the loan. Failing which, the lender can enforce its rights to possess the mortgaged property. Long term debt financing is usually more risky to the financier as it involves longer payback periods and thus higher credit risks. Hence, long-term debt financiers would usually require the borrowing company to pledge some form of asset as collateral. Such assets can range from inventories to factories and properties. The amount of funds that the company is able to obtain through long term debt financing would depend greatly on the value of assets, which the company is able and willing to pledge. Generally, long term debt financiers will also look at the credit worthiness of the borrowing company, in terms of its long term business prospects, cash flows, profitability, capital structure (debt-equity ratio) and other qualitative factors such as the transparency of operations, credibility and integrity of management etc. Long- term debt financiers such as financial institutions would usually require a set of up-to-date audited financial statements to perform their credit evaluation. Long term debt financing is usually less prone to short term shocks as it is secured by formally established contractual terms. Hence, they are relatively more stable than short-term debt. 147

Long term debt financing is directly linked to the growth of the company’s operating capacity (purchase of capital assets such as machinery). Long-term debt is normally well structured and defined. Thus fewer resources have to be channeled to monitor and maintain long-term debt financing accounts (compared to short term debt financing such as supplier credit which, changes overtime and need to be monitored on a regular basis). Long-term debt financing options such as leases offer a certain degree of flexibility, compared to having to purchase the asset (E.g. machinery). But Long term debt is often costly to service (interest charges are higher). Long term debt financiers usually demand a great amount of information from the company to perform its credit evaluation. Start-ups usually find it more difficult to obtain long term debt financing, or if they do, at unfavorable terms, as they have almost no proven track record, low cash flow, and small asset base. Long-term debt financing contracts normally contain a lot of restrictive clauses and covenants, including the scope of business operations that the company is allowed to engage in, capital and management structure limitations, etc. Fixed Rate vs Variable Rate Mortgage Fixed rate loan should typically mean the interest rate will remain fixed during the entire tenure of the loan. So, if you take a fixed rate loan for 15 years at 9% per annum, this will stay put through your 15 year loan period irrespective of whether interest rates rise or fall. However, in the Indian context, this is not always the case. Loans in which the interest rates are re-fixed at an interval of a few years are also called fixed rate loans. This interval period could be every two years, or three years, or five years, depending on the home loan company or bank. On the other hand, as far as a floating rate loan is concerned, the manner of its determination is very non- transparent. The bank will declare a benchmark rate. This home loan rate will be typically charged at a discount (lesser than the benchmark rate) or, in the case of some banks, at a premium (higher than the benchmark rate). An example will make this clear. Let’s say Bank A is offering you a floating rate loan at 9%. It will state that its benchmark rate is say, the Prime Lending Rate. (Or some such name that each bank or home loan players gives). This loan at 9% will be calculated at, say, a 1% discount to its PLR. Currently, If the PLR is 10%, so your loan will be 9%. Now let’s say that this PLR changes to 11%. The effective rate of your loan becomes 10% (11% - 1%). Loans are generally assessed by a lender on the basis of a borrower ’s capacity to repay the loan on time and, in the event he cannot, the ability of the lender to repay the debt with other assets. Thus, when approving finance, a lender will look to the borrower’s income and expenses to determine his/her ability to meet the repayments. A lender will normally look at the credit history of the loan applicant before 148

