The Economics of Insurance & Investments
Self-Study Course # 12
THE ECONOMICS OF INSURANCE & INVESTMENTS
Introduction
One of the earliest and most famous definitions of economics was that of Thomas
Carlyle, who in the early 19th century termed it the "dismal science." According to a
much- repeated story, what Carlyle had noticed was the anti-utopian implications of
economics. Many utopians, people who believe that a society of abundance without
conflict is possible, believe that good results come from good motives and good
motives lead to good results. Economists have always disputed this, and it was to the
forceful statement of this disagreement by early economists such as Thomas Malthus
and David Ricardo that Carlyle supposedly reacted.
Many other books of the period included in their definitions something about the "study
of exchange and production." Definitions of this sort emphasize that the topics with
which economics is most closely identified concern those processes involved in
meeting man's material needs. Economists today do not use these definitions because
the boundaries of economics have expanded since Marshall.
Economists do more than study exchange and production, though exchange remains
at the heart of economics. Most contemporary definitions of economics involve the
notions of choice and scarcity.
Perhaps the earliest of these is by Lionel Robbins in 1935: "Economics is a science
which studies human behavior as a relationship between ends and scarce means
which have alternative uses." Virtually all textbooks have definitions that are derived
from this definition.
Though the exact wording differs from author to author, the standard
definition is something like this: "Economics is the social science which
examines how people choose to use limited or scarce resources in
attempting to satisfy their unlimited wants."
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Economics as an area of study
Economics has been recognized as a special area of study for over a century. Virtually
all Economists maintain high profiles in governments, and they have been wellrepresented among the highest appointees in government. The press reports on their
doings and sayings, sometimes with praise and admiration, sometimes with ridicule and
scorn. Economics and economists are words that almost everyone has heard of and
uses. But what exactly is economics? Very few people can give a good definition or
description of what this field of study is all about.
If ordinary citizens cannot give a good definition or description of economics, they can
be excused because economists long struggled to define their field.
In addition, in recent years, the subject matter that economists have studied has
expanded, making its boundaries less defined. In recent years, for example,
economic journals have published papers on topics such as sex, crime, slavery,
childbearing, and rats. It is not surprising, then, that one economist, in a lighter
moment, suggested that economics can be defined as "what economists do." But
defining economics as "what economists do" does not tell us anything we did not
already know.
A good definition must explain what it is that makes economics a distinct subject,
different from physics or psychology. One should not expect to find a short definition
that conveys with absolute clarity all there is to know about economics (or else there
would be no reason to spend hours learning about it). Neither should one believe that
there is only one correct definition possible. Many good definitions are possible, and
each will focus on some important aspect of the subject. To use an analogy, there is
not one spot from which one can best view Niagara Falls.
Each viewpoint obscures some features and emphasizes others. There are, of course,
some spots that are clearly superior to others, but people can disagree about which is
the very best spot.
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How to Study Economics
Agatha Christie wrote a series of mystery novels in which she challenged the reader
to outwit her fictional heroine, Miss Jane Marple. By the end of the book, the reader
has the same facts that Miss Marple has. But the facts do not speak for themselves.
Rather it is Miss Marple's ability to look at those facts in a special way, to see
something significant where most readers see nothing, which lets her solve the
mystery.
Facts in economics, as in an Agatha Christie novel, need to be organized in some way
before they can tell one anything. By themselves they are meaningless. Thus, the
study of economics involves more than a memorization of facts. Economics tries to
organize facts with theory. Good theory tells us which facts are important and which
are not, and what is cause and what is effect. The study of economics involves learning
how to organize facts the way economists do.
People who do not understand economics still try to make sense of the world around
them by trying to see pattern in the facts they observe. Often they use a simplistic
"good-versus-bad" model. In a good-versus-bad model there are two conflicting groups
who are classified as good people and bad people.
These groups are usually involved in a zero-sum game: one person's gain is another's
loss. Further, evil motives, possessed by the bad people, lead to bad results unless
these people are in some way controlled. Good motives lead to good results.
An example of a good-versus-bad viewpoint was expressed at a town meeting of a
small community. The meeting focused on the gas shortages that the community was
facing. One citizen declared that the town faced not an energy problem, but a pricing
problem.
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He noted that several years previously there had been shortages of gasoline at 75
cents per liter but no shortages at $1.15.
Therefore, he declared, there must have been a conspiracy at that time by oil
companies to increase prices as there was now by gas producers. The events he
observed do fit into a good-versus-bad framework.
He saw a bad result. He saw a bad motive--the desire for profit seems to many people
the same as greed or avarice. To connect motive and result, he inferred the existence
of a conspiracy.
Although a good-versus-bad model is sometimes appropriate (especially in smallgroup situations), economists are very reluctant to use it. The economic model of
supply and demand gives a more sophisticated interpretation of the gasoline shortage,
one that is depersonalized and unemotional with no bad groups involved. This model
suggests that in cases of shortages one should search for government regulation of
prices.
The good-versus-bad model does not suggest that such regulation is something
one should look for. In fact there were price restrictions in place at the time, and
such restrictions can lead to shortages.
The good-versus-bad view of the world is attractive because we are able to
understand the model at a very young age and because we see the model used so
often: in fairy tales, in comic books, in movies, and in television shows, among other
places.
Because we know how to use this model, and because our culture discourages use
of alternative explanations such as fate or mystery, it is easy to fall back to this
model if we do not have a more sophisticated model to explain our world.
Economic issues affect us all and most people have opinions about them.
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These opinions may be based on a good-versus-bad view, some other non-economic
framework, or simply slogans that are often repeated.
Often the hardest problem students have in learning about how economists interpret
the world is to unlearn their old, non-economic views.
Unlearning old ways of thinking can be difficult, as a well-known example illustrates. In
the late 15th century Christopher Columbus believed that by sailing a relatively short
distance to the West, he could reach Asia. Contrary to popular myth, it was Columbus,
not his critics, who had an outdated view of the world.
He believed that the earth was much smaller and that Asia was much larger than they
actually are; his critics in their guesses were much closer to the truth.
Columbus made four trips to the Caribbean but he never realized the significance of
what he had found. He died believing that he had found a short cut to the Far East.
Rather than use the facts he had before him to alter and improve his ideas of
world geography, he insisted on keeping his old views and trying to make the
facts fit in.
Economic education involves learning to see reality from new perspectives. Sometimes
these new perspectives may surprise or even shock you. But if you take the time to
look at the reasoning behind these economic ways of looking at things, you will find
that they consist of carefully-thought-out-and-applied common sense.
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ECONOMICS: TWO AREAS OF STUDY
The economic life of our country rests on many complex factors and the study of
these factors are divided primarily into two segments:
1. MICROECONOMICS
2. MACROECONOMICS
MICROECONOMICS
Microeconomics concerns itself with determining the price we pay for products and
services, and what output is required by the market place. Also included in this study
is the impact of the Government’s role in market forces.
We could say that microeconomics deals with the small picture of the market forces.
To fully understand the microeconomic side of the economy, we need to understand
the importance and fundamental nature of the supply and demand concepts and
how they influence the operation of a market economy.
A good comparison of this modern economic equation can best be illustrated by
comparing to a market place selling natural foods (cereals, vegetables, meat) such as
found in Country Markets or (Jamaican Food & Straw Markets). The producer and
buyer meet face to face and haggle over the price, or the goods are auctioned off to
the highest bidder. In microeconomics, the system works the same way, but with
more influences that are invisible to the casual observer.
The study of microeconomics tells us the following facts about the behaviour of
the economy:
•
Consumer and producers interact to determine the price and output for goods
and services.
•
Consumer decisions are based on changes in the price of goods.
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•
Government regulations can influence consumer’s decisions.
At its simplest form, the price level determines the demand for a product. Other
factors of course influence this demand, but price is the primary motivation force.
Henry Ford’s credo for “a car for every family at a price that they can afford” is a
good example of this basic principal.
Economists define demand, as the relationship between the price of a product and
the consumer’s willingness to purchase. For easy illustration, we will defer the impact
of any other market forces by assuming that these forces remain constant.
Supply and Demand
Supply and demand is perhaps one of the most fundamental concepts of economics
and it is the backbone of a market economy.
Demand refers to how much (quantity) of a product or service is desired by buyers.
The quantity demanded is the amount of a product people are willing to buy at a
certain price; the relationship between price and quantity demanded is known as the
demand relationship. Supply represents how much the market can offer. The quantity
supplied refers to the amount of a certain good producers are willing to supply when
receiving a certain price. The correlation between price and how much of a good or
service is supplied to the market is known as the supply relationship. Price, therefore,
is a reflection of supply and demand. The relationship between demand and supply
underlie the forces behind the allocation of resources. In market economy theories,
demand and supply theory will allocate resources in the most efficient way possible.
How? Let us take a closer look at the law of demand and the law of supply.
The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price
of a good, the less people will demand that good. In other words, the higher the
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price, the lower the quantity demanded. The amount of a good that buyers purchase
at a higher price is less because as the price of a good goes up, so does the
opportunity cost of buying that good. As a result, people will naturally avoid buying a
product that will force them to forgo the consumption of something else they value
more.
Let us look at the demand schedule for automobiles:
DEMAND SCHEDULE FOR AUTOMOBILES
Price per Unit
Quantity Demanded
$20,000
4,000
18,000
10,000
16,000
18,000
14,000
30,000
12,000
42,000
10,000
50,000
As we can see from the previous chart, as the price of the unit decreases, the
demand increases correspondingly. Demand therefore is consumer willingness to
buy a certain product or service.
The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold
at a certain price. But unlike the law of demand, the supply relationship shows an
upward slope. This means that the higher the price, the higher the quantity supplied.
Producers supply more at a higher price because selling a higher quantity at a higher
price increases revenue.
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SUPPLY SCHEDULE FOR AUTOMOBILES
Price per Unit
Quantity Demanded
$20,000
76,000
18,000
60,000
16,000
52,000
14,000
30,000
12,000
16,000
10,000
12,000
Once again, if we were to create a graph from this information, we would see that the
supply curve slopes upward to the right illustrating that as price levels rise, producers
are willing to supply more products. This is referred to as the “Law of Supply”.
The Impact of Time
Unlike the demand relationship, however, the supply relationship is a factor of time.
Time is important to supply because suppliers must, but cannot always, react quickly to
a change in demand or price. So it is important to try and determine whether a price
change that is caused by demand will be temporary or permanent.
Let's say there's a sudden increase in the demand and price for umbrellas in an
unexpected rainy season; suppliers may simply accommodate demand by using
their production equipment more intensively.
If, however, there is a climate change, and the population will need umbrellas yearround, the change in demand and price will be expected to be long term; suppliers will
have to change their equipment and production facilities in order to meet the long-term
levels of demand.
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Supply and Demand Relationship
Now that we know the laws of supply and demand, let's turn to an example to show
how supply and demand affect price.
Imagine that a special edition CD of your favorite band is released for $20. Because
the record company's previous analysis showed that consumers will not demand CDs
at a price higher than $20, only ten CDs were released because the opportunity cost is
too high for suppliers to produce more. If, however, the ten CDs are demanded by 20
people, the price will subsequently rise because, according to the demand relationship,
as demand increases, so does the price.
Consequently, the rise in price should prompt more CDs to be supplied as the
supply relationship shows that the higher the price, the higher the quantity
supplied.
If, however, there are 30 CDs produced and demand is still at 20, the price will not
be pushed up because the supply more than accommodates demand.
In fact after the 20 consumers have been satisfied with their CD purchases, the price
of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs.
The lower price will then make the CD more available to people who had previously
decided that the opportunity cost of buying the CD at $20 was too high.
Equilibrium
When supply and demand are equal (i.e. when the supply function and demand
function intersect) the economy is said to be at equilibrium.
At this point, the allocation of goods is at its most efficient because the amount of
goods being supplied is exactly the same as the amount of goods being demanded.
Thus, everyone (individuals, firms, or countries) is satisfied with the current economic
condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.
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In the real market place equilibrium can only ever be reached in theory, so the prices
of goods and services are constantly changing in relation to fluctuations in demand
and supply.
Market Side
The supply side represents the manufacturers or suppliers side of the equation. Supply
decisions reflect a supplier’s willingness to produce and sell at the prevailing market
price and these factors all influence the quantity supplied. For most products, the
quantity supplied increases as the price level increases, all other factors remaining
constant.
Market Equilibrium comes about due to:
•
The forces of demand and supply lead to an equilibrium price and quantity.
•
If demand is greater than supply, price levels increase.
•
If supply is greater than demand, price levels decrease.
•
Only one price guarantees equilibrium.
The Laws of Supply & Demand then show us:
•
Quantity supplied increases as price increases.
•
As the price per unit decreases, the demand increases.
Supply therefore is a producer’s willingness to supply product as price increases.
COMBINING BOTH SIDES
When we combine both factors (Demand & Supply) on a graph where the two axis
cross, is known as “Market Equilibrium”.
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This will show the optimum price that will produce the largest number of sales. When
the prices are higher, producers will produce more than the buyers are willing to
purchase. This results in an oversupply, which causes the prices to fall. When the
prices fall to the level the buyers are willing to pay, this produces equilibrium. The
opposite effect occurs when prices are too low.
Other Factors Influencing Change
Previously we referred to other factors being held constant, but in actuality these
factors change frequently. When they do, they affect the supply and demand of
goods.
•
There are four fundamental shifts we can examine:
Results in increased demand
Positive demand shift
•
Negative demand shift
Results in a decrease in demand
•
Positive supply shift
Increases demand
•
Negative supply shift
Decreases demand
Demand Side Changes
Demand will increase (positive demand shift) if consumers have:
•
More income.
•
A change in preference.
•
A change in the price of substitute or complementary goods.
•
Change in the number of consumers.
If the opposite occurs, we will have a negative demand shift.
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Supply Side Changes
Supply will change if the following occurs:
•
Change in the cost of production.
•
Change in technology.
•
Changes in price of substitute or complementary goods.
In Canada, we “enjoy” a mixed system composed of “Market Forces” and
“Government Intervention”.
Government intervention is designed to achieve the following:
•
A fair distribution of income among individuals and
regions.
•
Encourage growth in employment and income, and protect low-income
earners. This intervention often takes the following forms:
Minimum Wages: Providing a floor for earnings, but not a
ceiling.
Rent Controls: Regulates the housing market costs for renters. This places a
maximum ceiling price and regulates increases.
Ultimately this creates a supply
shortage in rental housing.
Farm Marketing Boards: This intervention guarantees the price that farmers receive for
their products, thereby raising consumer prices. The Government uses quotas,
subsidies and floor prices to achieve their objectives.
Taxes: Taxes create huge government revenues and are applied at all levels. They
take the form of income, excise, corporate and goods and service taxes.
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As taxes are applied to pay for government health care schemes and OAS/CPP,
employment may drop.
MACROECONOMICS
Macroeconomics presents the “Big Picture” and analyzes the economic factors that
affect Nations and their relationship with other nations. If looks for answers on such
fronts as: Unemployment, Inflation, and Economic Growth (Business Cycle).
All Governments use indicators to reveal change in economic activity and to
maintain stable growth in three fundamental areas of employment, price levels and
output.
The price level is impacted by a broad range of prices in the economy and is
measured by a price index. Changes in price levels are measured by changes in a
price index over a period.
Consumer Price Index (CPI)
The most commonly used price index is the “Consumer Price Index”. This measures
over time the price level changes for a given “Common Basket of Consumer Goods”.
This basket of goods refers to those goods and services typically consumed by a
Canadian Family for necessities of life, such as food, shelter and clothing.
Subsequent changes in the CPI reflect in a consumer’s cost of living. If the CPI
increases faster than your income, your standard of living declines.
Each of the items in the basket is measured as to their importance to the average
family (e.g., Fuel Cost versus Vacation).
Two basic types of data are required to construct the CPI: price data and weighting
data. The price data are collected for a sample of goods and services from a sample
of sales outlets in a sample of locations for a sample of times. The weighting data are
estimates of the shares of the different types of expenditure as fractions of the total
expenditure covered by the index.
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These weights are usually based upon expenditure data obtained for sampled
periods from a sample of households. Although some of the sampling is done using
a sampling frame and probabilistic sampling methods, much is done in a common
sense way (purposive sampling) that does not permit estimation of confidence
intervals. Therefore, the sampling variance is normally ignored, since a single
estimate is required in most of the purposes for which the index is used.
The index is usually computed monthly, or quarterly in some countries, as a
weighted average of sub-indices for different components of consumer expenditure,
such as food, housing, clothing, each of which is in turn a weighted average of subsub-indices.
At the most detailed level, the elementary aggregate level, (for example, men's
trousers sold in department stores in the Atlantic Provinces), detailed weighting
information is unavailable, so elementary aggregate indices are computed using an
unweighted arithmetic or geometric mean of the prices of the sampled product offers.
(However, the growing use of scanner data is gradually making weighting information
available even at the most detailed level).
These indices compare prices each month with prices in the price-reference month.
The weights used to combine them into the higher-level aggregates, and then into
the overall index, relate to the estimated expenditures during a preceding whole year
of the consumers covered by the index on the products within its scope in the area
covered.
Thus the index is a fixed-weight index, but rarely a Laspeyres index. The
distinctive feature of the Laspeyres index is that it uses a group of commodities
purchased in the base period as the basis for comparison.
In other words, in computing the index, a commodity’s relative price (the ratio of the
current price to the base-period price) is weighted by the commodity’s relative
importance to all purchases during the base period.
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In a fixed-weight index the weight-reference period of a year and the price-reference
period, usually a more recent single month, do not coincide. It takes time to assemble
and process the information used for weighting which, in addition to household
expenditure surveys, may include trade and tax data.
Ideally, the weights would relate to the composition of expenditure during the time
between the price-reference month and the current month. There is a large technical
economics literature on index formulae which would approximate this and which can
be shown to approximate what economic theorists call a true cost of living index.
Such an index would show how consumer expenditure would have to move to
compensate for price changes so as to allow consumers to maintain a constant
standard of living.
Approximations can only be computed retrospectively, whereas the index has to
appear monthly and, preferably, quite soon.
Nevertheless, in some countries, notably in North America and Sweden, the
philosophy of the index is that it is inspired by and approximates the notion of a true
cost of living (constant utility) index, whereas in most of Europe it is regarded more
pragmatically.
The coverage of the index may be limited. Consumers' expenditure abroad is usually
excluded; visitors' expenditure within the country may be excluded in principle if not in
practice; the rural population may or may not be included; certain groups such as the
very rich or the very poor may be excluded. Black market expenditure and expenditure
on illegal drugs and prostitution are often excluded for practical reasons, although the
professional ethics of the statistician require objective description free of moral
judgments.
