Chapter 14

1. Non bank financial institutions in Australia

• Building societies
• Credit Unions
• Finance companies

2. Building societies
• ADIs
• Promote themselves as alternative to banks
• Historically concentrated on consumer products funded from deposits but recently
pursued corporate business to facilitate growth and product diversification
• How building societies have responded to competition: (MDRST)
• Achieve critical mass and economies of scale through merging with other societies
• Diversified product base to compete with banks
• Reducing costs by adopting technology such as internet banking and electronic
transfers
• Securitisation programs to improve balance sheets
• Transform into corporations and then banks

i. Regulation of building societies:

• ADIs- regulated by APRA
• Regulated in same way as banks
• Removes any competitive advantage that one may have over another in terms of
regulatory bias

Sources and uses of funds:

• Assets
• Loans and advances- mostly residential mortgages
• Reflects traditional business of mortgage lending
• Also some investment securities (bank bills, short-term government securities and
commercial paper of various types) These are used to satisfy legal reserve
requirements and provide liquidity also to invest surplus funds.

• Liabilities
• Most significant funding source being deposits
• Reflects traditional operations- accepting retail deposits and using these to fund
lending

Composition of assets and liabilities makes building societies vulnerable to interest rate
risk. Focus on long term residential mortgages and fund them with short term consumer
deposits.
Creates management challenges. If interest rates increase sharply, cost of funds
will rise. Also rising interest rates put pressure on variable rate loan customers whose
 interest rates will rise, putting more loans at risk of falling behind. Also there will be
expected reduced new loan demand because of the higher rates.

To manage this:
• Attract more capital by becoming corporations with contributing equity investors
• Used securitisation to shift interest and credit risk to third parties
• Australian regulatory environment requires minimum amounts of capital. Requirements
for suitable controls and monitoring of interest rate risk

Capital:
Due to legislative changes many building societies have turned into companies and others
into banks. These institutions have shareholders that contribute capital.

Income and expenses:

• Main source of income is interest income earned from deposits with financial institutions,
interest from investment securities and interest on loans and advances made to clients.
• Main source of interest income is interest on loans and advances to clients
• Sources of non-interest income: (FFC)
• Financial planning
• Fees on mortgages and other loans (application fees, service fees)
• Commissions and dividends from investments

• Main expense: cost of financing loan portfolios.

• Interest expense is interest paid to deposit customers and holders of other borrowings
and subordinated debt
• Other expenses: income tax, bad debts expense, personnel costs, depreciation of
property, plant and equipments and administration costs
3. Credit Unions
• ADIs- regulated by APRA
• Originated in Germany mid 1800s, Australia in 1940s
• Started to provide an outlet for savers to deposit small amounts of funds and provide
loans on relatively lenient terms to members
• Focus on consumer lending
• Owned and operated by members
• Members pool savings and loan them to one another
• Traditionally common bond of association (occupation, association, residence)
• Over time the common bond has been relaxed
• Kevin Yates introduced credit union in Australia in 1946
• Developed into diversified financial institutions that offer a full range of financial products,
compete directly with building societies, banks and other financial institutions
• Like building societies market themselves on basis of customer service, alternative to
banks, however unlike building societies becoming a member--> say in how business
operates

Reasons for joining a credit union:

• Being a member, having the opportunity to vote
• Excellent service: credit unions are for their members, not driven by profits
• Community involvement and support
• Strong local and international movement
• Commitment to consumer education
• Wide range of products and services
• Low fees and charges
• Safety and security
• Substantial market share
• Ease of joining

Regulation of credit unions:

• APRA
• Generally carry levels of capital relative to risk weighted assets in excess of the major
banks- offering greater security to members
• Credit Union Financial Support Scheme (CUFSS)- pool of funds used to support
credit union should it become financially distressed

Assets
• Primarily loans to members (2009- almost 80% of assets were residential and personal
loans)
• Exposed to interest rate risk because many liabilities are shorter maturity than assets
• Loans are primarily consumer and mortgage loans
• Actively seeking to grow commercial lending portfolios in recent years
• Also hold liquid assets and investment securities
• Expanded holdings in government securities- increased opportunities to invest as the
government has expanded its issuance due to credit crisis
 • Most invest in relatively safe government securities and securities offered by other ADIs
• Other assets include: property, plant and equipment, accrued receivables, deferred tax
assets and the sundry account other assets

Liabilities:
• Primarily member savings accounts
• Maintaining traditional funding model

Capital:
• Do not hold shareholders equity
• Membership shares are recorded as liabilities because they are refundable upon
resigning members.
• Capital thus is mostly retained profits
• Outside equity interests: general insurance, travel, financial planning and health fund
business
• Corporations Act 2001 requires that member shares be treated as redeemable
preference shares and withdrawn from retained profits

4. Finance companies
• Finance companies more diverse than building societies and credit unions
• Unlike building societies and credit unions they are NOT ADIs
• Obtain funds in large amounts by borrowing from banks or selling securities in capital
markets
• Some obtain funds from a parent company (which may be a bank)
• Emerged largely in response to restrictive regulations over banks
• Finance companies were established by the bans and others to get around restrictions
• However with deregulation in the 1990s the industry has contracted through mergers and
takeovers
• Sector characterised by several major players and other smaller entities:
• Three large finance companies dominate: Esanda owned by ANZ, CBFC owned by
the Commonwealth Bank and one large multinational GE Money