sanctioning the loan. For this reason, an applicant who is part of a co-operative credit society or has an existing banking relationship would find it easier to obtain loans, even, perhaps, at an advantageous rate of interest. A lender also considers other factors like purpose of loan, tenure, amount, guarantors and the type of security or collateral provided before extending the loan. He will look at the assets and may effect a ‘charge’ over the asset to protect their interests. A charge is a legally enforceable interest in the asset and provides the lender with rights to ‘seize’ and dispose of the asset in the event the borrower does not repay the loan. This process of effecting a charge over an asset is also known as ‘securing the loan’. Types of Loans 1. Mortgage - A mortgage is generally a loan secured against a property and used to purchase real estate. A mortgage is usually a loan where both the original (principal) of the loan and the interest charges are repaid over a specified period. As it is generally a very secure loan, the rates charged are often relatively low. At this stage, a short discussion on mortgages and their different types is warranted: Types of Mortgages A mortgage is transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or, to be advanced for the payment of loan, an existing or future debt or the performance of an engagement which may give rise to a pecuniary liability, as defined under Section 58(a) of the Transfer of Property Act, 1882. The characteristic feature in the case of a mortgage is that, the right created by transfer is accessory to the right to recover the debt. This means that when debt subsists, it is a mortgage but transactions taking place when debt is extinguished is a sale and not a mortgage. In simpler words, a mortgage of immoveable property is the transfer of the interest in the said property for securing a loan or money advanced or to be advanced or for the performance of an engagement. There are six different types of mortgages. These are: a) Simple mortgage - It is defined as: “where without delivering possession of the mortgaged property, the mortgagor binds himself personally to pay the mortgage money, and agrees, expressly or impliedly, that, in the event of his failing to pay according to his contract, the mortgagee shall have a right to cause the mort-gaged property to be sold and the proceeds of sale to be applied, so far as may be necessary, in payment of the mortgage money, the transaction is called a simple mortgage and the mortgagee a simple mortgagee.” In simple words, without the transfer of any property, if the mortgagor agrees that his property may be sold, if he fails to pay up any debt is a simple mortgage. Further, the mortgage can be effected or sale made in case of default, only through the intervention of the court. b) Mortgage by conditional sale - It is defined as “where the mortgagor ostensibly sells the mortgaged property on condition that on default of payment of the mortgage money on a certain date, the sale shall become absolute, on condition that on such payment being made, the sale shall become void, on condition that on such payment being made the buyer shall transfer the property to the seller, the transaction is called mortgage by conditional sale and the mortgagee is a mortgagee by 149

conditional sale.” In simple words, it involves an ostensible sale to start with which becomes absolute on default i.e. the sale becomes absolute in case of failure to repay the loan and void on payment i.e. if the loan is repaid on time, the ostensible sale becomes void or stands annulled. c) Usufructuary mortgage - It is defined as: “where the mortgagor delivers possession or expressly or by implication binds himself to deliver possession of the mortgaged property to the mortgagee, and authorises him to retain such possession until payment of the mortgage money, and to receive the rents and profits and to appropriate the same in lieu of interest, or partly in payment of the mortgage money, the transaction is called an usufructuary mortgage and the mortgagee an usufructuary mortgagee”. In simple words, possession stands transferred to the mortgagee and rents and profits from the property can be enjoyed by him till payment of the mortgage money. d) English mortgage - It is defined as: “where the mortgagor binds himself to repay the mortgage money on a certain date and transfers the mortgaged property absolutely to the mortgagee but subject to a proviso that he will re-transfer it to the mortgagor upon payment of the mortgage money as agreed, the transaction is called an English mortgage.” In simple words, the mortgaged property stands absolutely transferred to the mortgagee with a covenant to repay the mortgage money on a certain date by the mortgagor, when the property will be re- transferred to the mortgagor. e) Mortgage by deposit of title deeds - It is defined as: “where a person in any of the following towns namely the towns of Kolkata, Chennai and Mumbai, and in any other town which the state government concerned may, by notification in the Official Gazette, specify in this behalf, delivers to a creditor or his agent documents of title to immovable property, with intent to create a security thereon, the transaction is called a mortgage by deposit of title-deeds.” This is also known as ‘equitable mortgage’ in English law. In simple words, in this type of mortgage, the security for the money is intended to be created by deposit of the title deeds or papers of the property. This type of mortgage is quite common among bankers. f) Anomalous mortgages - It is defined as: “a mortgage which is not a simple mortgage, a mortgage by conditional sale, an usufructuary mortgage, an English mortgage or a mortgage by deposit of title deeds is called an anamolous mortgage”. For example a simple mortgage usufructuary is an anomalous mortgage which com-bines the features of simple mortgage and usufructuary mortgage. In such a mortgage, the mortgagee may sue for sale of the mortgaged property, though he could not have done so if it was only a usufructuous mortgage. In other words a simple mortgage giving an added right to take possession in case of default of payment becomes an anomalous mortgage and a suit for sale is permissible. 2 Overdraft facility - An overdraft facility against the security of a property is suitable where the amount of loan to be utilised is not determinable e.g. in repairs and maintenance of a property. The advantages of an overdraft facility are that interest is charged only on the drawn amount, there is no fixed liability every month and the loan amount can be repaid early without any pre-payment charges. However, the facility is available only for a year after which it can be reviewed. Some banks stipulate that commitment charges should be paid if the loan is not drawn and the interest is higher than a term loan. Unsecured overdraft facilities are also extended by banks. 3. Home equity - In the United States, loans are available against the security of residential property for any business activity or personal expenses whereas in India, a loan against house property is 150