Saving and investment are always excluded, though the prices paid for financial
services provided by financial intermediaries may be included along with insurance
expenditures.
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The index reference period, usually called the base year, often differs both from the
weight-reference period and the price reference period. This is just a matter of
rescaling the whole time-series to make the value for the index reference-period equal
to 100. Annually revised weights are a desirable but expensive feature of an index, for
the older the weights the greater is the divergence between the current expenditure
pattern and that of the weight reference-period.
Each year changes are measured against a base year. This base year is moved
upwards occasionally to keep the numbers meaningful. Since 1980, the CPI has
increased by approximately 6% per year.
Recently the number has been much lower.
The Consumer Price Index in Canada
The Consumer Price Index (CPI) provides a broad measure of the cost of living in
Canada. While there are other ways to measure price changes, the CPI is the most
important indicator because of its widespread use, for example, to calculate
changes in government payments such as the Canada Pension Plan and Old Age
Security.
Through the monthly CPI, Statistics Canada tracks the retail price of a
representative shopping basket of about 600 goods and services from an average
household's expenditure: food, housing, transportation, furniture, clothing, and
recreation.
The percentage of the total basket that any item occupies is called the "weight" and
reflects typical consumer spending patterns. Since people tend to spend more on
food than clothing, changes in the price of food have a bigger impact on the index
than, for example, changes in the price of clothing and footwear.
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Calculating the CPI
Prices are measured against a base year. The base year is currently 2002, and the
basket for that year is given the value of 100. In 2015 the CPI reached in excess of
126, which means that what you could buy for $100 in 2002 cost $126 in 2015.
The Bank of Canada website has an Inflation Calculator that uses monthly CPI figures
from 1914 to the present to show users the impact of inflation on purchasing power.
The rate of increase of the CPI is typically reported as the percentage increase in
the index over the past 12 months. To provide a reliable picture of the short-term
trend of inflation, comparisons of month-to-month changes in the index are
adjusted to reflect predictable seasonal price changes.
Updating the CPI
The CPI basket is updated from time to time by Statistics Canada to reflect broad
changes in consumer spending habits, as well as to take account of changes in
products and services.
Because of the difficulties of measuring price changes due to changes in the quality of
products and other factors, the CPI may contain a certain measurement bias that
prevents it from giving a completely accurate picture of inflation. Recent studies of this
bias suggest that the CPI may overstate inflation by about half a percentage point.
The Bank of Canada monitors changes in the CPI in deciding when to adjust its
policy interest rate to keep inflation on target.
To assess the trend of inflation, the Bank finds it very helpful to monitor “core” inflation
measures, including the CPIX, which excludes eight of the most volatile components
(fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity
transportation, and tobacco products), as well as the effect of changes in indirect taxes
on the remaining components.
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The Bank monitors core inflation to help achieve the total CPI inflation target, not as a
replacement for it.
Inflation
Inflation is the increase in the general level of prices in the economy from one period to
another. The inflation rates are shown regularly and refer to the percentage change in
the price level.
During the past 20 years, Canada’s inflation rate was quite low, generally in the range
of 1% to 3%. In the early 1980s, by comparison, the inflation rate exceeded 10%.
If prices increase—but your earnings stay the same—you cannot continue to consume
as much as before. High inflation makes it more difficult for families, businesses and
governments to plan for the future.
With an annual inflation rate of 5% a year, the average price level would double in just
over 14.4 years. Reducing that rate to 3% means that it would take 24 years for prices
to double.
So, as inflation increases, our purchasing power decreases (money is devalued). As
it becomes more expensive to buy goods, our standard of living falls. The Bank of
Canada (our central bank) makes monetary and financial changes to offset the
effects of inflation and control its effect. If inflation continues on a regular basis, it
tends to become ingrained in the public awareness and becomes a self-fulfilling
prophecy.
Unemployment
The unemployment rate is calculated by dividing the total unemployed by the labour
force. The labour force is defined as the total numbers of people unemployed who are
actively looking for work, plus the total number of people employed. This calculation
does not include part-time employees or those who have given up on working. It
fluctuates from one time period to another and varies from group to group.
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Economic Growth
The Gross Domestic Product (GDP) determines economic growth. This measures all
income and output through a series of national accounts. A region's gross domestic
product, or GDP, is one of the ways of measuring the size of its economy. The GDP of
a country is defined as the total market value of all final goods and services produced
within a country in a given period of time (usually a calendar year). It is also considered
the sum of value added at every stage of production (the intermediate stages) of all
final goods and services produced within a country in a given period of time.
The most common approach to measuring and understanding GDP is the
expenditure method:
GDP = consumption + investment + (government spending) + (exports − imports), or,
GDP = C + I + G +G (XM)
Business Cycle
At the end of their fiscal year, all cash flow in and out, is added up to determine the
Gross Domestic Product. Economists make a distinction between real GDP and
nominal GDP (Annual). Economists adjust for the distortion caused by inflation by
measuring the fiscal output of goods and services in a given year against the prices of
a base year. This is known as real GDP.
The GDP may improve over a given period, but since economics actively follows a
cyclical pattern, the GDP will not always rise in a straight line.
It is important to note therefore that nominal GDP measures output using current
year prices whereas real GDP measures output using prices in a base year.
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The Canadian Economy moves in a familiar pattern of four cycles
•
Contraction
Slowdown in growth (recession)
•
Trough
Bottom end of the cycle.
•
Expansion
Growth increases (recovery)
•
Peak
Top end of the cycle.
The normal business cycle experiences continuous fluctuations with one cycle leading
(no matter how prolonged) to the next. Recession contraction is defined as two
consecutive quarters of declining growth in real GDP. Recessions are characterized
by low consumer confidence, high unemployment and stagnating wages.
Economic expansion on the other hand experiences increase in consumer spending,
growth and business profit. If expansion continued unchecked, shortages would
occur in skilled labour, raw materials and business investments.
In summary we should note:
When the economy expands:
1. Unemployment decreases.
2. Real GDP rises; and
3. Inflation begins to increase.
When the economy contracts:
1. Unemployment increases.
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2. Real GDP falls; and
3. Inflation decreases.
Macroeconomics Equilibrium
Economists use the same technique to determine equilibrium in the entire economy
as they did on the supply and demand side.
Instead of targeting any one price or supply, they apply the measurements against
the price level and output for the entire economy. This is accomplished by adding
up all the totals for the entire period.
On the demand side, this is known as the aggregate demand curve (AD). This
measures the relationship between the total amount of all output that consumers are
willing to purchase, and the price level of that output.
Aggregate demand is the sum of what consumers, governments, business and
foreigners, through exports and imports, spend in the economy.
On the supply side of the aggregate supply curve (AS), correlates the relationship
between the total amount of final goods and services all producers plan to supply
at a given price level.
Where these two curves cross over, when graphed, it shows the macroeconomics
equilibrium. The two curves are used to predict changes in the real GDP and
price levels and the curves reflect what occurs in macroeconomics measurement
curves.
Macroeconomic Policies
When equilibrium exists in the overall economy, no government intervention is
required.
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When market forces cause a change in equilibrium and this shift causes inflation or
unemployment to increase, the government has several tools called stabilization
policies at their disposal.
Fiscal Policy
Fiscal changes are implemented to directly affect consumer spending and saving
habits. Government spending or tax policies are used to shift aggregate demand to a
new level.
There are two types of policies that influence economic activity
1. Expansionary fiscal policy
Expansionary fiscal policy involves, the government increasing their spending or
cutting taxes, thereby creating additional consumer dollars for spending.
2. Contractionary fiscal policy
If the government feels the economy is heating up (inflation) they can reduce
spending and increase taxes, inducing a slowdown.
Monetary Policies
In recent times, the workings of the Bank of Canada, our central bank, have been
more apparent. The bank also uses monetary policies to affect the growth of the
economy.
Bank Rate
The central bank is the supplier of money to the chartered banks. The C.B.lends
money at interest, which is known as the prime rate. The chartered banks add on a
few percentage points to their clients.
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When the central bank changes prime, this signals a change throughout the system.
When the bank rate increases, it tightens the monetary policy. A reduction has the
opposite effect.
Open Market Operation
Daily the central bank influences the money supply by buying and selling
Government of Canada Treasury Bills to other banks, financial institutions and
individuals. If the bank wants to pursue an expansionary monetary policy, it buys
treasury bills for money on the open market, which has the effect of increasing the
money supply.
This creates a situation of easy credit (lose money), which allows the interest rate of
the commercial banks to fall, thereby increasing their lending capacities. Therefore,
expansionary policy increases the monetary supply and lowers interest rates.
If the central bank pursues a contractionary monetary policy, the opposite happens.
To do this, the central bank sells treasury bills on the open market, which are bought
by the financial institution, which withdraws money from deposits to pay for them.
This takes money out of the system, creating higher interest rates, creating tighter
money and reduced credit. Therefore, a contractionary monetary policy reduces the
money supply and raises interest rates.
To sum up, the Government Fiscal Policy uses a mixture of spending and tax changes
to alter spending and saving habits to influence economic activity.
A contraction reduces inflation and GDP and increases unemployment.
An expansion increases inflation and GDP and decreases unemployment.
International Trade
Canada does not exist in a vacuum, but is part of a worldwide network of tracking
partners, which affects both our standard of living and the value of our dollar.
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If we export more goods than we import, we are known as a net exporter. This can
change on a monthly basis.
The volume of imports and exports is greatly affected by our foreign exchange rate.
Our dollar exchanges with foreign currency at this price. It usually is measured
against the American Dollar. Late in the 90’s and during the first decade of the 2000s,
our currency appreciated (was more in demand internationally) and the rate rose to
parity and beyond. A rise in the exchange rate triggers an increase by foreign
investors in purchasing our securities.
Canadian Dollar Impact
The Canadian Dollar is hostage to the winds of global financial markets and
commodity prices no matter how wonderful Canadian domestic fundamentals - if
commodity prices are weakening, so too will the Canadian dollar.
Winners on the dollar's rise:
•
Canadians planning trips to the U.S.
•
Importers
•
Currency speculators
•
Companies who have much of their debt in U.S. dollars
•
Cross-border and online shoppers
Losers on the dollar's rise:
•
Canada's manufacturing sector
•
Auto parts makers
•
Lumber and paper companies
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Exporters of farm products such as wheat, corn and other foodstuffs
When the central bank pursues a contractionary (tight) monetary policy, our
currency depreciates and we do not attract as many foreign investors.
THE SOCIAL AND ECONOMIC VALUE OF INSURANCE
Insurance plays an important role in the functioning of our economy. Insurance should
be perceived not only as a protection mechanism, but more importantly as a
partnership that allows individuals and businesses to spread their wings and go where
they might otherwise not have dared to go. Insurance provides very real value to
individuals, institutions and the economy by providing a sense of security and peace of
mind, encouraging loss mitigation, increasing prosperity, and generally making people
more aware of the reality of risks and their consequences through information and
pricing signals.
The role of insurance as a social protection mechanism is perhaps what first comes to
mind when asked to think about its benefits. Indeed, by mitigating the effects of
exogenous events over which we have no control—illness, accident, death, natural
disasters—insurance allows individuals to recover from sudden misfortune by relieving
or at least limiting the financial burden.
In the case of health insurance, it could even mean the difference between life and
death. Insurance, however, has a far wider and more profound impact than
this
initial perception, though its value to society derives from this primary function.
Because it manages diversifies and absorbs the risks of individuals and companies,
insurance is often a precondition for the development of other productive activities,
such as buying a home and starting or expanding a business.
In turn, these activities fuel demand, facilitate supply and support trade—but are only
generally engaged in once the associated external risks are managed through
insurance. This facilitating effect operates also on an individual level, spreading out as
a natural consequence of its social protection value.
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An insured person who does not suffer undue financial loss after a sudden misfortune
will more easily maintain his purchasing power. The aggregate impact of insurance,
therefore, is to level consumption patterns and contribute more widely to financial and
social stability. This stabilizing factor is reinforced by the role of insurance as a long
term investor in projects and businesses. Insurance has a real effect on the global
economy, of course, through the sheer number of people that the sector employs. But
it also acts in a complementary fashion with the banking sector, offering easier access
to credit, channeling savings into long-term investments and providing greater
transparency and liquidity to the markets, thus providing further support and growth to
the economy.
In addition, insurance contributes to public s af e t y and new product development by
raising awareness about security, leading to improved safety requirements that save
lives and fuel innovation in the manufacturing sector (e.g. car insurance and seat
belts, home insurance and fire prevention).
Finally, as a risk management service provider, the insurance industry is ideally placed
to help design innovative products and contribute to solving urgent global societal
challenges such as population ageing and emerging threats such as climate change
and cyber risks.
The ways in which insurance contributes to society and economic growth can be
summed up as follows:
•
it allows different risks to be managed more efficiently;
•
it encourages loss mitigation;
it enhances peace of mind and promotes financial stability;
•
it helps relieve the burden on governments for providing all services of
social protection to citizens via social security systems;
•
it facilitates trade and commerce, supporting businesses and economic growth;
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it mobilizes domestic savings; and,
•
it fosters a more efficient allocation of capital, advancing the
development of financial services.
For these many reasons—insurance should rightly be perceived not only as a
protection and risk management mechanism, which pays out when a catastrophe
occurs, but more as a partnership that allows individuals and businesses to thrive.
Shared Responsibility
Insurance involves the management and mitigation of risk, and is based on a principle
of shared responsibility between insurer and insured. However, insufficient
communication from the insurance industry has largely contributed to a lack of
understanding of its benefit to society.
Whether we are conscious of it or not, risk permeates our lives. We are threatened
every day by the possible occurrence of events that can have severe social, human or
financial consequences: property damage, natural disaster, sickness, disability,
accidents in their myriad forms, and of course death. The best we can hope for is to
mitigate their consequences and thus alleviate our fear of their occurrence.
Since it addresses these two fundamental and interconnected human emotions—fear
and hope—insurance is an intrinsic part of society and social behaviour. In its most
obvious expression, insurance eases the financial burden of sudden misfortune and
loss for individuals or entities in the form of monetary compensation or services that
can sometimes mean the difference between financial security and poverty or
bankruptcy: providing for a family after the breadwinner dies, encouraging a person to
seek medical help without fearing the expense, assisting a homeowner or business
owner in rebuilding his property after a fire or flood, protecting both consumers and
manufacturers against a defective product.. Yet this begs the question: if the value of
insurance is so widespread, why is the industry so poorly understood and often
maligned or—at best—the victim of a longstanding reputation for staid conservatism?
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UNDERSTANDING INSURANCE
At its most basic and fundamental level, insurance involves individuals or entities
(policyholders) paying a fixed amount at regular intervals (premiums) into a common
fund from which money is drawn (payout for a claim) to compensate one or more
policyholders who are victims of a predefined event under specific circumstances.
The insurance policy—the agreement between insurer and insured—can therefore be
considered a compact based on mutual trust; a partnership whereby the insured prefers
to pay with certainty a defined amount to guard against an uncertain loss, the financial
consequences of which would be much higher without insurance, and the insurer
compensates for that loss in the event of misfortune. The key term in insurance is
risk— or rather, “shared risk”.
This notion of “shared risk” between individuals and insurers is important because it
underlines the ideas of solidarity and individual responsibility that are traditionally at the
root of insurance. Indeed, the aspect of solidarity in insurance cannot be sustained if
each individual participant in the insurance pool does not make himself responsible for
preventing and mitigating risk as much as he can.
And though public trust in the insurance system remains stable, policyholders
sometimes no longer perceive their premiums as payment for a shared risk but rather
as down payment towards a future reimbursement or for a service which they are due.
Reduction and Mitigation of Risk
Insurance plays a crucial role in alleviating people’s fear of sudden misfortune by
mitigating loss through services and /or financial compensation. By extension, it
contributes to the social protection of citizens by enhancing their financial security and
peace of mind. It also sends pricing signals that lead to improved risk-resilient
behaviour.
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We can separate insurance into two categories: health and life insurance; and
general insurance, or property/casualty or non-life insurance. Risk management
fundamentally involves three major principles—risk assessment, risk
prevention/mitigation and risk transfer—and insurance deals with all three
aspects.
Economic Spillover
Enhancing financial security and peace of mind enabling families and businesses to
remain financially stable in the face of hardship constitutes the primary social
protection mechanism of insurance that has many positive economic spillovers or
facilitating effects. Thus insurance can help maintain a decent standard of living and
quality of life after retirement in the case of certain life insurance products and longterm care insurance. It can prevent business interruptions that could lead to
bankruptcies, which in turn can result in job loss and economic hardship for
employees.
And the financial security offered by insurance removes the risk of destitution if
someone falls ill for any length of time or their house burns down. Misfortune can also
occur at the hands of a third party, such as damage resulting from car accidents or
faulty products. In these instances, liability insurance plays an important role in
protecting innocent victims via the tort system because compensation for negligence is
no longer limited solely to the perpetrator’s financial situation and can be
commensurate to the nature of the injuries suffered.
RISK MANAGEMENT
Micro-insurance
Micro-insurance is yet another important economic tool designed for emerging
economies. It consists of providing low-cost life, health, crop and property insurance in
low income societies where people have traditionally relied on an extended network of
family and friends for support.
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By extending insurance with low transaction costs, micro-insurance serves to protect
the most vulnerable areas from floods, hurricanes and drought, and contributes to
alleviating poverty and supporting economic growth.
Reduction and mitigation of loss
Just as insurance provides individuals with greater peace of mind, it also makes life
more predictable for businesses, facilitating corporate planning.
And similarly to how it impacts social behaviour, insurance promotes sensible
corporate risk management measures through pooling and transparent pricing.
When individuals no longer fear destitution from sudden misfortune, they may
feel
more inclined to spend on life’s comforts and make longer-term investments—and
have the funds to do so. Policyholders of certain types of life insurance do not have to
curtail excessively their spending in retirement. As a consequence of providing
financial security and acting as a social protection mechanism, insurance also
therefore contributes to more stable and even increased consumption, which in turn is
a driver of economic growth. This is a foundational role of the insurance industry.
There is a circular and long-run relationship between insurance market size and
economic growth, in particular life insurance in developed countries. This would
suggest not only that a growth of the insurance sector in developing countries is to be
expected as their economies expand (as individuals and business seek to manage
their new risk exposures) but also that an increase in the presence and availability of
insurance should be actively encouraged in order to stimulate economic growth.
Empirical studies have highlighted this positive correlation between insurance
development and economic growth.