Types of finance companies: (CND)

• Three categories: captive, niche and diversified
• Captive sales finance companies: finance companies that finance goods sold by their
parent companies
• Sales finance companies: captive sales finance companies that are subsidiaries of major
retailers and car manufacturers

• Niche finance companies: finance companies that specialise in a particular type of

finance product. Types include:
• Large factoring companies- lend to clients by buying and collecting accounts
receivable
 • Payday lenders- small finance companies that offer very short term loans at very high
interest rates. Generally used by those who can least afford it
• Debt consolidation companies- finance companies that target individuals with
excessive levels of personal debt or those with several different loans, then
consolidate these into one loan that is easier to manage or has lower principal
repayment than the individual debts combined

• Diversified finance companies: e.g. GE capital which offer a range of financial products
including credit cards, personal loans, car loans and even mortgages
• Consumer finance companies: specialise in making cash loans to consumers

Assets:
• Divide lending between consumer and business lending. Loan and lease receivables
amount to more than 70% of net assets
• Other assets consist of cash, balances with financial institutions, investment securities,
buildings and computers
• Consumer receivables
• Personal loans
• Motor vehicle credit
• Revolving consumer installment credit (READ about)
• Other consumer installment loans
• Real estate lending- fastest growing area of finance company lending (READ WHY)
• Business credit
• Wholesale financing
• Retail financing
• Lease financing
• Other business credit
• Securitisation of receivables

Liabilities and net worth:

• Overall net worth very small relative to total assets
• Total liabilities account for 81% of total assets- highly leveraged
• Income can fluctuate substantially if they experience loan losses or interest rate changes
• Need to have adequate capital to maintain credit ratings and borrow easily from banks.
Many smaller finance companies have much larger capital ratios than large finance
companies
• Major sources of funds: (BLIB)
• Borrowing from related companies
• Loans from other Australian financial institutions
• Issuing debentures and unsecured notes
• Borrowing from foreign entities in the international capital markets

• Finance companies hold a mixture of both short and long term debt however the major
portion of liabilities, like their assets are short term
 Regulation of finance companies
• Lack of regulation led to their massive increase in numbers in 1970s and 1980s, however
a change in regulations led to gradual demise in recent years
• Primary regulator is ASIC
• Finance company consumer lending is heavily regulated under consumer credit code,
however finance company business lending is not. Business people are presumed to be
better able to act in their own interest than consumers
• Do not control the nature of lending or interest rates or fees that must be charged to
consumers but regulation concentrates on the information that must be provided to
borrowers and standard business procedures
 Chapter 15
• Large banks in particular are active in the international market both through direct
ownership of foreign based banks, offshore operations and as a source of capital
• International banking- banking in which transactions where one or more parties are
located outside the bank’s home country
• This includes transactions such as:
• Depositing in and borrowing funds from foreign banks
• Dealing in foreign currencies
• International funds management
• Facilitating international payments and settlements

1. Development of international banking

• Foreign banks effectively prohibited from business in Australia from 1940s to 1985
• This has changed- innovation of government desires to develop a strong, competitive
and efficient financial system and a strong economy

Origins of international banking

• 11th century- trade and war with Islamic states and North Africa put pressure of western
Europe to move beyond localised trade.
• At this time Italy became a major commercial and banking power- connection between
western Europe and Lebanon, Syria and Israel
• 12th - mid 16th century Italian banks dominated international finance
• With development of trade and international credit Antwerp became the financial hub of
Europe in the 1500s due to geographical location. Also it had one of the world’s two stock
markets at the time, on which capital and credit were tradeable
• This stopped when war broke out in Belgium and Netherlands. In 1585, spanish troops
ransacked Antwerp, ending its reign
• Amsterdam Exchange bank in 1609 and Amsterdam stock exchange in 1611. Throughout
most of the 17th century Dutch dominated international finance. Britain in 19th century
• Bank of England 1694. With defeat of Napoleon in 1814, political stability, economic
growth, sound fiscal policy etc the BoE became the worlds banker
• Implementation of global free trade system and gold standard- BoE
• American banks rise to power in late 1800s and early 1900s when US developed an
industrialised, self sufficient, market economy
• 1913 the US federal reserve was established
• After WWII American banks dominate global financial markets. US industry survived the
war intact (unlike European and Japanese), American banks became an important source
of capital to fund the reconstruction of Europe and US economy grew

• 1944- Bretton Woods- established rules, institutions and procedures to regulate

international monetary system
• Obligation for members to adopt monetary policy that maintain exchange rates within a
fixed value of the value of gold
• US dollar was the reserve currency- currency used as the international pricing currency
for products traded in international markets. Countries therefore hold substantial reserves
of this currency

IMF initial role:

• Promote international monetary cooperation and foreign exchange stability in addition to
facilitating the balanced growth of international trade

World Bank’s role:

• Provide long term finance for postwar reconstruction

General Agreement on Tariffs and Trade (GATT):

• Designed to promote free trade through tariff reduction. Eventually became WTO

Bretton Woods system came to an end in 1971: US government could no longer afford to
provide a reserve currency because of
• BoP deficits
• Inflationary pressures
• Growing expense of Vietnam

1973- floating exchange rate system

Decade of expansion
• Recent decline in US banks and branches is partly due to mergers
• Reasons for dramatic growth in US banking overseas:
• Expansion of US trade
• Growth of multinational corporations
• Government regulations on domestic profit opportunities

Recent activity
• No US banks in top 15 international banks (by asset size) in 1997
• Major drivers of international banking in recent years: (GMIDF)
• Increasing globalisation (G)
• Large scale cross border mergers between banks creating large multinationals (M)
• Rapid innovation and use of technology (I)
• Deregulation of national banking regulations
• Impact of financal crisis (asset values, consumer confidence, legislative changes)

Contagion:
• Risk of the effects of a financial crisis in one region or country spreading to another
• This risk has increased because of increasing interdependence of systems and institions

• Many international banks concentration on fee based business e.g. Consulting etc

Australia:
• 4th largest pool of investment fund assets
• 10th financial centre in the world
2. Structuring overseas banking services
Organisational forms of banks: (ROSFFC)
• Representative offices
• Offshore banking units
• Shell branches
• Foreign subsidiaries and affiliates
• Foreign branches
• Correspondent banking

Representative offices:
• Offices established in a foreign country primarily to assist the parent bank’s customers in
that country
• Cannot: accept deposits, make loans, transfer funds, accept drafts, transact in
international money market
• Can: Provide information and assist parent bank’s clients and business contacts in
foreign country
• Primary vehicle for establishing initial presence

Offshore banking units:

• Foreign branch that has limited access to that country’s domestic market
• Purposes: Tax effective presence to conduct international banking business including
foreign exchange transactions
• Vehicle for attracting nonresident business to the bank and provides a source of foreign
exchange reserves and investments

Shell branches:
• Easiest and cheapest way to enter international banking
• Effectively a booking office for bank transactions located abroad, no contact with the
public and no staff
• Activities: limited to interbank money-market transactions, foreign currency transactions
and the purchase of small shares of syndicate loans
• Environment is almost entirely tax free, liberal rules and simple banking regulations.
Modern communication systems linked to financial centres and stable political environment
• Little use to Australian banks because of global approach to corporate taxation etc which
limits tax advantages

Foreign subsidiaries and affiliates

• A separately incorporated bank owned entirely or in part by a domestic bank
• Provides identity and visibility of a local bank in the eyes of potential customers in the
host country, increased ability to attract local deposits
• Management typically composed of local national, giving the subsidiary bank better
access to local business community
 Foreign branches
• A legal and operational part of the parent bank
• Subject to two banking regulations:
• Subject to all legal limitations that exist for Australian banks
• Subject to regulations of home country
• Foreign governments may fear that branches of large foreign banks hamper growth of
their country’s domestic industry. Nationalism has slowed expansion of foreign banks
abroad
• Major advantages:
• Worldwide name identification
• Customers of foreign branch have full access to range of parent bank’s services.
• Disadvantages:
• Costs of establishing them and legal limits placed on their activities

Correspondent banks
• Most major banks maintain correspondent banking
• It is a business arrangement between two banks in which one agrees to provide the other
with special services such as cheque clearing or trust department services

3. International banking activities

International lending
• Greatest amount of income from international operations is mainly through foreign
branches or affiliate banks
• European banks collectively hold the most claims almost $14 trillion
• 10 banks or so dominate the market

Characteristics of international loans

• Similar to domestic business loans
• Differences in:
• Funding
• Syndication
• Pricing
• Collateral
• Can be denominated in any major currency (US dollars favourite)
• Tend to be larger in size than typical domestic loans ( borrowers governments or large
multinationals)
• Most large international loans are in eurocurrency market
• Loans priced with respect to LIBOR, a non bank borrower priced at premium above
LIBOR
• Eurocurrency favour market because: volume of credit available, low cost of funds,
service available
• Large international bank loans are syndicated- several banks participate in funding the
loan which is packaged by one or more lead banks. Allows banks to spread risk and
borrowers to obtain larger amounts of capital
• Most international bank loans are unsecured (without collateral) business loans generally
only made to large credit worthy multinationals

International lending products (PSTIC)

• Project finance
• Ship financing
• Trade financing
• International leasing
• Commodities finance

Project finance
• Structuring and finance of large scale projects and developments
• Often involves many parties: financiers, development and construction companies,
government agencies, customers etc
• It is the project that is financed not the company or companies involved

Ship financing
• One of the riskiest forms of lending
• Financing large vessels
• Risks derive from ship owners having very little equity interest in the vessel and the value
of used ships being little more than scrap value
• Risk depends on type of charter used:
• Bare boat charter: operating company is responsible for all operating, insurance and
maintenance costs associated with the ship. Character and standing of the operator
is of importance
• Time charter: operator rents ship for specific period and owner bears costs and risk