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By warding off bankruptcies that could result from non-commercially related outside
events, insurance saves jobs—which means less human and social distress, less
burden on the state welfare system and, again, more regular consumption not only
from employees who keep their jobs but also from clients would otherwise not be
able to buy the company’s products.
Insurance has a significant impact on supply and demand. Product liability insurance
has an effect on businesses that would otherwise not be able to develop and
manufacture new products. In the case of terrorism insurance, some companies may
opt out of setting up businesses in certain regions because of a major potential threat,
but choose to make that commitment when insured against loss. For example,
London’s Canary Wharf or New York’s Wall Street could have lost their positions as
major financial services centers if businesses hadn’t been able to insure themselves
against the relatively higher level of terrorism risk in both locations.
Constructive Risk Taking
Risk ,in and of itself, is neither good nor bad; risk-taking behaviour, on the other hand,
can be construed as “good” or “bad” in that it can be either constructive or destructive.
Constructive risk-taking, for its part, is clearly visible when someone decides to start a
new business, since a successful business generates employment and increases
consumption. In this context, insurance allows entrepreneurs to focus on the
commercial and financial challenges of their business model without fearing the
negative consequences of sudden, non-business-related events. Insurance further
enables companies to put reserves to better use by reducing the need for liquidity
against potential loss and encouraging long-term investments in infrastructure and
new projects.
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The degree to which the alleviation of exogenous risk promotes business growth and
competition, frees up creative thought and fuels innovation cannot be overstated:
insurance allows individuals and companies to innovate, and expand their economic
activities by managing, diversifying and absorbing risks for them. In fact, many venture
capitalists require entrepreneurs to be insured before they invest. This highlights
another important benefit of insurance for the economy— access to credit—which also
exists at the consumer level if one considers that it is almost impossible to obtain a
mortgage loan without homeowner insurance, even when it is not required by law.
A recent article in the magazine LifeHealthPro provides true-life examples of how life
insurance enabled the development, or even survival, of well-known icons such as
Disneyland and McDonald’s. “After failing in the pursuit of traditional means of
financing to build what would become Disneyland, Walt (Disney) decided to provide his
own financing. A large part of this came to be by collaterally borrowing money from his
cash value life insurance. Similarly, Ray Kroc, who bought out the McDonald brothers
in 1961, borrowed money from two cash value life insurance policies to pay salaries of
key employees for the first eight years of operation.
The Benefits of Long Term Investment
These contribute to alleviating poverty and creating new asset classes, as well as
supporting clean energy and eco-friendly projects. The effect is
developing countries, where life insurance assets
noticeable in
provide the basis for investments
in long-term projects such as infrastructure.
Indeed, emerging market infrastructure investment represents a potentially important
new asset class that can generate r e l i a b l e , long-term income and serve t o pay the
pensions of rapidly ageing populations.
The funds for long-term investments derive primarily from insurance products with a
long-term investment horizon such as life insurance as well as from dynamic capital
freed up by businesses that do not have to build up precautionary savings thanks to the
existence of insurance.
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As it has been shown, this long-term financing is a key driver of growth and prosperity in
the economy by amassing huge funds in the form of premium income, insurers
encourage long-term savings and help drive up the savings rate. In this way, the
insurance industry adds financial depth to the economy by channeling these savings
into investments in primary and secondary equity markets, corporate bonds and real
estate, thus transforming dormant or unproductive capital into more dynamic, long- term
capital.
Insurance and Systemic Risk
Insurance expertise is a vital requirement in the ongoing debate on systemic risk—the
threat posed by large institutions to the global economy in the event of a failure—and
the need to regulate financial institutions even at the highest regulatory levels. It has
been demonstrated, however, that core insurance activities do not present systemic
risk—that in fact the insurance industry acted as a source of stability during the recent
financial crisis.
The benefit of insurance in mitigating systemic risk has historical precedence. During
the Great Depression insurance proved to be a source of stability in a time of
upheaval and life insurers in particular “played an important role as a source of capital
in the ensuing years.” Indeed, in a context of high volatility such as exists today, “a
sector that can ride out this volatility has an important role to play.”
The first reason why insurers do not add to instability but rather serve a stabilizing
role lies in the structural functioning of insurance, i.e. it is pre-funded by up-front
payments of premiums.
The risks of those events taking place which might trigger payments are actuarially and
stochastically calculated, and the appropriate reserve funds are set aside.
Furthermore, since these events can generally not be triggered voluntarily, a run on
insurance companies is an alien concept to the sector, in stark contrast to the muchdreaded run on banks.
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There are also generally built-in disincentives in the form of penalties for policyholders
to surrender a contract, if the option for surrender exists at all, particularly in the case of
life insurance.
A second reason is the lack of interconnectedness between the insurance industry and
other financial sectors, and the industry’s independence from economic cycles
(different individuals in different geographical regions are affected by risk differently
and at different times). In other words, and based on the detailed research available
today, the failure of even a large insurance company would not destabilize the wider
financial market. In contrast to the banking sector, the insurance industry already has a
longstanding framework for recovery and resolution intended to protect policyholders in
the event of failure.
Insurance—A stabilizer in the last crisis
Insurers are long-term investors who contribute to stabilizing financial markets by
providing liquidity at critical times when those markets dry up. As such, they act as a
powerful counter-cyclical force and provide social benefits generated by their
investments in addition to long-term investment gains.
As alternate accumulators of large amounts of capital, institutional investors such as life
insurers and pension funds compete directly with banks, thereby improving the
performance and overall efficiency of the financial sector.
Because of their ability to make substantial funds available for long-term investments,
insurance companies are important stakeholders with professional management
systems in many national and multinational corporations—and as such exert efficient
checks and balances over the firms in which they invest. Indeed, with a vested interest
in more stable long-term revenue streams, insurers are more inclined to apply positive
pressure in adopting more prudent investment practices, encouraging greater
transparency in the equity markets and reining in “short-termism”.
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In a situation such as what existed after the financial crisis of 2008, with banks
pulling back from longer-term financing and reducing their purchasing of bonds and
securities, insurers also helped to improve the liquidity of the market in an
essential way by providing additional sources of funds.
Through its expertise in risk management and investment, and its underwriting and
pricing experience, the insurance industry is uniquely suited to play a key role in
meeting the changing needs of society and to offer comprehensive solutions that
address current and emerging threats. Increased public-private cooperation is
essential in confronting major global challenges such as population ageing, climate
change and other emerging risks.
Looking to the future
Since the advent of the internet, cyber- attacks— particularly in the form of social
engineering and data theft—have become far more pernicious and potentially
devastating than ever before, executed by professionals often working for organized
crime or foreign nation states. There are a number of far-reaching potential liabilities
for businesses, including: operational risks, financial risks, intellectual property risks,
legal and regulatory risks, and reputational risks. As it has done in the past—indeed
since its modern beginnings with marine insurance—the insurance industry can also
contribute to heightening the awareness of the issue by sending pricing signals (e.g.
refusing to cover certain risks if companies don’t enforce minimum security standards).
As some noted scholars have indicated, insurance offers the broader economy
three decisive strengths:
• The ability and independence to assess risk, including judgements as the
limits of insurability;
• The capacity to create insurance products to internalize external cost (e g., of
dreaded events);
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• And, most important of all, having the right incentive to impose provisions and
measures to manage risk exposures that can render dreaded events more
unlikely.
It is indeed important to remember why insurance is so pervasive (and usually
voluntarily so) in the developed world today and increasing its presence in the
developing world— because it answers some of our most basic needs and it is
generally far less costly in the long run to be insured than uninsured.
ECONOMICS AND INSURANCE
As noted above, insurance plays a central role in the functioning of modern
economies. Life insurance offers protection against the economic impact of an
untimely death; Heath Insurance covers the sometimes extraordinary costs of
medical care; and bank deposits are insured by the federal government (CDIC). In
most cases, the insured pays a small premium in order to receive benefits should an
unlikely but high-cost event occur. Insurance issues, traditionally a stodgy domain,
have become subjects for intense debate and concern in recent years.
The Basics
An understanding of insurance must begin with the concept of risk—that is, the
variation in possible outcomes of a situation. A’s shipment of goods to Europe might
arrive safely or be lost in transit. B may incur zero medical expenses in a good year,
but if she is struck by a car they could be upward of $100,000.
We cannot eliminate risk from life, even at extraordinary expense. Paying extra for
double-hulled tankers still leaves oil spills possible. The only way to eliminate autorelated injuries is to eliminate automobiles.
Thus, the effective response to risk combines two elements: efforts or expenditures
to lessen the risk, and the purchase of insurance against whatever risk remains.
Consider A’s shipment of, say, $1 million in goods.
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If the chance of loss on each trip is 3 percent, the loss will be $30,000 (3 percent of
$1 million), on average. Let us assume that A can ship by a more costly method and
cut the risk by one percentage point, thus saving $10,000, on average. If the
additional cost of this shipping method is less than $10,000, it is a worthwhile
expenditure. But if cutting risk by a further percentage point will cost $15,000, it
sacrifices resources.
To deal with the remaining 2 percent risk of losing $1 million, A should think about
insurance. To cover administrative costs, the insurer might charge $25,000 for a risk
that will incur average losses of no more than $20,000. From A’s standpoint, however,
the insurance may be worthwhile because it is a comparatively inexpensive way to
deal with the potential loss of $1 million. Note the important economic role of such
insurance: without it, A might not be willing to risk shipping goods in the first place.
In exchange for a premium, the insurer will pay a claim should a specified
contingency— such as death, medical bills, or, in this instance, shipment loss—arise.
The insurer— whether a corporation with diversified ownership or a mutual company
made up of the insureds themselves—is able to offer such protection against financial
loss by pooling the risks from a large group of similarly situated individuals or firms.
The laws of probability ensure that only a tiny fraction of these insured shipments will
be lost, or only a small fraction of the insured population will face expensive
hospitalization in a year. If, for example, each of 100,000 individuals independently
faces a 1 percent risk in a year, on average, 1,000 will have losses. If each of the
100,000 people paid a premium of $1,000, the insurance company would have
collected a total of $100 million. Leaving aside administrative costs, this is enough to
pay $100,000 to anyone who had a loss.
But what would happen if 1,100 people had losses? The answer, fortunately, is that
such an outcome is exceptionally unlikely. Insurance works through the magic of the
law of large numbers. This law assures that when a large number of people face a lowprobability event, the proportion experiencing the event will be close to the expected
proportion.
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For instance, with a pool of 100,000 people who each face a 1 percent risk, the law of
large numbers says that 1,100 people or more will have losses only one time in one
thousand.
In many cases, however, the risks to different individuals are not independent. In a
hurricane, airplane crash, or epidemic, many may suffer at the same time. Insurance
companies spread such risks not only across individuals, but also across good years
and bad, building up reserves in the good years to deal with heavier claims in bad
ones. For further protection, they also diversify across lines, selling both health and
homeowners’ insurance, for example.
The risks normally insured are unintentional, either due to the actions of nature or
the inadvertent consequences of human activity.
Terrorism creates a new model for insurance for three reasons: (1) the losses are
man- made and intentional. (2) Massive numbers of people and structures could be
harmed. (Theft losses fall in the first category, but not in the second.) (3) Historical
experience does not provide a yardstick for assessing likely risk levels. Nuclear war
presented equivalent challenges in the twentieth century. Had there been a significant
nuclear war, insurance companies simply would not have paid. The losses would
have been too massive to pay out of assets, and many of the assets underlying the
insurance would have been destroyed. In time, appropriate insurance arrangements
for this new category of massive risk will be developed.
The Identity and Behaviour of the Insured
An economist views insurance as being like most other commodities.
It obeys the laws of supply and demand, for example. However, it is unlike many other
commodities in one important respect: the cost of providing insurance depends on the
identity of the purchaser. A year of health insurance for an eighty-year-old costs more
to provide than one for a fifty-year-old. It costs more to provide auto insurance to
teenagers than to middle-aged people.
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If a company mistakenly sells health policies to old folks at a price appropriate for
young folks, it will assuredly lose money, just as a restaurant will lose if it sells twentydollar steak dinners for ten dollars. The restaurant would lure lots of steak eaters. So,
too, would the insurance company attract large numbers of older clients. Because of
the differential cost of providing coverage, and because customers search for their
lowest price, insurance companies go to great pains to set different premiums for
different groups, depending on the risks each will impose.
Recognizing that the identity of the purchaser affects the cost of insurance, insurers
must be careful to whom they offer insurance at a particular price. Those high-risk
individuals whose knowledge of their risk is better than that of the insurers will step
forth to purchase, knowing that they are getting a good deal. This is a process called
adverse selection, which means that the mix of purchasers will be adverse to the
insurer.
The concept of adverse selection
Adverse selection is a situation where an insurer’s portfolio includes substantially more
high-risk people compared to the average population. This situation can arise when, for
example, mostly people with risky profiles seek a specific insurance coverage because
of advantageous premiums. Such a positive correlation between risk and insurance
makes the diversification of risks difficult (since insureds will tend to have similar
exposures), and the pooling of risks becomes not only ineffective but can possibly
increase the chance of claims far out-weighing the amounts covered by premiums.
Insurance companies safeguard against adverse selection through careful screening,
which is the primary explanation for the myriad forms often required for certain kinds of
insurance as well as the differences in premium rates.
As an example, a company that charges flat rates across the board for life insurance
could run the risk of attracting an inordinate amount of smokers, and would not be
protecting itself against this outcome by being able to charge higher premiums for this
higher-risk category of insureds.
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Another example resides in the growing need for long-term care (LTC) as populations
worldwide but especially in developing countries tend to live longer lives. This presents
a particular challenge to insurers to make LTC products attractive to both parties, i.e.
low enough premiums to make it palatable for consumers but not too low as to be
detrimental to the insurer—a delicate balance to strike for a product that tends to
interest people only as they approach old age and are most at risk. For these
situations, insurers are developing solutions such as combining LTC insurance with
life insurance because they are complementary (i.e. an individual cannot be at high risk
for LTC and life insurance), or group insurance.
Employee-sponsored plans, for instance, reduce the impact of the voluntary opt-in
aspect of LTC that contributes to adverse selection, and avoid underwriting and antiselection concerns.
What leads to this adverse selection is asymmetric information: potential purchasers
have more information than the sellers.
The potential purchasers have “hidden” information that relates to their particular risk,
and those whose information is unfavourable are thus most likely to purchase. For
example, if an insurer determined that 1 percent of fifty-year-olds would die in a year, it
might establish a premium of $12 per $1,000 of coverage—$10 to cover claims and $2
to cover administrative costs.
The insurer might naively expect to break even. However, insureds who ate poorly or
who engaged in high-risk professions or whose parents had died young might have an
annual risk of mortality of 3 percent. They would be most likely to purchase insurance.
Health fanatics, by contrast, might forgo life insurance because for them it is a bad
deal. Through adverse selection, the insurer could end up with a group whose
expected costs were, say,
$20 per $1,000 rather than the $10 per $1,000 for the population as a whole; at a
$12 price, the insurer would lose money.
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The traditional approach to the adverse selection problem is to inspect each potential
insured. Individuals taking out substantial life insurance must submit to a medical
exam. Fire insurance might be granted only after a check of the alarm and sprinkler
systems. But no matter how careful the inspection, some information will remain
hidden, and a disproportionately high number of those choosing to insure will be high
risk. Therefore, insurers routinely set high rates to cope with adverse selection. Alas,
such high rates discourage ordinary-risk buyers from buying insurance.
Though this problem of adverse selection is best known in insurance problems, it
applies broadly across economics. Thus, a company that “insures” its salesmen by
offering a relatively high salary compared with commission will end up with many
salesmen who are not confident of their abilities. Colleges that insure their students by
offering many pass- fail courses can expect weaker students to enroll.
Moral Hazard or Hidden Action
While insurance is designed to allow people to act more serenely and more positively
with the prospect of financial security in the event of misfortune, it could also be
perceived as enhancing risky behaviour because the associated risk is mitigated and
insureds don’t have to bear the consequences of their actions. An example of this
would be a homeowner neglecting ageing water pipes or a car owner with
comprehensive car insurance being more careless about knocks and scratches.
There is no doubt that the existence of insurance can at times result in negative rather
than positive behaviour. For this reason the issue of moral hazard has sometimes
been raised to dampen the argument that insurance acts as a social protection
mechanism by suggesting that insurance does as much harm as good.
However, much of the debate centers on opposing opinions on the correct balance
between social welfare and personal responsibility, and not on life and non-life
insurance where benefits are generally perceived to outweigh the negative
consequences of moral hazard, even in contested areas such as healthcare.
Insurance companies nevertheless attempt to address the issue of moral hazard and
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rectify risky behaviour by the proper pricing of premiums and limiting the level of
compensation or imposing a deductible or a co-pay system, all approaches which
require the insured to share part of the loss. In the example above, the car owner will
now presumably be more careful because he will have to pay for minor scratches but
does not have to fear severe consequences in the case of serious damage. But there
are some situations where moral hazard can be so pronounced that insurance
companies may choose not to cover them, e.g. covering track racing for nonprofessional drivers in a regular car insurance policy. Moral hazard highlights the
degree to which insurance starts with individual responsibility.
Some governments actually offer pension insurance – and this induces
companies to underfund and weakens the incentives for their employees to
complain. Federally subsidized flood insurance encourages citizens to build
homes on floodplains. Moral hazard really comes down to this: people respond to
incentives.
To address moral hazard, ideally, the insurer would like to be able to monitor the
insured’s behaviour and take appropriate action. Flood insurance might not be sold to
new residents of a floodplain. Collision insurance might not pay off if it can be proven
that the policyholder had been drinking or had otherwise engaged in reckless
behaviour. But given the difficulty of monitoring many actions, insurers accept that
once policies are issued, behaviour will change adversely, and more claims will be
made.
The moral hazard problem is often encountered in areas that, at first glance, do not
seem associated with traditional insurance. Products covered under optional
warranties tend to get abused, as do autos that are leased with service contracts.
Equity Issues
The same insurance policy will have different costs for serving individuals whose
behaviour or underlying characteristics may differ. Because these cost differences
influence pricing, some people see an equity dimension to insurance.
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Some think, for example, that urban drivers should not pay much more than rural
drivers to protect themselves from auto liability, even though urban driving is riskier.
But if prices are not allowed to vary in relation to risk, insurers will seek to avoid
various classes of customer altogether, and availability will be restricted. When sellers
of health insurance are not allowed to find out if potential clients are HIV-positive, for
example, insurance companies often respond by refusing to insure, say, nevermarried men over age forty.