Trade finance
• Short term financing of importing and exporting activities across the globe
• Less risky than project and ship financing
• Backbone of many banks international lending operations and a source of profitable
lending
• Three basic forms: (TBL)
• Trade accounts: involving the importer paying for the goods only after they are
received and title has been transferred, exporter bears the risk. 75% of Aus imports
50% of exports
• Banks drafts: a financial instrument that provides an exporter with a written guarantee
that a financial institution will honour payment once the goods have been delivered.
Bank drafts are prepared by the exporter and sent to the importer as a request to pay
before the actual export of the goods.
• Sight drafts: bank draft that requires payment when goods are received
• Term drafts: a bank draft that requires payment some time (specified) after the
goods are received
• Letters of credit: greatest security for parties, commonly used. Importers bank issues
LOC that agrees to honour the importers obligation

International lease financing

• Two kinds of leases:
• Operating: short term arrangements where the asset is maintained by the lessor for
the duration of the lease, with the asset returned to lessor at the end
• Finance: longer term, at the end of which ownership is usually transferred to lessee
• Leasing is usually tax driven
 Commodity financing
• Short term debt used to purchase commodities that are on sold hopefully with a profit
margin to service debt and produce a net profit
• High risk for banks because success of traders depends on movements in commodity
prices

Investment banking
• Provision of a range of services and products including underwriting and selling shares
and bonds, making markets in securities, advisory services and structured financing

Euro fundraising
• Raising of funds in international markets is important activity of banks
• Major source of these funds is eurocurrency market
• Instruments:
• Euronotes (Short term secured securities)
• Euro commercial paper (short term unsecured)
• Euro medium term notes (unsecured 3-5 years)
• Eurobonds (unsecured long term, fixed maturities and interest rates)

International retail and private banking

• Retail banking services such as deposit accounts and consumer loans on a global scale
has been one of the last areas banks sought to develop
• Barriers to entry are high: domestic banking regulations, differing types of financial
products across countries and established local banks making it difficult for new entrants
to establish themselves
4. International banking risks
• Face credit, market, liquidity, interest rate and operational risk

Country risk
• Possibility that future returns from international activities may be impaired by economic or
political events surrounding the foreign currency
• Types: (TCPS)
• Transfer risk
• Currency risk
• Political risk
• Sovereign risk

Transfer risk
• Not being able to convert domestic currency into foreign currency
• Usually occurs because of government imposed exchange controls
• Not uncommon in developing nations

Currency risk
• Concerned with currency value changes and exchange controls
• Loans denominated in foreign currencies, if currency in which loan is made loses value
against the banks domestic currency during the course of the loan, the repayment will be
worth less in domestic currency terms
• Can be hedged in developed markets however in developing markets this may not
always be the case

Political risk
• Possibility that political factors may impair a borrower’s ability to meet debt servicing
obligations
• Includes civil unrest, political turmoil, corruption and governmental nationalisation or
expropriation of assets (Only really Chile and Cuba)

Sovereign risk
• Possibility that a sovereign country as a borrower may become unable or unwilling to
service its foreign obligations or meet guarantees of nongovernmental or private
borrowings

Risk Evaluation
• Evaluations of expected inflation, fiscal and monetary policy, country’s trade policy,
capital flows and political stability and credit standing of individual borrower
• When in depth analysis too expensive- turn to on site reports, checklists and statistical
indicators
 Methods of reducing risk (TPD)
• Third party help
• Third party agree to pay back principal and interest if borrower defaults.
• Typically done by foreign governments and central banks but if the nation is politically
unstable this may not mean much
• Alternative is external guarantee from outside institution
• Pooling risk
• Banks join together to provide the funds for loans and so directly reduce the risk
exposure for individual banks
• Diversification
• Portfolio diversification- if a borrower defaults earnings from other investments will
minimise the effect of the loan loss on the bank’s total earnings
• Loans that are less correlated with the banks existing portfolio would be more
attractive
• Geographic diversification reduces political risk but diversification for diversifications
sake not always good a bank develops expertise in certain countries and cultivates
sources of primary information that may not be available to other banks. This type of
information, plus longstanding experience with a particular borrower, may allow the
bank to formulate better estimates of the risk involved in a particular loan.

5. Regulation of overseas banking activities

• Banking traditionally highly regulated- need to promote financial system safety, supports
economic stability
• Net regulatory Burden (NRB)
• Banking regulation a matter of national sovereignty, no supranational institution to make
laws for all
• Basel Accord- minimum capital adequacy requirements for banks of member nations
• The Financial Action Task Force on Money Laundering, which examines and makes
recommendations on action to combat money laundering.
• Differing level of regulatory intervention into a national financial system may be a factor
that influences the decision of a foreign institution to set up operations in that country
• Representative offices of foreign banks are not ADIs, cannot accept deposits
• Money laundering: the processing of the financial proceeds of criminal activities to
disguise the illegal origin of the funds.

6. International activities of Australian banks

Reasons banks engage in international activities (DASFO)
• Diversify business as a means of risk management and business growth
• Access different products, expertise and technology
• Service the needs of multinational clients around the globe
• Follow clients as they expand their operations internationally and to be able to provide
them advice on operating in these regions
• Obtain favourable regulatory and tax environments
 This last point is of little advantage to Australian banks because of Australia's
international approach to corporate taxation and the Basel Accord.

7. Foreign banks in Australia

• Significant competition for Australia’s domestic banks
• Technology driven: without having to create branches, a website and phone centre is fine
• Offer advantages such as improved access to foreign capital, employment and training
opportunities, increased product choice for consumers and increased competition
• Foreign banks in 2008 controlled approximately 21.4% of all banking assets in Australia

8. Future directions of international banking

Industry faces significant challenges and opportunities:
• Recent consolidation of the European economy
• Capital needs of developing nations likely to put pressure on world credit markets
• Asian financial crisis and other shocks have increased financial institutions awareness of
operational risks
• Restriction of capital flows as a result of GFC and near halt to securitisation
• Impact of climate change
 Chapter 16
• Individuals and business face risk, which is uncertainty concerning the occurrence of
loss
• Methods of dealing with risk: (RLR)
• Retention: individual or business is responsible for the loss (e.g. Uninsured risk)
• Loss control: includes any effort to reduce the frequency and severity of risk (e.g.
Smoke detectors, seat belts)
• Risk transfer: risk transferred to another party through contract e.g. Insurance

1. The insurance mechanism

• Insurance is the transfer of pure risk to an entity that pools the risk of loss and provides
payment if loss occurs
• Risk transfer: shifting the responsibility of bearing the risk from one party to another
• Pooling: Spreading losses suffered by a few insured over the entire group so that
insurance purchasers substitute the average loss for the uncertainty that they might suffer
a large loss
• Pure risk: Situations where there may be two outcomes: loss or no loss
• Speculative risks: There may be three outcomes: loss, no loss or gain

• Insurance benefits society:

• Reduces fear and worry
• Provides an incentive for loss control because insurance premiums are determined by
the chance of loss, and loss control reduces the chance of loss
• Facilitates credit by protecting collateral pledged to secure loans

Insurers and objective risk

• Objective risk is the risk that an insurer faces once it has accepted the transfer of risk
from insurance purchasers. It is the deviation between actual losses and expected losses
• Sources of catastrophic losses include natural disasters and terrorism

Methods of reducing objective risk

1. Law of large numbers: as the number of insured risks increases the deviation between
actual and expected results will decline. Although an insurance companies underwriting
risk increases as more units are insured (more potential claims to pay), objective risk
declines
2. Careful underwriting: Selection and classification of insurable risks
3. Make the insured pay a portion of any loss that occurs (excess). Makes the insured
responsible for the first portion. Co-insurance: insured pays portion of the loss
4. Charging higher premiums where the risk of loss is higher (aged based, smokers etc)
5. Restrictive covenants: legal obligation to do or not do something (e.g a minimum level
of security on a property)
6. Reinsurance: insurers shift some of the risk they have insured to another insurance
company
 Requirements of privately insurable risks
• Many similar exposure units
• Losses that occur should be accidental and unintentional by the insured
• Losses must not be catastrophic - usually excluded from policy
• Losses should be determinable and measurable
• Chance of loss must be calculable
• Premium for insurance must be affordable

Regulation of insurance industry

• APRA regulated insurance industry
• Life insurance Act 1995
• Insurance Act 1973
• ASIC regulates legislative requirements applied to insurance companies

2. How insurance companies make money

• If total premiums collected are worth more than the total claims, the insurer has made an
underwriting profit
• This is bolstered by investment income earned on the pooled premiums

Pricing insurance
• Charge enough to cover claims and admin expenses
• Competitive markets
• Insurance regulators require that rates are adequate to pay losses
• If interest rates are expected to be high and investment income expected to be large,
lower rate will be charged
• If interest rates are expected to decline and investment income less, rates charged will
be higher
• Some cases excesses are imposed, some they are optional (trade off higher excess for
lower premium)

Interest rate risk and insurance companies

• Underwriting cycle
• High premiums and tight underwriting standards (hard insurance market)
• Low premiums and loose underwriting standards (soft insurance market)
• Cash- flow underwriting: writing of insurance on just about any risk to get the premium
dollars to invest at high interest rates
3. Types of insurance
• Three broad types of insurance: Life, general and health

Life policies
• Provide financial support to dependants in case of premature death (when others are
financially dependent)
• Replace lost income and cover expenses that may coincide with death
• Policyholder pays regular premium in return for a payment upon death, disablement or
on specified maturity date

Term insurance
• Most popular
• Pure life insurance for a specified period of time, less than all of life
• Paid if insured dies while policy is in force, if policyholder does not die, no payment
• Premiums low at younger ages but increase at increasing rate based on risk of death
• Straight term insurance: written for certain period then terminates
• Decreasing term insurance: face amount decreases while premium stays level
• Increasing term insurance: face amount increases
• Renewable term insurance: policy may be placed back in force at end of coverage
period. This is usually limited at a specified age to protect against adverse selection
• Convertible term insurance: permits term coverage to be switched to whole life insurance
without providing evidence of insurability