Equity issues in insurance are addressed in a variety of ways in the real world. Most
employers cross-subsidize health insurance, providing the same coverage at the same
price to older, higher-risk workers and younger, lower-risk ones. In pursuit of equity,
governments may set insurance rates, as many provinces do with auto insurance. The
traditional public-interest argument for government rate regulation is that it serves to
control a monopoly.
But this argument fails with auto insurance: in most regulated insurance markets, there
are dozens of competing insurers.
Insurance rates are regulated to help some groups—usually those imposing high
risks—at the expense of others. In some jurisdictions, high-cost drivers are subsidized
at the expense of all other drivers.
Such practices raise a new class of equity issues. Should the government force people
who live quiet, low-risk lives to subsidize the high-risk fringe? Most people’s response
to this question depends on whether they think people can control risks. Because most
of us think we should not encourage people to engage in behaviour that is costly to the
system, we conclude, for example, that non-smokers should not have to pay for
smokers.
The question becomes more complex when it comes to health care premiums for, say,
gay men or recovering alcoholics, whose health care costs are likely to be greater than
average. Moral judgments inevitably creep into such discussions. And sometimes the
facts lead to disquieting considerations.
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Smokers, for example, tend to die early, reducing expected costs for public health care
and OAS. Should they, therefore, pay lower taxes?
Government’s Role in Insurance
Government plays four major roles with insurance: (1) Government writes it directly,
as with programs like Old Age Security and Guaranteed Income Supplement. (2)
Government subsidizes insurance: quite explicitly in some programs (e.g., crop and
flood insurance). (3) Government mandates a residual market for high risks.
Governments hold down prices in such markets either by creating a fund to cover
losses or by requiring insurers who participate in the voluntary market to pick up a
certain portion of this high- risk market. (4) Government regulates matters such as
premiums, insurance company solvency (to make sure that insureds get paid), and
permissible criteria for pricing insurance (e.g., for auto insurance, rating a client for
race and ethnicity are banned everywhere).
The three main regulatory approaches to pricing have been: (1) prior approval
(regulators must approve rates before they go in effect); (2) use and file (companies
set rates, but regulators can disallow them subsequently if they are found excessive);
and (3) open competition (a market-based system in which rates are deemed not
excessive as long as there is competition).
Empirical studies conflict as to whether regulation leads to lower prices.
Government participates far more in insurance markets than in typical markets. The
two great dangers with government participation in insurance arise when, as is
common, the goals for participation remain vague (e.g., promoting the insured
activity, redistributing income, or spreading risk effectively), or when its expected
cost is not recognized in budgets.
With insurance, as with all government endeavors, the citizenry deserves to know
both the rationale and the cost.
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The role of insurance
The traditional role of insurance remains the essential one recognized centuries ago:
that of spreading risk among similarly situated individuals. Insurance works most
effectively when losses are not under the control of individuals (thus avoiding moral
hazard) and when the losses are readily determined (lest significant transactions costs
associated with lawsuits become a burden).
Individuals and firms insure against their most major risks—high health costs, the
inability to pay depositors—which often are politically salient issues as well. Not
surprisingly, government participation—as a setter of rates, as a subsidizer, and as a
direct provider of insurance services—has become a major feature in insurance
markets. Political forces may sometimes triumph over sound insurance principles, but
such victories are Pyrrhic. In a sound market, we must recognize that with insurance,
as with bread and steel, the cost of providing it must be paid.
BEHAVIOURAL ECONOMICS AND INSURANCE
It is easy for a consumer to make mistakes in the insurance market, especially when
deciding whether to purchase insurance against low-probability, high-consequence
(LP- HC) events. Consumers have a hard time collecting and processing information to
determine the likelihood and consequences of these risks which (by definition) they
have had limited or no experience.
Hence, people often rely on feelings and intuition rather than careful thought when it
comes time to decide what coverage to purchase
On the supply side, insurance companies face the risk of experiencing large claims
payments, only part of which can be spread or diversified away through the law of large
numbers if losses are highly correlated.
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Decision makers in the insurance industry and those who regulate, litigate, and
legislate about insurance are also likely to make mistakes for the same reasons that
consumers do — they sometimes are forced to rely primarily on their intuition rather
than undertaking deliberative thinking because they have limited information from past
experience on which to base their decisions.
According to insurance theory, those at risk benefit from incurring a small cost in the
form of a premium to obtain protection against an event that could produce significant
financial losses but that has a low probability of occurrence. If insurance can be
offered with relatively small administrative costs so it is reasonably priced, a risk
averse individual should prefer a smaller certain premium to taking the chance of
experiencing a large loss. If properly designed and priced, insurance also offers
incentives in the form of premium reductions for people who mitigate their risk in a cost
effective way, if the insurer can accurately incorporate the impact these mitigation
measures will have on reducing the likelihood and/or consequences of events for
which they offer financial protection.
There is considerable empirical evidence that many consumers fail to take advantage
of insurance protection against losses of life, property and health, and do not invest in
efficient loss reduction measures in the LP-HC setting. In both cases they fail to
behave in ways that would not only benefit them personally, but might also enhance
social welfare if there are societal concerns about people’s wellbeing.
Behavioural economics offers some explanations for these decisions and suggests
remedies. However, designing these solutions may require interventions by public and
private institutions beyond just structuring information and options to take advantage of
individuals’ decision processes.
To illustrate this point, field and controlled experiments in behavioural economics
reveal that consumers are sometimes more likely to select a default option rather than
going to the trouble of opting out in favour of some other alternative.
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These findings have been used to encourage consumers to choose options that are in
their best interests, such as “Save More Tomorrow” plans that encourage consumers
to earmark a portion of their increased earnings into retirement savings. To date, this
framing technique has been applied to situations where the outcome is either known
with certainty, or when the chosen option (such as setting up an automatic deposit
RRSP program), has a higher expected return than the other options. For decisions
under uncertainty that involve insurance, the economic benefits of having coverage are
reaped only when the (low-probability) loss-producing event occurs.
It is unlikely that most people who failed to purchase insurance would reverse course if
a loss did not occur, or purchase coverage even if insurance were the default option. In
this regard, there is considerable empirical evidence that insurance behaviour is
guided by misperception of the risk, and the use of simple but inappropriate heuristic
decision rules. Many who do not purchase property and such health policies as Critical
Illness and Long Term Care insurance perceive the likelihood of a serious event to be
below their threshold level of concern. Individuals are often unwilling to voluntarily buy
insurance coverage against a particular risk until after experiencing a loss. Many who
purchased a policy are likely to cancel it if they have not made a claim after several
years because they consider their insurance purchase to be a poor investment
decision. It may thus be necessary to utilize more stringent policy tools, such as
premium subsidies or mandatory coverage, to induce individuals to protect themselves
when they should have protection. Mandating insurance against losses from natural
disasters or serious illnesses can also be justified from the vantage point of social
welfare if the majority of citizens feel that those at risk should protect themselves
financially before losses occur rather than relying afterwards on federal and provincial
assistance (i.e., taxpayers’ money).
Justifying such requirements politically has proven to be difficult given individuals’ lack
of interest in voluntarily purchasing coverage against LP-HC events.
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Mandatory auto insurance coverage (in most provinces), for example, requires
consumers to buy coverage at reasonable or even favourable premiums while
recognizing the need to make the purchase of insurance more feasible for low- and
medium-income individuals.
Measures of this nature encourage the adoption of risk reducing measures. Other
countries have also incentivized individuals to undertake protective measures and
mandated the purchase of insurance against natural disasters and health risks. In the
case of natural hazards, in France, New Zealand and Spain, the government plays a
key role by providing insurance coverage against all disasters and requiring those at
risk to protect themselves with insurance.
With respect to health insurance, all developed countries have compelled virtually
universal coverage of catastrophic medically-related expenses, with financing through
tax or tax-like instruments.
Even so, challenges to such universal requirements persist in all countries. Mandates
usually permit exceptions (for higher income people, for non-citizens, for certain
classes of risk or types of medical care).
Poor Insurance Decisions
For LP-HC events such as natural disasters, terrorism or catastrophic health-related
expenses, not only consumers but also insurers and regulators often do not behave in
accordance with any logic, but, instead follow their intuitions. After a severe loss,
insurers may refuse to continue to offer coverage against this risk because they focus
on the losses from a worst-case scenario without adequately reflecting on the
likelihood of this event occurring in the future. Even when decision makers make an
effort to think carefully, the intuitive appeal of some heuristics implies that they still
make mistakes.
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While intuitive processes often lead to reasonably good decisions, they do not work
well for LP-HC events, either because of a decision maker’s undue focus on a recent
event or because individuals perceive the likelihood of an extreme event to be below
their threshold level of concern.
Deliberative thinking with respect to assessing risks requires considerable time and
attention and the use of decision tools such as probability estimation, and the use of
formal logic.
Consumers at risk would ideally make their decision on whether to purchase
insurance – and if so, how much coverage – by comparing the expected costs and
benefits of a set of different alternatives available to them using models of choice
such as expected utility theory or decision analysis. If insurance premiums reflected
risk and households used these more formal models, those facing an LP-HC event
would purchase coverage. If all consumers at risk (rather than just a fraction of them)
undertook deliberative thinking, then flood insurance and catastrophic health
insurance coverage would be viewed as highly valuable and would be purchased by
almost everyone. Research into flood insurance in the U.S., for example, has shown
that consumers tend to ignore rare risks until after a disaster occurs. This is a principal
reason why individuals tend to purchase insurance only after a disaster and cancel
their policies several years later when they have not suffered a loss and perceive the
likelihood of a disaster as so low that they do not pay attention to its potential
consequences. This behaviour occurred even in situations where homeowners were
required to purchase flood insurance as a condition for a federally insured mortgage.
The relatively thin market for catastrophic coverage is due to the unwillingness of a
majority of buyers to pay a relatively small additional premium for essentially
unlimited coverage.
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It is easy to understand how consumers make mistakes about insurance. Surprisingly,
insurance managers, despite high levels of expertise and strong incentives to make
logical decisions, also make errors with respect to situations where there is
uncertainty or ambiguous information regarding the low probability risks they face.
When insurers have
limited data and limited past experience with extreme events, there is a tendency for
them to engage in intuitive thinking when determining what coverage to offer against
specific risks and how much to charge.
To illustrate, prior to the terrorist attacks of September 11, 2001, actuaries and
underwriters, despite their mathematical expertise and experience, did not specify a
price for protection against terrorism coverage nor did they exclude this coverage from
their standard commercial policies. This implied that they were essentially covering
this risk for the very modest add-on for unspecified events included in typical property
insurance premiums. The failure to examine the financial risks associated with
terrorism was surprising given the attempted bombing of the World Trade Center in
1993, the 1995 Oklahoma City bombing and other terrorist attacks throughout the
world.
Following 9/11, most insurance companies completely changed course and refused to
offer coverage against terrorism, considering it to be an uninsurable risk despite
increased buyer demand. The few who did provide insurance charged extremely high
premiums for coverage. Prior to these terrorist attacks Chicago’s O’Hare Airport had
$750 million of terrorism insurance coverage at an annual premium of $125,000. After
9/11, insurers offered the airport only $150 million of coverage at an annual premium of
$6.9 million. The new cost per dollar of coverage was 275 times higher than the old
cost! The airport was forced to purchase this policy since it could not operate without
coverage. Meanwhile the Golden Gate Park in San Francisco was simply unable to
obtain terrorism coverage at any price.
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If actuaries and underwriters had used estimates based on more formal models of
choice that characterize deliberative thinking for determining protection against these
extreme events, they would have more accurately estimated the change in likelihood of
future terrorist attacks in different parts of the country and their potential
consequences. Insurers could then have determined what types and amounts of
coverage they would want to offer and the prices they would have to charge so as to
maximize their expected future profits based on their current portfolio of policies. It
seems implausible that they would have concluded that the likelihood of terrorist
attacks took such a large jump as to call for the kinds of premiums just described.
In contrast, private insurance companies have been willing to offer catastrophic
health coverage in Critical Illness polices.
Because illnesses that are financially catastrophic for patients are uncorrelated, even
insurance carriers of moderate size are not concerned about a large loss relative to
their portfolio from a single person’s high medical expense.
Improving Insurance Choices
A key challenge in utilizing economic incentives for improving insurance choices is that
they may be viewed by some citizens as being unfair or inequitable. Suppose, for
example, the house that a homeowner purchased years ago is now categorized as
being in a floodplain, or a family’s vacation cottage on the coast faces a greater risk of
damage due to climate change. At the time the property was bought, damage from
climate change and floods may not have been considered a problem. Or suppose
some people’s current health status is adversely affected by past behaviour or genetic
disease propensities.
Premiums that reflect their current property or health-related risk are likely to be viewed
as unfair by the affected individuals who feel they are too high. But for insurance to
operate efficiently, it is necessary for insurers to raise premiums for those now facing a
higher likelihood of a property loss or illness.
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Insurers would then be in a position to charge lower premiums to those that have low
expected claims, so that purchasing coverage is viewed as an attractive option for this
group. If premiums do not reflect the hazardous location of property or adverse genetic
conditions, insurance will be ipso facto subsidized for these high-risk individuals. They
will have less reason to undertake actions to reduce their risk because they will not be
rewarded with lower premiums. Another result will be that lower- risk consumers who
undertake deliberative thinking will tend to purchase less insurance.
In fact, they will likely run away from coverage if premiums are set higher than they
should be, perceiving insurance to be a bad buy. On the other hand, the high risks will
insure even small losses because they consider coverage to be a bargain. In
summary, insurance is a policy tool that has two principal purposes – encouraging cost
effective investment in loss reduction measures via premium reductions, and providing
financial protection should those at risk suffer severe losses.
A system of insurance where premiums are not risk-based fails to address these two
objectives effectively. Insurers will have limited or no financial incentive to offer
reductions in premiums to individuals if they undertake loss reduction measures. In
fact, insurers are losing money on these individuals in the long run and would prefer
that they bought coverage elsewhere. Individuals who are charged too high a premium
are unlikely to purchase coverage.
To address these challenges insurance experts have proposed the adoption of the
following principles which are designed to make insurance more transparent,
understandable and equitable with the dual objectives of improving individual and
social welfare:
Principle 1
Require insurance against rare catastrophic risks. Given the reluctance of
individuals to voluntary purchase insurance against losses that are large relative to
their wealth or income, catastrophic coverage should be required for all individuals
who face this risk.
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Principle 2
Premiums must reflect risk. Insurance premiums should accurately reflect risk to
signal to individuals how safe and healthy they are and to encourage individuals to
undertake measures to reduce their vulnerability to illness and/or property losses by
reducing their premiums. Risk-based premiums should also reflect the cost of capital
that insurers must integrate into their pricing to assure adequate return to their
investors.
Principle 3
Any special treatment given to consumers at risk (e.g., low-income uninsured, highrisk moderate income groups, or inadequately insured individuals) should be means
tested and subsidized by government (as is the case with Canada’s province health
care systems).
Principle 4
Multi-year insurance. A multi-year policy provides stability of premiums since it
prevents individuals from being reclassified into higher risk strata during the term of
the contract. Such policies currently exist for life insurance and long term care
coverage.
Under Protection
A primary example of inadequate coverage is in the areas of life insurance. Although
most people do have some life insurance protection, they may buy too little and often
make the mistake of dropping their coverage soon after purchasing it because they feel
the premiums are too high given budget constraints. Life insurance tends to be a
concern of the middle class and above, and largely protects the bequests they leave to
their middle class heirs so there is little concern by others and hence no public
intervention. The availability of CPP death and survivors’ benefits further attenuates the
public policy motivation to deal with this problem.
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Over Protection
Over-purchasing insurance is another story. Many people purchase more coverage
than needed. The most prevalent case is deductible aversion: the desire for low
deductibles. By undertaking deliberative thinking, a person would realize that he or
she could save so much more on the premium reduction from purchasing a high
deductible on automobile, homeowners’, or individual health insurance when
compared to the expected benefits in the form of additional claims payments should
one suffer a loss.
There are many hypotheses about why people make this mistake: they overestimate
the chances of collecting on the lower deductible, they want to increase the chances of
collecting on their policy so they can view insurance as a positive investment, or they
just want peace of mind and freedom from regret. There are some serious puzzles in
the literature regarding this anomaly. Many individuals do not make a claim on their
policy when their losses exceed the deductible, which suggests they should have
taken a higher one. If insurance markets are competitive, how can overpriced low
deductible plans survive?
Then there are some cases where insurance or insurance-like arrangements can be
bundled with other products. Individuals often go for the bundle even when portions of
the package are overpriced. Insurance for rental cars, appliance warranties, or the
purchase of flight insurance all exhibit this characteristic. These examples show that
individuals clearly misunderstand the purposes of insurance. There are almost no
regulations beyond standard consumer protection rules that are intended to affect the
usual cases of anomalous over-purchase.
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Helping Consumers to make better choices
One thing that could be done to help consumers make better insurance decisions
would be to stretch out the time horizon when presenting information on the likelihood
of an LP- HC event occurring. Rather than saying that there is a 1 in 100 chance next
year of damage from a severe hurricane, reframe the same probability by saying that
the chance that one’s property will be damaged from a hurricane in the next 25 years is
greater than 1 in 5. Empirical studies have shown that data presented in this fashion
leads individuals to take protective measures. One of the biggest challenges is to
convince consumers that if they don’t suffer losses from a disaster or incur health
related expenditures next year, the purchase of insurance was not a waste of money. It
is extremely difficult to get the message across that those at risk should celebrate not
having collected on their insurance policy. One way to do this is to remind people that
something serious could happen to them next year, so they should not cancel their
insurance policy without good reason.
Financial Market Participants
Before insurers decide to pull out of the market or raise rates significantly after a
serious loss, they should characterize worst-case scenarios and then assign a best
guess probability to each of these events occurring and the uncertainty surrounding
these estimates.
As well an effort should be made to provide transparent information related to the
rationale for insurance. This should go a long way to helping the general public
better understand this policy tool. Insurance can then fulfill the roles it is designed
to play: reducing future losses and financially protecting those at risk.
FINANCIAL MARKETS
The health and operation of the economy is affected by many components, none
more important than the segment known as the Financial Markets. This affects the
rate of growth, prices, exchange rates, and distribution of wealth and income.
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For the economics system to function well, money must flow from the individuals
who have it (savers) to those that need it (borrowers).
This is accomplished by:
Direct financing
With direct financing, the borrower goes directly to the investor and borrows funds.
Indirect financing
Indirect financing on the other hand uses a financial intermediary or middleman to
provide the funds. In Canada the chartered banks, trust and insurance companies as
well as other savings and lending institutions accomplish this.