Whole life insurance

• Provides coverage for all of life
• Level premium policy
• Policyholders ‘overpay’ the cost of mortality in early years and ‘underpay’ in later years
• Insurers pay interest on the cash value that is returned to policyholders as a ‘bonus’
• An endowment policy is a variation that has a fixed term
• Popular but popularity has declined

Disability policies
Total and permanent disablement insurance
• Provides benefit if insured becomes TPD through accident or injury, preventing work
• Either lump sum or annuity
• Definition of TPD is critical

Trauma insurance
• Lump sum insurance if insured suffers a specified trauma

Income protection
• Provides regular payment to policyholders if unable to work for extended period because
of accident or illness
• Based on income earned, paid as a percentage
 Business overhead insurance
• Provides cover for ‘eligible business expenses (leases, rent, taxes, phones, rates) as
agreed when policy is taken out whilst person is incapacitated
General insurance policies

• Predetermined payment should a specified peril occur

• No investment component, pure insurance: no money repaid
• Fee for a service

Property and liability insurance

• Direct and indirect loss caused by perils
• Direct losses: fire, windstorm, explosion, flood, earthquake
• Indirect losses: profits that could have been made in a business
• Property insurance is financial loss associated with destruction or loss of property
• Liability insurance protects against the peril of legal liability (negligent insured that
causes bodily injury etc)

Property insurance
• Named perils coverage: list of perils that are covered
• All risks coverage: or open perils insures against all loses except those excluded
• Most common: house and contents and motor vehicle

Liability insurance
• Legal responsibility for bodily injury, property damage etc
• Damages awarded have no upper limit: difficult to gauge

Health insurance policies

• Cover over and above provided by government: Medicare
• Private health insurance provides coverage for ‘nonessential’ procedures: choice of
doctor, avoidance of waiting lists
• High income earners that do not take out higher cover are required to pay higher
Medicare levy

Issues in insurance

Adverse selection
• Results in poor products or consumers being more likely to be selected because of
information asymmetries between buyers and sellers
• Those at greatest risk of loss more likely to insure than others
• Higher premiums because the insurers will increase them as more claims are made
• Thus it is less likely that those with lower risk will insure: cost-benefits
• Information asymmetry: two parties do not have equal information

Moral hazard
• The risk of immoral behaviour that has negative consequences because the person does
not suffer any loss or perhaps benefits
• Complacency or inappropriate action
• Problem when assets are overinsured
 • Can be mitigated: (IICPE)
• Sufficient investigation of claims made
• Sufficient information is obtained to assess the value and condition of insured items
• Impose covenants: provision of security systems, fire safety equipment
• Premium restrictions for the provision of covenants and premium restrictions for those
who do not claim on policies: no claims bonus
• The use of an excess discourages moral hazard, insured is responsible for first
portion

Viability of insurance companies

• Insurance premium is paid in advance to provide loss coverage in the future
• If insurance company fails coverage and premium lost

Complexity of insurance contracts

• Concern: consumers select inappropriate polices for their circumstances, not
understanding the conditions of their policy or decide not to take out policy because of a
lack of confidence in insurance products
• Negative media coverage of insurance companies refusing to pay claims on basis of
technicalities

Redlining
• Insurance companies refusing insurance in particular geographical areas
• Reasons: crime rates, risk of flood, fire, earthquake
• Also due to factors as age, gender, education etc
• E.g. Young male drivers paying much more in insurance premiums

Patents
• Patenting insurance products to protect them being copied by competitors
• Argued to promote innovation because investments in R+D are protected
• E.g. Pay as you drive car insurance with GPS system, also identify location of car if
stolen

Securitisation of risk
• Insurance risk is transferred to the capital markets through the creation of a financial
instrument such as a catastrophe bond or futures or options contract

4. Investment companies
• Gather funds from savers for investment in capital and money market instruments or
investment in specialised assets such as real estate
• Advantage of providing investors with risk intermediation by investing in a diversified
portfolio of assets
• Denomination intermediation: investing in large blocks of assets and selling shares to
customers in smaller amounts

Main categories:
• Statutory funds of life insurance offices
• Superannuation funds
• Public unit trusts
• CMTs
• Common funds
• Friendly societies

Closed-end investment companies

• First started in Belgium in 1822
• A fund that initially sells its shares to the public to obtain cash to invest and then operates
with a fixed number of shares outstanding
• Typically does not offer more
• Most property property funds are listed, closed-ended
• Two important values for shares in closed-end investment companies:
• Net asset value (NAV) per share: the sum of total current value of funds assets -
value of debts divided by total number of shares
• Premium or discount to NAV: price at which funds shares can be bought or sold in
stock market, vaires from 10% above to 20% below NAVs
• Reasons why premium or discount:
• Premium: people want to invest in a specific country may be willing to pay a premium.
Fund with a superior manager
• Discount: Poor managers who cannot easily be replaced, fund with unrecognised tax
liabilities

Open-end investment companies

• Started in US in 1924
• Allows investors in the fund to redeem some or all of their investment at NAV on any
given day
• In US: mutual funds
• In Aus: Managed funds
• Unit investment trust: trust with pro rata interests in a managed pool of assets. Shares or
units are sold to the public to obtain the funds needed to invest in a portfolio of securities
• Trustee administers the trust which holds the assets and liabilities of the fund
• When an investor buys shares or unit in the trust the fund issues new shares or units in
the fund
• No limit to the number of shares or units other than market demand
• Popular because it is guaranteed that investors could redeem shares at NAV

Reasons for explosive growth in investment companies:

• Many new types of managed funds and investment companies
• Deregulation of international capital markets
• Government policies that give incentives for additional payments to super
• Increased interest in investments by ageing baby boomers
• Knowledge and investment sophistication of investors
• High rates of return available on common stocks
5. Types of managed funds in Australia
Investment strategies
• Strategies determine mix of assets held by funds
• Trust deed sets out mix of asset classes in terms of target percentages
• Product disclosure statement (PDS) contains details in relation to the management of the
fund, fees it charges, how the manager will communicate with unit holders and options for
withdrawing and switching funds

Fund strategy Risk profile Recommended minimum

investment horizon

Cash management low No minimum

Fixed interest low No minimum

Balanced medium 3-4 years

Property medium 3-5 years

Diversified Medium-high 4-5 years

Domestic shares Medium-high 4-6 years

International shares high 5-7 years

Growth funds high 5-7 years

• Important decision is amount of cash to hold for liquidity without sacrificing performance
• Usually 4-10%
• Stock and bond oriented managed funds typically hold more liquid assets when market
interest rates are high, yield on liquid assets is high and stock prices are expected to fall

Growth and income funds

• Seek a balanced return, consisting of both capital gains and current income
• Hold high quality common stocks

Growth funds
• Focus of capital appreciation
• Invests primarily in common stocks that judged to have above average growth potential

Aggressive growth funds

• Stocks of small companies with high price/earnings ratios or companies whose stock
price is volatile

Balanced funds
• Balanced portfolio of stocks and bonds
• Current income and capital appreciation
 • Typically generate higher income than growth and income fund will be less volatile
• Opportunity for capital gains is less

International and global equity funds

• Diversify asset holdings internationally
• Global funds can invest anywhere in the world
• International funds tend to invest outside their home nation

Socially responsible investment funds

• An investment process that considers the social and environmental consequences of
investments, both positive and negative within the context of rigorous financial analysis

Income- equity
• Seek higher income by investing in stocks with relatively high dividend yields

Speciality funds
• Index funds: designed to match the return from a particular market index
• Single segment of the market, industries such as telecommunications, oil, biotech, health

6. Superannuation
• A government-controlled investment strategy aimed at providing resources that can be
used upon retirement
• Deals with the risk of outliving ability to earn a living
• Several problems with retirement savings:
• Many delay retirement saving, spending financial resources today for current
consumption rather than saving for retirement
• Some do not earn enough to afford retirement savings
• Period of retirement saving is shortening while period that the funds are required is
lengthening
• Super schemes among the fastest growing financial intermediaries in the past 25 years
• 99% of funds are small self managed funds (SMSFs)

History of superannuation
• Originally established by banks to provide a pension to long serving employees
• 1986 this changed as the government decided superannuation was to be a condition of
employment
• 3 per cent employer super payment was added to industrial awards
• This did not cover all workers, but in 1992 the government’s Superannuation Guarantee
Charge (SGC) Act made it compulsory for all employees
• 2003- grew to 9%
• World Bank’s 3 pillars model:
• Provision of basic pension- antipoverty measure and minimum standard of living for
elderly
• Forced contribution from income to a super scheme
• Voluntary savings of individuals over and above second pillar
• In NZ there is no compulsory super savings

Singapore’s Central Provident Fund 3 accounts:

• Ordinary account: can be used to buy a home, pay for insurance, investment and
education
• Special account: For old age, contingency purposes and investment in old age related
financial products
• Medisave account: hospital expenses and medical insurance
• Aims:
• Sufficient retirement savings
• Property is fully owned before retirement
• Sufficient savings to pay for medical costs in retirement

Types of super funds

Defined benefits plan

• Employer states benefits that employee will receive at retirement: flat dollar amount,
percentage of average salary over specified period or unit benefit formula
• Difficult to administer and place investment risk on employer

Accumulation fund
• Super fund that pays out the sum of the contributions made by the employee and the
earnings on those funds
• Shift away from defined benefits plans to accumulation funds with growing risk to
employers of having to pay lifetime pensions to defined benefits plan holders with
increasing life expectancies
• Once employee has retired, super is paid out and no further obligation on employer

Self managed super fund

• Funds with fewer than 5 members
• Regulated by the ATO whilst other funds report to APRA
• Advantages: control the individual has over their super investments, potentially lower cost
of running the fund relative to paying super fund managers
• Disadvantages: costs, reporting requirements and time required to comply with
regulations