Financial intermediaries use economies of scale to minimize the following:
•
Cost of borrowing
•
Monitoring of borrowers.
•
The risk of invested funds.
There are four main participants, namely:
1. The Central Bank.
2. Deposit Intermediaries.
3. Contractual Savings Intermediaries.
4. Investment Intermediaries.
Central Bank (Federal Government’s Bank)
•
Lender of last resort.
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•
Overseas and conducts monetary policy.
•
Preserves the value of the dollar.
Deposit Intermediaries (Savings)
•
Chartered Banks.
Schedule 1.
•
Trust Companies.
Schedule 2.
•
Credit Unions.
•
Mortgage Loan Companies.
Contractual Savings Intermediaries (Deposits of Periodic Payments)
•
Life Insurance Companies.
•
Pension Funds.
•
Property and Casualty Insurance Companies.
•
Canada and Quebec Pension Funds.
Investment Intermediaries
•
Mutual Funds Companies.
•
Investment Dealers.
•
Consumer Loan Companies.
•
Business Finance Companies.
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FINANCIAL MARKET STRUCTURES – DEBT AND EQUITY MARKETS
Fund borrowers may utilize debt instruments such as: Bonds, Debentures or
Mortgages. These financial instruments are legal documents that require the borrower
to pay the lender certain amounts at fixed intervals (interest payments) until a
specified date (maturity date). The maturity date is the date the bonds expire
(repayment of principal). Interest is paid at stated intervals until the maturity date,
when the borrower repays the principal.
A debt instrument can be:
1. Short Term - One year or less to repayment.
2. Medium Term - Between one to ten years to repayment.
3. Long Term - Longer than ten years to repayment.
EQUITY INSTRUMENTS
Raises funds by the issue of shares that creates ownership in the Corporation.
Primary and Secondary Markets
Primary Markets only sell new issues of a security. Brokerage Houses act as
intermediaries and underwrites the securities by guaranteeing the price received by
the corporation or government issuing them. Initial Public Offerings (IPO’s) are
usually pre- sold and not available to the public.
Secondary Markets are reselling securities that have already been issued through
the primary market. Stockbrokers and dealers sell them without a price guarantee.
This is the main market for buying and selling securities.
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Exchange and Over the Counter Markets
Stock Markets arrange for buyers and sellers to interact in one physical location.
Over the Counter Markets (OTC)
Traders operate by telecommunication networks and do not meet in one specific
location. Each party holds an inventory of securities and they buy and sell when prices
are acceptable.
Market Types
1. Money Markets trade securities with maturity dates of one year or less.
2. Capital Markets trade securities with maturity dates on one year or longer.
Foreign Exchange Market
Currency is bought and sold on the foreign exchange market, which is currently trading
a trillion dollars a day.
Buying Wholesale or Retail
If a buyer requires smaller amounts of currency from a chartered bank or institution,
they buy retail.
If they require very large sums, subsequently to be resold in smaller amounts to their
customers, they buy wholesale.
FINANCIAL MARKET INSTRUMENTS
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Money Defined
Money performs three vital functions:
1. Medium Exchange - Used to buy goods and services.
2. Unit of Account - Used to measure the monetary value of goods and services.
3. Store of Value - Maintains its purchasing power from the time something of value
is purchased until it is sold.
Money Market Instruments
Securities are usually held for a short-term period and have smaller price fluctuations.
Government of Canada Treasury Bills (T-Bills)
•
Debt instruments purchased by corporations, other Governments and consumers
to finance Federal Government deficits.
Short Term Government of Canada Treasury Bills
•
Bonds, which have a maturity date of less than three years, carry a fixed interest
rate. Equal in security to a T-Bill.
Provincial and Municipal Short Term Notes and Bonds
•
Carry interest rates that are determined by the credit rating of their issuer.
Bankers Acceptance
•
Bank drafts are issued by a firm and have a stated maturity date (30 – 90 days)
that are guaranteed by a bank for a fee and are virtually risk free.
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CAPITAL MARKET INSTRUMENTS
These instruments generally mature in one year or longer.
Stocks
Equity shares in a Corporation.
Government of Canada Bonds
Long-term debt instruments that have specific maturity dates, interest rates and is
highly liquid.
Canada Savings Bonds
Sold directly to the consumer and always maintains their face value and may be
cashed at any time.
Provincial Bonds
Issued by Provincial Governments.
Municipal Bonds
Issued by local government and regulated by Provincial statutes to finance projects.
Corporate Bonds
Used to finance short or long-term activities. Lower credit rating than government
bonds, hence a higher interest rate.
Warrants
Certificates that give an individual the option to buy, but not the obligation, a
stated number of shares, at a specified price for a specified period.
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OTHER MARKETS
Currency
Notes and Bills issued by the Bank of Canada.
Demand Deposits
Issued by deposit accepting institutions.
Savings Deposits
Major source of funds for chartered bank and lending institutions.
Mortgage Loans
Loans secured by real estate property.
Mutual Funds
Investment Firms used pooled funds to reduce the risk to individual investors
through diversification. Monies are invested in stork market instruments.
Insurance Policies
Insurance Companies collect premiums, which are invested and guarantee
payments to beneficiaries of policies.
Options Market (Formal Contracts)
Options that give an individual the right, but not the obligation, to buy and sell a
security at a specified price for a stated period of time.
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Interest Rates
Interest rates are what the borrower of funds must pay for the use of funds and what
the provider of the funds receives for allowing them to be used. The same rule
applies in the financial market, but may be expressed in a different way.
Interest rates in the money and capital markets are determined in the same way as our
analysis of supply and demand. For example, when the demand for bonds and the
supply of bonds are equal, there is an interest rate that satisfies this condition and this
is known as the equilibrium point of the bond markets.
Points to Note:
•
T-Bills are sold to central banks, financial institutions and individuals. These
are generally sub-divided and retailed to other investors, financial institutions
or individuals.
•
The quantity of T-Bills depends on many factors, such as the wealth of the
buyer, expected return and risk as compared to other investments.
•
The Supply of T-Bills depends on the actions of the Bank of Canada and
Government budget changes.
•
Price and interest rates on financial assets move in opposite directions. As
the interest rate of a T-Bill increase, the price of the T-Bill falls.
•
T-Bills (as well as Bonds) are purchased at a discount e.g. $1,000 T-Bill sells for
$900 and matures in 91 days. The $100 difference is the interest earned.
PRESENT VALUE VS. FUTURE VALUE
The concept that a dollar today is worth more than a dollar tomorrow is the basis of the
concept underlying the time value of money. Simply put, a dollar invested today
earning interest will grow in value when the interest is paid. If the dollar plus interest is
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automatically reinvested for a further period, new interest will be earned on both the
dollar and original investment, and on the interest already earned as this is repeated
over a period, we call the result “Compounding Interest”. Most time value of money
problems involves three known and one unknown.
Present Value Growing to Future Value
Present Value represents the original investment that we have in hand today. Future
value represents what that investment will grow to when interest is earned on a
sequential renewal of investment where the original investment, plus all interest
earned keeps being reinvested for subsequent periods until maturity.
Formula for Future Value of a Single Sum would be:
FV = PV (1 +I) ²
Term Definitions
I
Annual interest rate (%)
N
Number of compounding periods
PV
Present Value (initial sum)
FV
The future value (or end amount at the end of N periods)
(1 + I) ²
The interest factor
Example: $10,000 invested in a 5 year GIC, earning 6% interest compounded
annually, will grow to (Future Value) $13,382.26.
The knowns are:
•
The amount
•
The length of time invested
•
The interest rate and how often it is paid but,
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•
We do not know what it will grow to until we solve the future value.
•
Using a financial calculator simplifies the process.
Present Value of a Single Sum (In the Future)
Conversely, if we start out knowing that in five years, the single sum we have is
$13,382.26 and we know the interest rate and how often the interest will be
compounded, we could solve for the present value.
In the future value, we are adding on interest to determine what sum our initial
investment will grow to. When we solve for present value, we must take the final sum
and discount it by the interest factor by working backward from our known single sum.
The formula for Present Value would be:
PV = F V
(1 + 1) ²
Term Definitions
PV
Present Value
FV
Future Value (1 + 1) ² = the interest rate
factor
I
Discount interest rate
N
Number of discounting periods
Example: $10,000 is the final sum to be received from a three-year term
bond earning 6% per year.
•
Present Value invested $8,396.14 at 6% interest (annually) will grow in 3 years to
$10,000.
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Key Points
•
Present value is the beginning value or amount of a payment discount by a
given interest rate.
•
Future value is the amount a payment will grow to by a given future date
when compounded by a given interest date.
Future Value of an Annuity
In the previous examples, we dealt with single sums of either at the start of the
calculation or as the result of the calculation. The following deals with a series of
equal payments or receipts over a fixed number of years. This is known as an
Annuity.
Annuities come in two types:
1. If the receipts on payments are made at the end of the period, we have an
ordinary annuity or deferred annuity.
2. If the receipts or payments occur at the beginning of the period, we have an
annuity due.
Key Points:
•
Annuity therefore is a series of equal payments or receipts over a fixed
number of years.
•
An Annuity due occurs when payments are made at the beginning of the year.
•
An Ordinary Annuity occurs when payments are made at the end of the year.
Income for $1,000 will be received at year-end each year for 3 years. This income will
be invested at 6% annually. What we need to know is what this will accumulate to at
the end of three years.
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•
If the payment is made at the first of the year the future value will be $3,374.62.
Present Value of an Annuity
The concept of present value is used to determine the current value of a future
stream of income. It is used to determine how much needs to be invested today, at
interest, to pay a sum of money at a certain time in the future.
ECONOMICS AND SAVING
Saving means different things to different people. To some, it means putting money
in the bank. To others, it means buying stocks or contributing to a pension plan. But
to economists, saving means only one thing—consuming less out of a given amount
of resources in the present in order to consume more in the future. Saving,
therefore, is the decision to defer consumption and to store this deferred
consumption in some form of asset.
Saving is often confused with investing, but they are not the same. Although most
people think of purchases of stocks and bonds as investments, economists use the
term “investment” to mean additions to the real stock of capital: plants, factories,
equipment, and so on.
In recent years Canadians consumers have been saving a smaller and smaller
portion of their income, in absolute terms and when compared to other countries.
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Why do countries save at different rates? Economists do not know all the answers.
Some of the factors that undoubtedly affect the amount people save are culture,
differences in saving motives, economic growth, demographics, how many people in
the economy are in the labour force, the insurability of risks, and economic policy. Each
of these factors can influence saving at a point in time and produce changes in saving
over time.
Motives for Saving
The famous life-cycle model of Nobel laureate Franco Modigiani asserts that people
save—accumulate assets—to finance their retirement, and they dissave—spend their
assets—during retirement. The more young savers there are relative to old dissavers,
the greater will be a nation’s saving rate. Most economists believed for decades that
this life- cycle model provided the main explanation. But in the early 1980s, Lawrence
H. Summers of Harvard showed that most wealth accumulation is saving that is
ultimately bequeathed or given to younger generations. The motive for bequests and
gifts from older to younger citizens is unclear. A very large component of the bequests
may be unplanned, simply reflecting the fact that many people do not spend all their
savings before they die. In this case, people save to consume, not bequeath, but end
up bequeathing nonetheless.
In recent years, a much larger fraction of the retirement savings of the elderly has
been annuitized. That is, the savings take the form of company pensions, CPP and
OAS which pay until death, with no payments after the person dies. Having your
retirement finances come in the form of an annuity eliminates the risk of living longer
than your money lasts. One possible result of the increased annuitization of retirement
assets may be that people, especially those who have already retired, have less
incentive to save more in case they “live too long.”
The precautionary motive—that is, the motive to save in order to be prepared for
various future risks—is one of the key reasons people save. Besides the risk of living
longer than expected, people save against more mundane risks, such as losing their
job or incurring large uninsured medical expenses.
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Computer simulation studies show that the amount of precautionary saving can be
very sensitive to the availability of insurance against these and other kinds of risks.
For example, the decision not to insure low-risk but high-cost health expenditures such
as nursing-home care can lead to a 10 percent increase in national saving.
Another issue related to motives and preferences for saving is the role of the rich in
generating aggregate saving. Do rich Canadians account for most Canadian saving?
Not really. Relative to their incomes, some of the rich save a lot, and some dissave.
So, too, for the poor. There is considerable mobility of wealth in Canada, at least over
long periods of time. The fact that the ranks of the rich are continually changing
suggests that some of those who are initially rich dissave and dissipate their wealth,
while others who are not initially rich save considerable sums and become rich. Former
heavyweight champion Michael Tyson, for example, grossed an estimated $400 million
during the heyday of his boxing career but ended up declaring bankruptcy. Sam
Walton, who started Wal-Mart, started life in poverty and ended as one of the richest
people in the world.
Economic Growth and Demographic Change
A country’s saving rate and its economic growth are closely connected. This follows
from the life-cycle model. If there are more young people around than old people
because the population is growing, there will be more workers saving for their
retirement than there will be retirees who are dissaving, that is, spending down their
assets. This will leave overall net saving positive. The higher the population growth,
other things equal, the higher will be the saving rate. The same is true of technical
change. Suppose there are the same number of young people around as old people,
but the young earn more than did the old because of technological change. Then the
young will save more than the old will save, which, again, will imply a positive saving
rate.
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In an economy not experiencing growth in technology or population, one would expect,
at least in the long run, saving to be zero, with the exception of the saving needed to
replace depreciating capital. If there is no engine for growth, in the long run the saving
the young do for retirement, to leave bequests, or for any other reason would exactly
offset the dissaving of retirees, leaving the economy’s total saving at zero. The
economy would have positive assets (claims to capital) but would experience no
increase or decrease in the level of these assets over time.
That an economy’s overall long-run saving rate is zero does not mean that no one
saves or dissaves. Rather, it means that the positive savings of those accumulating
assets exactly balance the negative savings of those decumulating assets. For
growing economies, long-run saving is likely to be positive to ensure that the stock of
capital assets keeps pace with the number and productivity of workers.
Recent years have seen a large increase in the number of workers and in productivity
per worker. The increase in the number of workers is due to baby boomers entering
the workforce. The increase in productivity is due to the fact that baby boomers are in
their peak years of productivity, and also due to a growing capital stock and to
technological improvement, especially in information and communications technology.
The fact that these factors did not suffice to raise Canadian saving rates means that
other forces, to be discussed below, reduced national saving.
Labour-Supply Decisions
National saving is the difference between national income and national consumption.
Labour income represents about three-quarters of national income. So changes in
labour income, if not accompanied by equivalent changes in consumption, can greatly
affect an economy’s saving rate. Take, for example, the recent remarkable increase in
Canadian female labour force participation. In 1975 half of the women age twenty-five
to forty-four participated in the labour force; by 1988 more than two-thirds were in the
labour force.
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This increase in the female labour supply is a major reason, if not the main reason, for
the rise in Canadian per capita income since 1975.
If the additional net-of-tax income these women earned had all been saved, the
Canadian saving rate after 1980 would have exceeded 20 percent. Because much of
the increase in labour supply was by women age eighteen to thirty-five, particularly
married women, one would expect them to have saved some portion of that income for
their old age. Assuming this did occur, we need to look elsewhere to understand the
puzzle of why Canada’s savings fell.
Adding to the puzzle is the ongoing increase in the expected length of retirement.
More and more Canadians, particularly men, are retiring in their late fifties and early
sixties.
At the same time, life expectancies continue to rise. Today’s thirty-year-old male
can expect to live to his early 80s. If he retires at age fifty-five, today’s thirty-yearold will spend more than half of his remaining life in retirement. Economic models
of saving suggest that aggregate saving should depend strongly and positively on
the length of retirement. Thus, with the retirement age decreasing and life
expectancy increasing, economists would expect people to save a lot more—not
a lot less.
Economic Policy
Government policy also can have powerful effects on a nation’s saving. To begin
with, governments are themselves large consumers of goods and services. More
government consumption spending does not, however, necessarily imply less
national saving. If the private sector responds to a one-dollar increase in government
consumption by reducing its own consumption by one dollar, aggregate saving
remains unchanged.
The private sector’s consumption response depends critically on who pays for the
government’s consumption and how the government extracts these payments.
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If the government assigns most of the tax burden to future generations by borrowing
in the present and repaying principal plus interest on the borrowing in the future,
current generations will have little reason, other than concern for their offspring, to
reduce their consumption expenditures.
If current generations are forced to pay for the government’s spending, the size of the
private-sector consumption response will vary according to which generation foots the
bill. The older the people who are taxed, the larger will be the reduction in
consumption. The reason is that older people, being closer to the ends of their lives,
consume a higher share of their remaining lifetime resources than do younger ones.
Thus, taxing retirees, say, instead of forty-year-old workers, will reduce private-sector
consumption and increase national saving.
Finally, different taxes have different incentive effects. For example, the government
might raise its funds with taxes on capital rather than taxes on labour income. By
lowering the after-tax return to saving, taxes on capital income discourage saving for
future consumption and thus reduce saving.
Explaining the Decline in Canadian Saving
What explains the recent decline in Canadian saving?
Could disincentives to save be responsible for the decline in Canadian saving? Not
likely. Marginal personal tax rates on taxable capital income have fallen dramatically
over the past two decades. In addition, the effective marginal tax on capital income
earned on saving done within a retirement account, such as an RRSP Account, is
zero. The main explanation for the decline in national saving appears to be the major
and ongoing government policy of taking an ever larger share of resources from
young and future Canadians and giving them to older Canadians. Because the elderly
are close to the ends of their lives and have much higher propensities to consume
than younger people and the unborn, redistributing from young and future Canadian
generations to older generations raises national consumption and lowers national
saving.
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The distribution of resources across generations arises through a host of fiscal
policies, including deficit finance, the pay-as-you-go finance of OAS and Health Care,
shifts in the tax structure away from consumption and capital income taxation toward
wage taxation, and even capital depreciation and expensing provisions. In recent
decades, increased distribution to the current elderly has come primarily in two forms.
The first is giving the elderly additional medical benefits. The elderly receive these
benefits in kind, which means the only way they can get the benefits is to use them;
one cannot “save” a healthcare expenditure. The second is cutting the taxes the
elderly pay.
The Implications of Low Saving for Baby Boomers
Canadians used to save at a fairly high rate. As a consequence, the collective stock of
Canadian wealth holdings is still quite large. But about 60 percent of this wealth is
owned by people who are fifty or older, who appear to be spending a good deal of it on
themselves. If the elderly do end up spending rather than bequeathing the bulk of
existing wealth, will younger Canadians, particularly baby boomers, accumulate
enough savings to maintain the standard of living they currently enjoy in their old age?
Based on current evidence, the answer appears to be no. Compared with their parents,
baby boomers can expect to retire earlier, live longer, rely less on inheritances, receive
less help from their children, experience slower real wage growth, face higher taxes,
and replace a smaller fraction of their preretirement earnings with CPP and OAS
retirement benefits. Unless baby boomers change their saving habits substantially and
relatively quickly, they may experience much higher rates of poverty in their old age
than those currently observed among Canada’s elderly.
PLANNING YOUR INVESTMENTS
To assist clients in achieving their goals requires a planner to have knowledge of
not only the strategies required, but also a comprehensive insight into investment
products.
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A Financial Planner has many responsibilities, such as:
1. A fiduciary duty to their client and a duty of care to “know your client rule”.
2. Assist in portfolio building.
3. Helping a client identify financial goals.
4. Developing programs of investment objectives to reach these goals.
5. Selecting appropriate investments.
A portfolio is a selection of investments designed to produce a clients’ investment
objectives, which are based on their risk tolerance, financial expectations and
acceptable investment types.
The three basic markets we will examine are:
1)
Money Markets
Dealing in debt instruments that generate primarily interest with some small
amounts of risk attached.
2)
Bond Markets
Trade debt instruments, which are issued primarily by governments and large
corporations.
3)
Equity Markets
Trade equities (Common & Preferred) shares of corporations. This market has
a higher degree of risk attached.
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The concept of Risk VS Return is one that must be clearly understood by both the
Advisor and the client.
The following are the major concepts that form the working knowledge required,
amongst many others, by the planner to carry out their fiduciary responsibilities
to their clients.
Portfolio
A portfolio refers to all of an investor’s assets and gives a complete investment
picture of the various types of investments. The investment mix expresses the
client’s investment philosophy, as it will reveal the amount of risk and potential for
return held in the portfolio.
It is vitally important that the planner associate the risk and potential with the
goals of the client. It is important to build the portfolio for the client, while not
exceeding their risk tolerance, but being consistent with their financial objectives.
Financial Goals
•
A financial objective is a specific condition with certain financial implications.
•
An accumulation objective targets a specific accumulation of wealth.
•
A financial goal includes amounts required to meet a specific
accumulation of objective. This usually requires specifics based on
financial objectives.
All of these need to be defined by the advisor before proceeding with
any specifics
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Investment Objectives
The following are four specific benefits an investor might require from an investment:
1. Income: A return on an investment, interest or dividend, is referred to as income.
Income may provide a return on investment or if the investor is retired, it may require a
steady income flow.
2. Safety of Principal: The objective here is to ensure the original investment, called
the principal, is not lost. Some investments guarantee a safety of principals, if held to
maturity such as T-Bills, CSBs and GICs. This requirement will eliminate higher
risk/higher return products.
3. Liquidity: Liquidity is the ease with which an asset can be converted to cash with
minimum or no loss of capital. Short-term savings and emergency funds require
liquidity.
4. Capital Growth: Capital growth or capital appreciation is the increase value earned
by the original investments. These investments are best targeted for long-term
investments. Growth vehicles usually experience spurts of growth and periods of
market correction. In summation, the planner needs to be guided by the period dictated
by the overall financial objectives.
Investment Risk
All investments involve some risk, and a clear understanding is required for the
client to manage these risks properly.
Systemic Risk
All business experience economic reversals, and so market risk is a systemic risk
that the value of the investment may suffer from some economic, political, or social
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change.
Unsystematic Risk
Specific risks such as financial and default risk of an individual company is considered
unsystematic risks. Quality of management, ability to offer profitable goals and service
as well as control costs and meet competition, all play a part in reducing the risk.
Financial Risk
A company may not perform as well as expected, or may fail and go bankrupt.
Investment advisors study the financials of firms to be able to advise on these
risks.
Default Risk
Default risk is risk that the issuer of a bond or debenture may not be able to repay
the loan. In the event of bankruptcy, secured creditors come first, shareholders
second. If the security pledged has declined in value, it may no longer satisfy the
claims.
Interest Rate Risk
This risk is associated with fluctuations in the interest rate and how it affects the
investment. If interest rates rise, bond prices will drop if sold before maturity. If a
fixed interest rate security is held, it protects against falling interest rates, but also
locks in the investments, if interest rates rise. Bonds are more subjects of IRR.
Marketing Risk
Marketability risk occurs when a buyer cannot be found when an investor wants to
sell.
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The three degrees of marketing are:
1. No market (Company gone out of business)
2. Thin market (Poor exposure or reversal)
3. Active market (Everybody wants a piece)
Exchange Rate Risk
Foreign investments are subject to this type of risk. If an investment is
denominated in foreign currencies and the domestic currency rises, the foreign
investment value decreases.
Inflation Risk
Inflation erodes the purchasing power of an investment so that over time it declines in
real rate of return. This is known as “Inflation Risk”.
Nominal rate of return is the rate as given, but when this has been adjusted for
inflation, this gives the “real rate of return”.
When a financial planner has defined his client’s risk tolerance, only then can the
client make informed decisions that will meet their objectives. Diversification is the
spreading of investments over a wide variety of investment types and helps reduce
the investment risk.
Investments and Income Tax
Interest earned on an investment is taxable. Interest earned, but not paid is accrual
interest. Interest may be paid at various times, according to the terms of the
investments. The interest-paying period is referred to as “term”.
If the investment has a term of less than one year, the interest does not need to
be accrued at the end of the first calendar year, but is taxable when paid.
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If the investment has a term greater than a year, interest must be accrued as of the
anniversary date of its purchase.
A bond year is the twelve-month period between anniversary dates. Therefore,
interest for the bond year must be accrued on the anniversary date and reported for
tax purposes. Canada Revenue Agency uses a modified cash-accrued basis for
reporting Interest income.
•
Interest income received during the year is taxable income for the calendar year
unless it was accrued and reported in a previous calendar year.
•
Interest earned, but not paid during a bond year must be accrued as at the end
of the bond year and reported as taxable income for the calendar year in which
the bond year ends.
Canadian Corporate Dividends
Taxpayers who have received dividends from a taxable Canadian corporation must
gross the dividends up by one-quarter and include that grossed-up amount in
taxable income.
If you did not receive an information slip, you must calculate the taxable amount
of other than eligible dividends by multiplying the actual amount of dividends
(other than eligible) you received by 125% and reporting the result on line 180.
You must also calculate the taxable amount of eligible dividends by multiplying
the actual amount of eligible dividends you received by 138%. Report the
combined total of eligible and other than eligible dividends on line 120.
If you did not receive an information slip, how you calculate the divided tax
credit will depend on the type of dividend.
For eligible dividends, the federal dividend tax credit will be 15.02% (in 2015
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and beyond) of your taxable amount of eligible dividends included on line 120 of
your return.
For other than eligible dividends, the federal dividend tax credit is 13.3333% of
your taxable amount of dividends reported on line 180 of your return.
Federal Dividend Tax Credit Calculation - 2015
Eligible
NonEligible
Actual Dividend
$ 100
$100
Dividend Gross up
38%
25%
Taxable Dividend
$138.00
$125.00
Federal Dividend Tax Credit Rate
15.02%
13.33%
40%
40%
Tax Payable
$ 55.20
$ 50.00
Federal Dividend Tax Credit
$20.73
$16.67
Tax Payable
$34.47
$33.33
Tax Rate
Canadian residents are taxable in Canada on world income from all sources. Income
from foreign jurisdictions may also be subject to tax in the foreign jurisdiction. Foreign
tax paid may be claimed as a foreign tax credit against Canadian taxes, subject to
limitations.
Foreign income that is exempt from tax in a foreign jurisdiction pursuant to say, a
tax treaty, might not be included in the foreign income base for purposes of the tax
credit calculation. Although this income may be exempt in a foreign jurisdiction,
however, it must still be included in the taxpayer’s world income for Canadian tax
purposes.
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A separate credit calculation is required for both business and non-business
income of each source country. Using Form T1135, taxpayers are also required to
annually report specified foreign assets whose total cost exceeded $100,000 at
any time during the previous taxation year.
Taxable Gains
Investors are subject to tax on 50% of Capital Gains received from
investments are allowed to deduct 50% of capital losses. The taxes are
based on 50% to adjust the taxes for inflationary growth.
A capital loss is the excess of the adjusted cost base over the proceeds of disposition.
The word “adjusted” in adjusted cost base (ACB) refers to the fact that the cost of
acquiring, the investment may be adjusted by certain costs such as commission,
legal fees and transfer charges. A capital gain results from a sale or other
disposition of a capital property for more than its adjusted cost base and any
disposition expenses incurred, such as commissions. Unlike ordinary income
however, only 50 per cent of the gain is included in income.
Where the investor experiences a loss, the 50 per cent "allowable" amount must first
be used to offset any capital gains they may have in the same year. Any unused
allowable amount may be carried back up to three years or forward indefinitely to
reduce taxable capital gains of other years. The inclusion rate for capital gains and
losses has not always been 50 per cent. In 2000, for instance, the inclusion rate was
decreased twice from 75 per cent to 66.67 per cent, then to 50 per cent. Individuals
may therefore need to make complex adjustments when applying capital losses of one
year against capital gains of another.
The March 19, 2007 Federal Budget increased the capital gains exemption from
$500,000 to $750,000.
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An individual’s ability to claim the capital gains deduction may be reduced by past
claims for capital gains deductions, allowable business investment losses (ABIL) or a
cumulative net investment loss (CNIL).
Capital Gains are taxable in the year they are realized, and Capital Losses can be
deducted from Capital Gains. This deduction can be carried back three years, but
any balance can be carried forward until no further loss exists.
TAX DEFERRED PLANS
A plan registered with Canada Revenue Agency, in accordance with the provisions of
the ITA, is a trust.
Registered Plans include:
•
Registered Pension Plans (RPP)
•
Registered Retirement Savings Plans (RRSP)
•
Registered Retirement Income Funds (RRIF)
Contributions are tax-deductible, all earnings are tax-deferred and all withdrawals
(including payments after maturity) are taxable. Many investors like to diversify
their registered RRSP portfolios and seek higher returns by holding securities from
foreign markets.
Registered RRSP holders used to be subject to a 30% foreign content limit on the
investments in their plans. Under the 2005 federal budget, that foreign content limit
was eliminated entirely. Canadians who are so inclined can now invest globally without
foreign content restrictions.
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ECONOMICS AND PENSION PLANS
A private pension plan is an organized program to provide retirement income for a
firm’s workers. Approximately 35 percent of full-time, full-year wage and salary
workers in Canada participate in employment-based pension plans. Pension plans
receive special tax treatment and are subject to eligibility, coverage, and benefit
standards.
For individuals, future pension benefits provided by employers substitute for current
wages and personal savings. A person would be indifferent between pension benefits
and personal saving for retirement if each provided the same retirement income at the
same cost of forgone current consumption.
Tax advantages, however, create a bias in favour of saving through organized pension
plans administered by the employee’s firm and away from direct saving.
For a firm, pension plans serve two primary functions: first, pension benefits substitute
for wages; second, pensions can provide firms with a source of financing because
pension benefits need not require current cash payments.
Basic Features
Pension plans offer favourable tax treatment. The tax advantages are three: (1)
pension costs of a firm are, within limits, tax deductible; (2) investment income of a
pension fund is tax exempt; and (3) pension benefits are taxed when paid to retirees,
not when earned by workers.
To qualify for these tax advantages, pension plan benefits must not discriminate in
favour of highly compensated employees, and plan obligations must be satisfied
through an organized funding program.
Benefits are calculated through formulas established in the pension plan. There are
two primary plan types: defined contribution and defined benefit.
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Defined Contribution Plans
Defined contribution (DC) plans specify (define) a firm’s payments (contribution) to the
pension fund. The funds are allocated to individual employees, much like a bank
account or mutual fund. When the individual reaches retirement age, he or she
usually can take the accumulated money as a lump-sum payment or use it to
purchase a retirement annuity.
For example, suppose a DC pension plan specifies that 5 percent of a worker’s salary
be contributed each year to a pension fund. Suppose the worker starts at age thirtyfive, retires at age sixty-five, and earns $50,000 annually.
Then the firm’s annual contribution would be $2,500 (5 percent of $50,000). If the fund
earns 7 percent annually, the worker would have $244,277 in the pension fund at
retirement, which could purchase a twenty- year annuity paying $22,727 annually.
Defined Benefit Plans
A defined benefit (DB) plan specifies (defines) the monthly payment (benefit) a retiree
receives instead of the annual contribution the employer makes. The benefit is typically
specified in terms of years of service and percentage of salary. For example, a plan
might specify that a worker will receive 1.5 percent of his or her average monthly salary
in the last five years of service, times years of service. If the worker began at thirty-five,
retired at sixty-five, and earned an average of $50,000 in the last five years, the annual
retirement payment would be $22,500 (45 percent of $50,000). The worker’s firm must
pay the promised benefit, either by taking money from the pension fund annually or by
purchasing an annuity for the worker from an insurance company. For the pension
expense to be tax deductible, the firm must establish an actuarial funding program
designed to accumulate enough assets to provide promised benefits.
An actuarial funding program combines data on plan specifications, employee
characteristics, and pension fund size with assumptions about future interest, salary,
turnover, death, and disability rates.
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Given these assumptions and data, an actuary estimates the firm’s future pension
obligations and an annual payment schedule to satisfy those obligations. Different
interest rate and salary assumptions can have a substantial effect on annual
contributions, given a plan’s characteristics and an actuarial funding method. A rule of
thumb is that an increase of the valuation interest rate by one percentage point will
lower pension liabilities by 15 percent, holding all else constant.
Similarly, different actuarial funding methods can substantially affect required and
allowable contributions in any given year, even with the same plan characteristics
and actuarial assumptions.
Defined benefit plans are more common among large firms, unionized labour forces,
and public-sector employees. Defined contribution plans are smaller, on average, but
more numerous, and they frequently supplement an existing defined benefit plan.
Defined contribution plans have been growing more rapidly, possibly because
government regulation has made defined benefit plans relatively more costly to
operate, especially for small firms.
Hybrid Plans
Hybrid plans combine elements of defined benefit and defined contribution plans. The
most common type is known as a cash balance plan. Benefits are defined in a
manner similar to that of a defined benefit plan. However, a cash balance is
established for each employee, which is really just a bookkeeping device to track
benefit accruals. An employee who leaves the firm before retirement is permitted to
take the cash balance on leaving.
Plan Termination
Pension plans can be terminated. With defined contribution plans, the firm merely
passes the pension fund management to an insurance company and stops making
future contributions.
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Terminating a defined benefit plan is more complicated and controversial since pension
fund assets do not necessarily equal the present value of pension benefits. If assets
exceed promised benefits, the excess assets may revert to the employer, subject to
certain tax penalties. If a company fails and its pension assets fall short of obligations,
problems can arise.
Economic Issues
A basic premise of the extensive economic literature on pension policy in Canada is
that pension benefits are not free goods: they are provided to workers as substitutes
for current wages. Economists have found that the higher a person’s marginal tax rate,
the higher his pension is likely to be as a percentage of his wages. This makes sense
because pensions are, in part, a means of tax avoidance.
Also, the higher an individual’s income, the higher his pension benefit will be as a
percentage of current income. So, if a person’s income doubles, the pension portion of
his current total compensation might rise from, say, 8 to 12 percent.
How do firms choose how much to fund pension plans and what kinds of assets to
invest in? For defined contribution plans, the first half of the question is simple: the
employer has to make the promised contribution (e.g., 5 percent of salary or wages)
each year and has no other funding decisions to make.
Thus, the only ongoing issue for a defined contribution plan is how to invest the
assets. Standard portfolio theory suggests that workers would be best off with some
well- diversified combination of stocks, bonds, and cash investments. The relative
weights on the portfolios would depend on the worker’s tolerance for risk: the more
risk the worker wants to take, the higher the proportion in stock. Because attitudes
toward risk differ among individuals and for any one individual as he ages, defined
contribution plans frequently allow participants to allocate their contributions among a
handful of mutual funds.
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For defined benefit plans the answers to both parts of the question are much more
complex. In practice, most pension plans are roughly “fully funded” (meaning that
assets equal the present value of benefits already earned by workers), and the pension
fund is split equally between stocks and bonds. Economists are not sure why this is so
but have come up with two possible explanations. The first assumes that the firm owns
the pension fund. If so, the firm should choose the funding and portfolio strategy with
the highest net present value to it. This leads to two polar-opposite solutions:
underfund and buy risky assets, or overfund and buy high-grade bonds.
Why does the first strategy—underfunding and buying risky assets—make sense? A
firm can terminate its pension plans without further cost only if the pension fund is
greater than accrued benefits or if the firm is bankrupt. In cases where government
“insurance” is provided the firm has an incentive to fund the pension plan only to the
minimum required, to substitute pension benefits for wages as much as workers will
allow, and then to invest the fund in risky assets such as stock or junk bonds.
If the investment works out, the firm gains. If the investment fails, the government and
the firm’s workers lose.
DEBT MARKETS
Money may be invested or loaned to create opportunities for business. Money,
which is loaned, with appropriate security in the world of finance, is invested in the
Debt Market.
Financial instruments found in the market are:
•
Term Deposits
•
Canada Savings Bonds
•
Treasury Bills (T-Bills)
•
Money Market Funds
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Government of Canada Bonds
•
Corporate Bonds and Debentures
•
Domestic Bond Funds
Term Deposits
Banks and Trust Companies offer debt contracts that are called Term Deposits:
•
Minimum Deposit - $5000 +
•
Length of Deposit - Various duration’s
•
Short term deposit (less than 1 year)
•
Long term deposit (up to 5 years)
Interest Rate - Depends on length of deposit and competitive interest rates.
Term deposits may be cashed before maturity, but this may incur a penalty.
GICs generally cannot be cashed, although some deposit takers are now more
flexible.
Term Deposits satisfy the objectives of safety of principal and if the interest
earned is withdrawn, to provide income that was a required objective.
The interest is taxable in the year earned for bonds of one year or less and for
bonds, which are long-term, are taxed on a bond year basis.
Term deposits are guaranteed by the Canadian Deposit Insurance Corporation (CDIC)
The CDIC is a federal Crown corporation created by Parliament. CDIC insures
Canadians’
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savings in case their bank or other CDIC member institution fails or goes bankrupt.
CDIC is NOT a bank. CDIC is NOT a private insurance company.
Banks in Canada can fail. It does not happen often, but it has happened and it could
happen again. If your bank or other CDIC member fails or goes bankrupt and your
savings are covered by CDIC, you will get up to $100,000 of your savings back. If your
savings are NOT covered, you might lose them.
These instruments are qualifying investments for Registered Plans.
Long term deposits are called Guaranteed Investment Certificates (GICs) and can be
purchased for a lessor amount ($500) and alternately may be called Certificate of
Deposit (CD).
Rates may vary as little as .10% amongst the deposit takers.
CANADA SAVINGS BONDS (CSBS)
•
Issued first in 1946.
•
Registered Bonds provide protection against loss; theft or destruction and bonds
are not transferable.
•
Sold with a minimum of $100 to maximum of $100,000.
•
The interest earned is taxable and is competitive with GIC’s.
•
They require Canadian residency.
A Canada Savings Bond (CSB) is a safe and secure investment product issued and
fully guaranteed by the Government of Canada, available to all Canadians to achieve
personal financial goals.
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Canada Savings Bonds can be redeemed at any time during the year. While the
Canada Savings Bond has a ten-year term to maturity, interest rates are often
announced for a shorter period and remain in effect for that announced period. At the
end of the period, new rates will be announced by the Minister of Finance based on
the prevailing market conditions.
THE CANADA PREMIUM BOND
The Canada Premium Bond (CPB), introduced in 1998 by the Government of Canada,
offers the same general features as Canada Savings Bonds, but has a higher rate of
interest at the time of issue than a CSB on sale at the same time, and can be
redeemed each year on the anniversary of the issue date and during the 30 days
thereafter. While the Canada Premium Bond has a ten-year term to maturity, interest
rates are often announced for a shorter period and remain in effect for that announced
period. At the end of the period, new rates will be announced by the Minister of
Finance based on the prevailing market conditions.
Investment Return set by Canadian Government annually:
They are offered with a guaranteed minimum rate of return with the greater of the
established rate or the guaranteed minimum to be paid. The guarantee usually applies
for the 1st three years. They may be cashed early with the interest payable to the end
of the previous month. Interest rates may be boosted when the Government wants to
encourage retention.
Bonds are issued as:
•
“R” Bonds - Regular interest in denominations of $3000 to $10,000.
•
Interest is paid annually.
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These bonds can be converted to “C” Bonds before August 31st of the year of issue.
•
“C” Bonds - Compounded interest in denominations of $100 to $10,000
•
Interest is paid and automatically invested on November 1st yearly
These bonds can be converted to “R” Bonds
Investment Risk is nil, since the Bond is guaranteed by the Government of
Canada. Investment is subject to inflation and interest risk. A CSB is always
worth face value.
•
Safety of Principal
•
Income Investments
•
Liquidity
Taxation
Bonds generate interest and are taxed on a Bond year basis.
TREASURY BILLS (T-BILLS)
Treasury Bills are a short-term money market instrument. The Federal Government
issued them in terms of 30, 60, 91, 182, and 364 days. They are sold every Tuesday
by auction. This auction is only open to chartered banks and investment houses who
bid on the issue.
The highest bidder buying as much of the issue as they wish, second highest then
buying as much as they desire, until the issue is completely sold out.
These organizations buy at wholesale in multiples of 5 million denominations, and
then sell to brokers and investment dealers who break down their purchases until the
average person can buy them in $1000 lots.
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Investment Return
T-Bills are sold at discount. E.g., Face value of $1000 Bond purchased at $963 to
mature in 182 days. The $37.00 difference represents the interest earned and is fully
taxable.
T-Bills are also sold on the secondary market and their value fluctuates depending
on competitive interest rates at times of resell.
Associated Risks
The short-term nature of the T-Bills does not cause a large exposure to interest rate
risk, but to some extent to inflation risk.
Objectives
•
Highly liquid
•
Good yield & May be purchased on a regular basis
Taxation
Taxed as interest income. If sold before maturity, a capital gain or loss will result.
MONEY MARKET FUNDS
A money market fund holds T-Bills and other short-term money market contracts.
Investors pool their investments through the mutual fund. The units can be bought
and sold daily.
Investment Return
Money market funds produce capital gains, although their primary functions are to
generate interest income. Interest is generally paid monthly, while capital gains are
paid annually.
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These amounts are noted on a tax form, called a T3 supplementary.
Associated Risk
The risk depends on the investment mix. If the fund has all T-Bills held to maturity,
the results are guaranteed.
If there is a Bond component, the fund is open to the risk of default for that portion.
Objective
•
Security of principal (T-Bills)
•
Liquidity
•
Eligible for registration
Taxation
•
Taxation on a calendar year basis.
BONDS OR DEBENTURES
•
Bonds - are loans, secured by the assets of the issuer.
•
Debentures - are loans, secured by the general credit of the issuer
(Corporations, Municipalities, and Governments)
These instruments provide for a maturity at which time the principal will be repaid.
In addition to the payback of principal, the borrower will pay interest at stated
intervals, usually semi-annually.
This legal agreement is outlined in a trust deed (indenture) that lists the rights of
the bondholder.
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The four most common types of Bonds that we will discuss are:
1. Government Bonds and Debentures
2. Corporate Bonds and Debentures
3. Domestic Bond Funds
4. International Bond Funds
Bond Security
Bonds are secured debt, because assets are pledged so that if the borrower defaults,
the assets can be seized to satisfy the bondholder.
Debentures are unsecured, but are supported by the general credit of the
Corporation issuing the Bonds and are in the care of the Government, their ability
to raise taxes to honor this repayment obligation.
Contract Features
•
Prominent players in the debt market are Bonds and Debentures. They come
in three-maturity duration.
•
Short Term -Three years or less
•
Medium Term -Three to five years
•
Long Term -More than ten years
The most common features are:
•
Term to maturity
•
Interest payment structure
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A coupon rate (rate of interest)
•
The valuation and pricing
Notes on Bonds & Debenture Terminology:
•
Issuer is the borrower
•
The lender is the Bond owner
•
When bonds are sold on the secondary market, the ownership changes
Each bond sold requires the presentation of a prospectus:
•
A prospectus is a document that lists the names of the issuer, bond features,
assets securing the loan and other detail. In addition, it gives the companies
background, purpose of the bond and any other information of value to the buyer.
Various bonds are issued, but the two most common are bearer bonds and
registered bonds.
Bearer Bonds
Bearer Bonds are owned by the holder and are issued with coupons for
Interest payments. The holder may sell the bond at any time.
Registered Bonds
These bonds are registered with the issuer who keeps a record of the owner. They
may only be sold by the registrant and interest payments are made by cheque to this
registered owner.
Generally, a certificate is not issued for a registered bond, but is a computerized
record, such as the coupon rate (interest rate) and when payment is due.
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Additional Bond Types Are:
Redeemable. Callable and retractable bonds are where the principal borrowed may
be paid back prior to maturity. Thirty day’s notice is generally required before
exercising the option.
Bonds as Investments
Interest is paid from date of issue, which is the date of purchase when the funds are
exchanged. Interest is generally paid on a semi-annual basis. The maturity date is
the date the funds are repaid. The issue date becomes the bonds annual anniversary
date.
The yield to maturity is the rate of return if the bond is held to maturity.
If the bond is sold before maturity, it can be sold:
1. At Par - Yield will be identical to the coupon rate.
2. At Discount, -Yield will be less than the coupon rate.
3. At a Premium, -Yield will be more than the coupon rate.
The deciding factor is the current market value. The market value reflects other
bond coupon rates, general interest rates and contrary market new.
The value of the bond increases as interest rates fall and the value decreases as
the interest rates increase.
Associated Risks
Long-term bonds are more exposed to market risk than short-term bonds, therefore
offer higher interest rates.
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Bonds and the Secondary Market
When bonds are resold on the secondary bond market, the buyer and seller negotiate
the price that best suits their objectives. In addition, any accrued interest from the date
of the last interest payment, until the time of the sale, must be taken into account.
The accrued interest is added on to the negotiated price, but of course the buyer
recovers the portion of the cost of purchase at the next scheduled interest date.
Currency
Canadian Bonds may be issued in Canadian dollars or in a foreign currency. These
are known as a domestic issue, foreign pay bond.
Taxation of Bonds
Bonds are taxed on a bond year basis and are eligible as RRSPs and RRIFs
(including domestic issue, foreign pay bonds).
Capital Gains
The adjusted cost base of a bond is the purchase price plus any sales commission
less any accrued interest paid.
The proceeds are worth:
•
The face value if the bond was held to maturity.
•
The proceeds are worth the price received at sale, less any sales fees and
any accrued interest received. Any profit is considered a capital gain and
any loss is considered a capital loss.
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1. GOVERNMENT OF CANADA BONDS
Government of Canada Bonds are debentures. The investment risk is extremely low
due to the Federal Government’s ability to increase taxes that will generate additional
income to make bond payments.
Associated Risks
•
Bonds and debentures are subject to interest rate
risk.
Investment Objectives
•
Income & Safety of principal. Usually considered to be liquid.
CORPORATE BONDS AND DEBENTURES
These bonds are quite similar to Government Bonds except:
•
Corporate bonds are backed by company assets and earnings
•
Assets securing bonds may decrease in value
•
Corporate bonds may be retractable. (Bondholder has the right to redeem the
bond at a specific date for a specified price, before maturity).
Risks
Higher default risk demands higher interest rates.
Investment Objectives
Identical to Government of Canada Bonds.
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Tax Treatment
Same treatment as Government of Canada Bonds.
DOMESTIC BOND FUNDS
This mutual fund type invests in Canadian issue government and corporate bonds and
debentures. The units are redeemable at will and the fund is professionally managed.
This expertise should provide for less investment risk when interest rates are falling.
The management fees should be offset somewhat by the fund manager’s higher
returns and lower buying and selling costs.
Investment Return
Bonds provide both interest income and capital gains (or losses). These flow through
to the investor and are taxed appropriately.
Associated Risks
•
Interest rate risk.
Objectives
•
Provides income and liquidity.
Tax Treatment
All bonds are taxed the same.
INTERNATIONAL BOND FUNDS
These bonds are similar to the domestic bond fund, but are issued in foreign
currencies.
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Associated Risks
Investment rate and exchange rate risks.
Objectives
Provides income and liquidity.
Tax Treatment
Interest and capital gains (or losses) flow through and are taxed appropriately.
EQUITY MARKET
As an alternative to obtaining capital by borrowing money, a company can sell shares
to raise capital. A shareholder invests in the company and gains a degree of
ownership, plus income. The total amount paid for the share(s) is the shareholder’s
equity. Investment funds, pension funds as well as individuals can purchase shares.
The main equity market instruments are:
•
Common and preferred shares as found in Domestic and International equity funds.
Common Stock usually provides the following rights:
Voting shares provide the shareholder the right to vote on important company issues,
including attending the annual meeting and to vote on Board or Directors elections.
Non- voting shares do not provide this voting right. Shares after the initial offering
(IPO) are resold in the secondary market, either through the listed or unlisted common
share market. The unlisted market is called the “over the counter” share market and
the listed market is called the “stock exchange”.
In the secondary market, the company does not share in any gain (or loss) on the sale
of their share and their only involvement is the registering of the new owner’s name.
Both markets are reported to the public by the financial news media.
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RETURN ON INVESTMENTS
Dividends
•
Portion of the corporation’s profits and is paid on a per share basis.
•
Dividends can be paid quarterly, semi-annually, annually or whenever.
•
The decision on how much dividend (or if to pay a dividend) and when it is to be
paid, are made by the company’s directors.
•
As profits go up or down, so do the dividends.
Earnings per Share
•
Earnings per share are calculated by dividing the amount of annual earnings by
the number of outstanding shares.
•
It should be noted that dividends paid per share, is only a portion of the profits,
since the company will need to retain some portion of the profits for future
expansion and operation.
Growth
The values of shares are determined by the amount of annual earnings by the number
of outstanding shares. The goal is capital appreciation gained by price increases.
Increased corporate profits suggest increased dividends, making the stock more
valuable. The risk the investor takes is that, just as quickly as share prices increase,
adverse conditions can cause a decrease.
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INVESTORS UTILIZE TWO METHODS TO PICK STOCKS:
1. Fundamental Analysis
Involves an analysis of the particular company’s financials, future corporate prospects
and an evaluation of the company’s market.
2. Technical Analysis
This method ignores the individual company and looks at the volatility in the
marketplace.
Associated Risk
All but the most “blue chip” types of stock are exposed to:
•
Systemic and unsystemic risk
•
Poor liquidity will result if low market activity is experienced
Objectives
•
Capital growth is the priority objective
•
In an active market, stocks have high liquidity
Taxation
•
Taxed on capital gains basis and losses provide write-off against gains
•
Dividends are taxed on a gross-up basis with an accompanying dividend tax credit
•
Eligible for tax deferral if registered as a RRSP or RRIF
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PREFERRED STOCK
Preferred stock represents ownership, but their primary function is to provide
income. They generally do not have voting rights, but their dividends tend to be fixed
and have a higher payment priority than common shares. The adjective before the
word preferred indicates that other features of the shares.
It may be referred to as accumulative or non-accumulative, participating or
non- participating. Preferred shares may be callable or retractable.
Investment Return
•
Dividends are paid at a fixed rate based on corporate earnings.
•
Preferred share dividends must be paid before common share dividends.
•
The corporation has the right to omit or defer the payment of the dividend. There is
no legal requirement that the dividend must be paid, although most preferred
shares contain a cumulative feature.
If the shares are cumulative, dividends that have not been paid referred to as arrears
must be paid before common shares or current year preferred dividends are paid.
This provides preferred shares with a lower risk element than common shares.
The prospectus, published by the company and provided to the purchaser,
outlines all the details and rights of each particular issue.
Preferred shares are similar to bonds, in that they have a fixed dividend rate (like
interest) and the market value can increase or decrease with fluctuation of interest
rates the same as bond experience.
Preferred shares do not usually participate in increased company profits and so do
not experience the same potential for capital gains or losses.
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Associated Risks
•
Exposed to systemic and unsystemic risks
•
Could experience liquidity risk due to low market activity
•
Interest rate risks
•
Lower dividend payment risk, than common shares
•
Income by way of dividend payments
•
Generally highly liquid
Tax Treatment
•
Taxed using previously mentioned gross-up and dividend tax credit system
•
Capital gains & losses subject to taxation rules
•
May be eligible for RRSPs & RRIFs tax deferral
DOMESTIC EQUITY FUNDS
This mutual fund invests in the common and preferred shares of Canadian Corporations
(hence the title domestic). Each fund may specialize in a certain area.
Example - Small “Cap” funds or high technology companies as opposed to “Blue
Chip” companies. A fund provides the investor with a professionally managed
diversified portfolio and the units can be bought and sold daily.
Investment Return
Same as if personally held, less management fees.
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Tax Treatment
“Flow through” taxation of capital gains, interest and dividends. Income is reported on a
T3 or T5 tax slip and the fund is eligible for registered funds.
INTERNATIONAL EQUITY FUNDS
Operates the same as its domestic counterpart and may be sectionalized in that it
concentrates on one location only, such as Asia or emerging markets. The funds
provide for a diversified portfolio, which is professionally managed, and the units are
bought and sold daily. It is exposed to currency risk. Investment risk is identical to
domestic funds, but the capital gains or losses may be augmented by the currency risk.
Income is taxed as capital gains, interest, but dividends do not attract a dividend
tax credit. In addition to normal capital gains, currency fluctuations can add to
the size of the gain or loss.
OVERVIEW OF THE INVESTMENT OBJECTIVES AND RISK
The following table gives the primary risk and objective of each of the
investment types discussed.
Summary of Investment Risks and Objectives
Investment
Primary Risk
Primary Objective
Term Deposit
Inflation
Safety of Principle
CSB
T-Bill
MMF
Interest Rate
Inflation
Inflation
Liquidity
Bonds
Interest Rate
Safety of Principle
Income
Unsystemic
Interest Rate
Exchange Rate
Income
Income
Income
Income
Debentures
Domestic Bond Fund
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Common Stock
Unsystemic
Capital Growth
Preferred Stock
Domestic Equity Fund
Int’l Equity Fund
Systemic
Unsystemic
Exchange Rate
Income
INVESTMENTS WITH AN INSURANCE COMPONENT
Capital Growth
Capital Growth
A Segregated Fund or Seg Fund is a type of investment fund administered by
Canadian insurance companies in the form of individual, variable life insurance
contracts offering certain guarantees to the policyholder such as reimbursement of
capital upon death. As required by law, these funds are fully segregated from the
company's general investment funds, hence the eponym. A segregated fund is
synonymous with the U.S. insurance industry "separate account" and related
insurance and annuity products.
A segregated fund is an investment fund that combines the growth potential of a mutual
fund with the security of a life insurance policy. Segregated funds are often referred to as
"mutual funds with an insurance policy wrapper".
Like mutual funds, segregated funds consist of a pool of investments in securities such
as bonds, debentures, and stocks. The value of the segregated fund fluctuates
according to the market value of the underlying securities.
Segregated funds do not issue units or shares; therefore, a segregated fund investor is
not referred to as a unitholder. Instead, the investor is the holder of a segregated fund
contract. Contracts can be registered (held inside an RRSP or TFSA) or non-registered
(not held inside an RRSP or TFSA). Registered investments qualify for annual taxsheltered RRSP or TFSA contributions. Non-registered investments are subject to tax
payments on the capital gains each year and capital losses can also be claimed.
Insurance Contracts
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Segregated funds are sold as deferred variable annuity contracts and can be sold only
by licensed insurance representatives. Segregated funds are owned by the life
insurance company, not the individual investors, and must be kept separate (or
“segregated”) from the company’s other assets. Segregated funds are made up of
underlying assets that are purchased via the Life assurance companies. Investors do
not have ownership share. Segregated Funds have guarantees and run for a period.
Should the investor leave before the end date, he/she may be penalized.
All segregated fund contracts have maturity dates, which are not to be confused with
maturity guarantees (outlined below). The maturity date is the date at which the
maturity guarantee is available to the contract holder. Holding periods to reach maturity
are usually 10 or more years.
Maturity & Death Guarantees
Maturity Dates
Guarantee amounts are offered in all segregated funds whereby no less than a certain
percentage of the initial investment in a contract (usually 75% or higher) will be paid
out at death or contract maturity. In either case, the annuitant or their beneficiary will
receive the greater of the guarantee or the investment’s current market value.
Guarantees of this nature are of particular value when an investor is nearing, or
has begun retirement, and cannot afford to lose any of the original capital invested, in
a volatile market. Even if the fund's actual unit value declined, the seg fund investment
guarantees that the investor will get back a very high percentage of the initial capital
invested (in some cases as high as 100%).
Potential Creditor Protection
Granted certain qualifications are met, segregated fund investments may be
protected from seizure from creditors. This is an important feature for business
owners or professionals whose assets may have a high exposure to creditors
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Probate Protection
If a beneficiary is named, the segregated fund investment may be exempt from
probate and executor’s fees and pass directly to the beneficiary. If the named
beneficiary is a family member (such as a spouse, child, or parent), the investment
may also be secure from creditors in case of bankruptcy. These protections apply to
both registered and non- registered investments.
Reset Option
A reset option allows the contract holder to lock in investment gains if the market value
of a segregated fund contract increases. This resets the contract’s deposit value to
equal the greater of the deposit value or current market value, restarts the contract
term, and extends the maturity date. Contract holders are limited to a certain number of
resets, usually one or two, in a given calendar year.
Cost of the Guarantees
The shorter the term of the maturity guarantees on investment funds - whether they
are segregated funds or protected mutual funds - the higher the risk exposure of the
insurer and the cost of the guarantees. This inverse relationship is based on the
premise that there is a greater chance of market decline (and hence a greater
chance of collecting on a guarantee) over shorter periods. A contract holder's use of
reset provisions also contributes to costs, since resetting the guaranteed amount at
a higher level means that the issuer will be liable for this higher amount.
TAXES, INFLATION AND INVESTMENT PLANNING
All asset growth attracts taxation and some of the growth is due to inflationary
influences. Taxes are paid on these investment returns, whether as the result of true
market growth or inflation.
While the nominal rate of return may appear impressive, part of the return goes to the
Government in the form of taxes and part is eroded by inflation. Both of these
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influences can be taken into account, to disclose the real rate of return. Formula is
as follows: Inflation – adjusted return (real return)
Income tax adjusted return (after tax return)
After tax, real rate of return
=
r = i X (1 – MTR) - infl
1+
infl.
Legend for the above
i
the nominal rate of return
infl
the inflation rate
mtr
marginal tax rate
I*
real return
i**
after-tax return
r
after tax, real return
Calculation
GIC is invested at 5% annual interest. Inflation rate is 3% and the MTR is 40%
Real Return:
After Tax Return
(Interest – Inflation) (1 + inflation)
5% X (1 – 40%) = 3%
(5% - 3%) (1 + 3%) = 1.941%
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After Tax Real Return
(Interest X (1MTR) – Inflation) + (1 + Infl)
5% X (1 – 40%) – 3%) + (1 + 3%) = 0%
Break Even Rate
As we can see, the real return can be 0 or even a negative position, which means that
the investment is losing its purchasing power. The rate of return at which the principal
amount retains its purchasing power is called the Break Even Rate.
The formula to determine the rate is as follows:
Break even rate = Inflation rate
(1 – MTR)
In Conclusion
The assumptions that investments that offer safety of principal are risk free are not
quite true. Since these investments offer a low rate of return, they are exposed to
inflation risk.
Risk/Return Trade off
Risk and return operate on a teeter-totter evaluation. As the return potential
increases the chance of loss (risk) is enhanced.
Generally, investments that offer safety of principal also offer low rates of return.
Since the low rates of return are subject to inflation, the result may be a negative
real rate of after tax return.
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Capital stock is more exposed to risk, but offer a greater opportunity for gain. Since
many forces affect a stock’s price, besides the company’s performance, predicting
changes in share prices is risky.
INVESTMENT STRATEGIES
An investment strategy is a systematic approach to picking stock.
There are two types of investment strategies:
1. Active Strategies
2. Passive Strategies
1. Active Strategies
Require regular decisions about what securities to invest in and how much to invest
as well as the timing of the sale of assets and the reinvestment in new equities.
Stock Picking
In stock picking, the investor looks for stock that is undervalued, since this offers the
greatest opportunity for growth above the market averages. Picking the stock
involves analysis of publicly available information, looking for the indication that this
stock is undervalued.
In addition, this type of investor will hold fewer companies in their portfolio so they
can stay better informed about each company’s situation, thereby providing for
better management. If a new stock shows a high potential, it will be purchased
replacing the worst performing stock in the portfolio.
Market Timing
When an investor attempts to purchase stock when its value is low, and sells when
its value peaks, he is relying on his ability to time the market.
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Market timing is also used to outguess interest movements.
It generally involves the use of financial ratios and statistical trends to determine
if a stock is under or overvalued. Stock prices can fluctuate widely and so
careful timing can be profitable.
Markets are cyclical by nature and provide for very unpredictable activity.
Market timing provides, at the best, an educated guess. Very few investment
managers over the long haul are successful at this type of prediction.
Bond Swapping
Capital growth of bonds is linked to interest rate changes. Long-term bonds with
higher coupon rates are very sensitive to interest rates. In bond swapping, the
investor attempts to pick rising interest rate times to sell long-term bonds and
buy short-term bonds to pursue the opposite action when rates fall.
Ladder Approach
The ladder approach method is used to purchase different investments that will
mature at different times, to provide a fixed income with low risk.
2. Passive Strategies
Passive strategies as the name implies involves little change in the portfolio mix, with
a few occasional adjustments to offset major market changes. This method assumes
that their investments are made in an efficient market. This is a market where the price
reflects all the available information and the investor will experience few surprises.
Only an inefficient market has undervalued stock, which in-depth analysis can disclose.
The investor has established by research that his investments are held in an efficient
market and that few bargains are available.
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Balanced Mutual Funds
Balanced fund managers offer diversification for the small investor, and the fund
primarily invests in a mix of equities, different maturity date bonds, and stocks
and bonds with different risk levels.
Indexed Portfolios
An indexed portfolio is designed to duplicate a major index, like the Toronto Stock
Exchange 300 index (TSE300) or the TSE 35. The portfolio includes the same shares in
the same proportion and the purpose is to duplicate performance, not to outperform the
market. The returns are quite predictable. This method is used more often with equities
than with bonds. For the small investor, who cannot afford the large investments, there
are indexed mutual funds available.
Buy & Hold
The goal of a buy & hold strategy is to achieve the highest possible rate of return for a
gives level of risk. In this method the stocks are held for a predetermined holding
period or until the investment matures. This results in less transaction charges and is
thought to produce better results than Market Timing.
Dollar Cost Averaging
In this method, investments are purchased at regular time intervals (e.g., monthly) and
the price is not considered. If the price trend is downward, the average price will be
greater than the current price. If the trend is up, then the average cost will be less than
the current price. This method is also an alternative for Market Timing.
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Dividend Reinvestment Plans (DRIPs)
In this method, the publicly traded companies allow the dividends paid to be reinvested
in additional shares. The investor pays tax on the dividend as though it were taken in
cash.
A trustee makes the reinvestment plan purchases. This allows for the reinvestment of
small amounts of cash.
It gives detailed information on the three markets
1. Money Markets
2. Bond Markets
3. Equity Markets
It also exposes you to a new terminology and techniques required to assist a client
in the pursuit of a well-performing asset.
GLOSSARY OF TERMS Accrual Basis
A method of calculation that dictates the inclusion of earned interest or dividends
whether they were received or not.
Accrued Interest
Is all earned interest even if the interest was not received in cash.
Active Investment Strategies
A method of managing a portfolio that requires regular decisions and adjustments
to the portfolio by the investor. Decisions involve how much to buy, what to buy,
when to buy and sell and how to reinvest.
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Adjusted Cost Base (ACB)
Is the cost to the taxpayer of the property plus certain adjustments of cost imposed
under the Income Tax Act.
Aggregate Demand
The relationship between the total quantity of goods and services demanded and
the price level.
Aggregate Supply
The relationship between the total quantity of goods and services supplies and
the price level.
Annuity
A series of equal payments over a fixed number of years at a certain
interest or compounding rate.
Annuity Due
A series of equal payments over a fixed number of years where the payments are
made at the beginning of each period.
Arrears
Are dividends or interest payments, accrued since the last payment, which is still owed
but that have not been paid yet.
Assets
Anything of value that a household, government or business owns.
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Balanced Mutual Fund
A fund that balances risk by diversifying. Investments include equities and bonds of
different maturity periods and stocks and bonds of different risk levels.
Bank of Canada
Canada’s central bank.
Bank Rate
The rate of interest that the Bank of Canada is prepared to lend to the chartered banks.
Bearer Bonds
Are owned by the person who possesses them. They usually come with attached
coupons that can be clipped and redeemed.
Bonds
A legally enforceable obligation, issued by borrowers, to pay back the
principal amount plus interest earned at a specified date.
Bond Swap Strategy
A strategy that sells long-bonds and buys short-bonds during periods of rising interest
rates. It also does the opposite during periods of falling interest rates.
Business Cycle
The continuous ebb and flow of economic activity.
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Buy-and-hold Strategy
Assets are purchased in a portfolio and held until maturity or until the investor’s
investment horizon is reached.
Callable Bonds
Issuer may pay off bond before maturity.
Capital Gain
The excess of the proceeds of disposition over the adjusted cost base and any
expenses incurred in disposing of the property.
Capital Loss
Any excess of the adjusted cost base plus expenses over the proceeds of disposition.
Capital Markets
A financial market with assets of longer-term maturity, usually greater than one year.
Ceiling Price
A maximum allowable price regulated by government.
Chartered Banks
A private firm chartered under the Federal Bank Act to receive deposits.
Compounding
The process of determining the future value of a payment or stream of payments.
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Compound Interest
In interest rate whereby interest in succeeding periods is earned on principal and on
interest earned in previous periods.
Compound Interest Bonds
Canada Savings Bonds on which accrued interest is reinvested automatically. Interest
is not paid to the investor in cash.
Consumer Price Index
A measure of the average price of goods and services commonly purchased
by consumers prepared to a value of the same basket of goods and services
in a base year.
Convertible Bond
Some bonds may be exchanged for another type of investment such as common stock.
Coupon Rate
The interest rate paid on the par value of a bond.
Currency
The bills and coins issued by the central bank that we use in the market.
Currency Appreciation
An increase in the value of a nation’s currency in terms of another currency.
Currency Depreciation
A fall in the value of a nation’s currency in terms of another currency.
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Debenture
Has the same structure as a bond, but is not secured by assets or property.
Default Risk
The uncertainties that the borrower will not be able to pay back the bonds or make
interest payments.
Demand
The relationship between quantity demanded and price of a particular good or service,
holding constant those factors that influence quantity demanded.
Demand Curve
A graph that illustrates the relationship between the quantity demanded and the price.
Demand Schedule
A table that shows numerically the quantity demanded of a good or service
at different price levels.
Direct Financing
Occurs when funds flow directly from a saver to the borrower.
Discount Rate
The interest rate used in the discounting process.
Discounting
The process of finding the present value of a payment or stream of payments.
(Discounting is the reverse of compounding).
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Disposable Income
Defined as total consumer income less taxes and government transfers.
Diversification
The process of spreading out risk in a portfolio by including investments with many
different levels of risk and return potential.
Dividend Gross-up
Adjustment to dividend amount used to calculate tax credit. Dividends paid by
Canadian Corporations are subject to a dividend gross-up. The dividend gross-up is
the amount added to the actual dividend when calculating the dividend tax credit.
Dividend Reinvestment Plan
A plan that allows shareholders to purchase more shares from dividends rather than
receiving the dividend as income.
Dollar Cost Average
A method of obtaining investments by purchasing a certain dollar amount of
investments at regular time intervals.
Earnings per share
Is calculated as the after-tax income for a corporation dividend by the number of
outstanding common shares.
Economics
The study of how people use scarce resources to satisfy unlimited wants.
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Economics of Scale
The possibility of spreading out costs among a greater number of transactions, inputs,
etc. that reduces the overall cost of productions. Through financial intermediaries, the
cost of using loans is greatly reduced.
Efficient Market
The market in which all the available information has been analyzed and is reflected in
the current stock price.
Equity Markets
Trade in common and preferred shares of corporations.
Equilibrium
A condition that satisfies the decisions of both consumers and producers.
Equilibrium is a state of rest in the economy where demand and supply are in
balance or equal one another.
Exchange
An organized market for buying and selling financial securities, such as the Alberta
Stock exchange.
Exchange Rate Risk
The uncertainty that a rise in the foreign exchange rates of a domestic currency will
cause the value of investments in foreign currencies to fall.
Expansion
That phase in the business cycle in which economic growth increases.
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Exports
The goods and services sold to foreign countries.
Farm Marketing Board
Intervention in the agricultural sector aimed at stabilizing the prices of agricultural
products.
Fiduciary Duty
The fiduciary duty of care calls for complete loyalty and fidelity to the client. It is
inferred from the special relationship of trust between the client and the professional.
Financial Intermediaries
A firm that acts as the go-between for savers and lenders. They receive
deposits from consumers and businesses and make loans to other
consumers and businesses. They increase the productive use of invested
funds.
Financial Risk
Is the uncertainty that a company will fail to meet expected financial goals and provide
a lower return than anticipated.
Fiscal Policy
The attempt by the government to influence economic activity by altering spending or
taxes.
Floor Price
A minimum allowable price regulated by government.
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Foreign Exchange Market
An organized market that trades one currency for another.
Future Value
The amount to which a sum or annuity grows over a given period at a certain interest
rate.
Gross Domestic Product (GDP)
The value of all-final goods and services produced in the economy in a given year.
Guaranteed Investment Certificates
Fixed interest bearing, money market instruments issued by banks and trust
companies with terms of one to five years.
Imports
The goods and services bought from foreign countries.
Indenture
Is the documentation of a legal agreement on the rights of a bondholder.
Indirect Financing
The process whereby funds flow from savers to financial intermediaries
and then to borrowers.
Inflation
Is the increase in the general price level.
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Inflation Risk
The uncertainty that the return on investment will be low enough to result in negative,
real, after- tax rate of return; a situation described as a decrease in purchasing power.
Inflation rate risk
The uncertainty in the direction of interest rates. Changes in interest rates could lead
to capital loss or a yield less than that available to other investors.
Investment Income
Is the money paid, either as interest or dividends on an investment, to the investor.
Investment Strategy
The method used to select which assets to include in a portfolio and to decide when
to buy and when to sell those assets.
Know Your Client Rule
The rule that recognizes the fiduciary duty of the investment advisor to understand
the client’s investment objectives and make appropriate recommendations for
investments.
Labour Force
The total number of employed and unemployed workers.
Ladder Approach
Method involving purchase of several investments, each with a different maturity date,
to reduce inflation, interest rate risk and default risk for fixed income investments.
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Law of Demand
As the price of a good or service falls, quantity demanded rises.
Law of Supply
As the price of a good or service increases, quantity supplied rises.
Liquid Asset
Something of value that is easily converted into cash.
Liquidity
The ease with which an asset can be converted to cash.
Market
An arrangement where the buying and selling of goods and services takes place.
Market Risk
The uncertainty of economic, social or political events that would result in an
investment has decreased value, since these events usually affect the entire
market; market risk is called systematic risk.
Market Timers
Look to buy and sell stocks at the most profitable time in the market cycle.
Marketability Risk
Is the uncertainty of there being a buyer for an investment.
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Maturity Date
Is the date upon which a debt must be repaid and interest payments stop.
Monetary Policy
The attempt by the central bank to control inflation and the value of the dollar and to
manage the business cycle by altering the supply of money and interest rates in the
economy.
Money
Anything that is accepted as payment for goods and services.
Money Market
A financial market with assets of short-term maturity, usually less than one year.
Moral Hazard
The risk (hazard) that once a loan is made it will not be repaid.
Mutual Fund
A collection of many investors’ assets that is managed by a manger that invests in
securities as dictated by a prospectus.
Nominal GDP
The value of final goods and services at current market prices.
Ordinary Annuity
A series of equal payments over a fixed number of years where the payments are made
at the end of each period.
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Over-the-counter Market (OTC)
A secondary market, where dealers hold an inventory of securities that they sell “overthe counter” to anyone willing to accept his or her prices.
Passive Investment Strategy
Use a selected portfolio mix that is re-balanced only after a financial goal is met or
securities mature.
Portfolio
Is a selection of investments designed to achieve a client’s investment objective
especially of return and acceptable risk.
Preferred Shares
Class of capital shares that pays dividends at a specified rate and that has preference
over common shares in the payment of dividends and the liquidation of assets.
Preferred shares do not ordinarily carry voting rights.
Present Value
The value today of a future payment or receipt. The present value is the discounted
value of future payments.
Price Level
The average price as measured by a price index.
Primary Market
A financial market where new issues of a security are offered.
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Prospectus
Is a document that contains detailed information on the nature of an investment, the
investor’s rights and the borrowers obligation and any other information useful to the
investor.
Purchasing Power
Is the amount of goods that can be purchased for a given dollar amount.
Quantity Demanded
The amount of a good or service consumers are willing to buy in a given year at
a certain price.
Quantity Supplied
The amount of a good or service producers are willing to sell in a given year at
a certain price.
Real GDP
The value of final goods and services at prices prevailing in a base year. This
removes the distortionary effects of inflation.
Real Return
Is the return on an investment that has been adjusted for tax and inflation.
Recession
That phase in the business cycle in which the pace of economic growth slows. Real
GDP falls for two consecutive quarters (six months) to be recorded as a recession.
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Registered Bonds
Are bonds that are owned by the person who is registered as the owner. The
registered owner may only sell registered bonds.
Regular Interest Bonds
Canada Savings Bonds that pay interest annually and are therefore non-compounding.
Risk
The variability or uncertainty in an assets return.
Safety of Principal
Is an objective that emphasizes the security of the invested principal.
Secondary Markets
Are markets that only deal in the trade of already issued securities.
Stock Exchange
Is a market for trading of equities.
Stock Picking
Investors analyze individual stocks and select the most promising ones in this active,
investment strategy.
Supply
The relationship between the quantity supplied of a good or service and its price.
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Supply Curve
A graph that illustrates the relationship between quantities supplied and price.
Supply Schedule
A table that lists the quantities supplied at their corresponding prices.
Systematic Risk
Is any uncertainty that affects the whole market such as political, social and economic
decisions.
Taxable Capital Gains
50% of a capital gain.
Taxable Capital Loss
50% of a capital loss.
Term Deposits
Are short-term, fixed interest, money market instruments that can be purchased from
banks or trust companies.
Trade Balance
The value of exports minus the value of imports.
Trust Company
A private intermediary that operates as a deposit-accepting institution, which
also makes loans.
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Unemployment Rate
The number of people unemployed measured as a percentage of the labour force.
Unsystematic Risks
Are uncertainties that are specific to one particular company and do not affect the
market as a whole.
Voting Rights
Are given to shareholders of common stock and allow the shareholder a voice in
determining the directors of the company and company policy.
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