Public offer fund

• Offer super products to the public, on commercial basis
• One of the following:
• Not a standard employer-sponsored fund
• A standard employer sponsored fun that has some non-standard employer sponsored
members
• A fund whose trustee has elected for it to become a public offer fund

Non-public offer fund

• APRA regulated, not public offer and have greater than 4 members
• Include:
 • Eligible rollover fund (ERF): fund eligible to receive benefits automatically rolled over
from other funds
• Pooled superannuation trust (PSF): a trust in which assets of super funds, approved
deposit funds and other PSTs can only be invested
• Approved deposit fund (ADF): can receive, hold and invest certain types of rollovers
until such funds are withdrawn or a condition of release is satisfied
• Small APRA fund (SAF): a super fund managed by an approved trustee that is
regulated by APRA, less than 5 members
• Self managed super fund (SMSF)- super fund regulated by ATO, less than 5
members

• Corporate fund: company super fund, either non public or public offer. Largely non public
• Industry funds: draw members from a range of employers across a single industry,
established under agreement between parties to an award. Traditionally non-public offer,
recently more becoming public offer
• Public sector funds: Sponsoring employer is a government agency or business enterprise
that is majority government owned. Typically non-public offer
• Retail fund: offer super products to public on a commercial ‘for profit’ basis. Usually run
by large financial institutions
• Small funds: < 5 members, include small APRA funds, single member approved deposit
and SMSFs

Regulation of superannuation
• Responsibility of APRA- prudential supervision
• ASIC- market integrity and consumer protection
• Concessional rate of tax (15%) on super contributions- motivating factor for individuals to
invest in super

7. Cash management trusts

• CMTs are managed funds that invest in wholesale money-market securities such as
short and medium term Commonwealth government securities, international government
securities and banking and corporate debt
• Established in early 1980s: banks had interest rate controls imposed on them, limited
return to investors of cash savings
• CMTs could purchase securities in the wholesale markets and provide improved returns
• Deregulation throughout 1980s CMTs lost competitive advantage as banks began to offer
products with higher interest rates

Public unit trusts

• Governed by a trust deed
• Units sold to investors, proceeds invested in accordance with guidelines in trust deed
• Types:
• Equity trusts
• Fixed interest trusts
• Mortgage trusts
• Property trusts
 Equity trusts
• Invest in a range of equity stocks across a range of markets to form a portfolio
• Some funds focus on: domestic stock, international stocks, industry stocks, firms in
particular stage in life cycle, high dividends, high growth potential

Fixed interest trusts

• Invest in a range of securities with fixed rates of coupon interest: govt bonds etc

Mortgage trusts
• Process of securitisation has allowed banks and other financial intermediaries to on sell
lending assets
• Mortgage trusts are one of major purchasers
• These trusts purchase a variety of mortgages and package them into a trust
• Buy the rights to the principal and interest payments that you make on a loan from the
bank

Property trusts
• A trust that pools the resources of investors to purchase commercial, industrial and retail
property with a view to generating both income and capital gains for investors

8. Hedge funds
• Investment pools that use a combination of market philosophies and analytical
techniques to develop financial models that identify, evaluate and execute trading
decisions. Goal is to provide above market rates while substantially reducing the risk of
loss
• Traditionally investing in long and short positions, buying stocks long and selling
borrowed shares short.
• Growth in hedge funds fueled by need to manage risk and generate returns
• Target absolute not relative rates of return

Hedge fund strategies

Domestic hedge strategies

• Value and growth strategies. Tend to be short term
• Managers select long and short positions through research

Global hedge strategies

• Specialise in specific geographic regions

Global macro strategies

• Based on shifts in global economies
• Managers speculate on changes in countries economic policies and shifts in currency
and interest rates by the use of derivatives and leverage
 Market neutral strategies
• Seeks to eliminate market risk by equally balancing long and short positions

Sector strategies
• Invest long and short in specific sectors of the economy
• Examples: technology companies, financial institutions, health care, utilities

Short selling
• Sale of securities that are overvalued from either a technical or fundamental viewpoint.
• Investor does not own shares sold but borrows them from a broker in the expectation that
the share price will fall and the shares may be bought later at a lower price to replace
those borrowed

Fixed income arbitrage

• Taking long and short positions in bonds with the expectation that the yield spreads
between them will return to historical levels

Index arbitrage
• Buying and selling a ‘basket’ of stocks or other securities and taking a counter position in
index futures contracts to capture differences due to inefficiencies in the market

Closed-end fund arbitrage

• Buys or sells a basket of stocks

Convertible arbitrage
• The fund manager simultaneously goes long in the convertible securities and short in the
underlying equities of the same insurers

Event driven investing

• Risk arbitrage: long position in the stock of a company being acquired in a merger. If the
takeover fails, this strategy may result in large losses because the target company’s stock
price likely will return to its previous price
• Distressed securities: invest in the securities of companies undergoing bankruptcy or
reorganisation: financial rather than operational distress
• Special situations: take advantage of unusual events with a significant position in the
equity or debt of a firm. Depressed stocks, impending mergers or acquisitions or emerging
bad news that may temporarily cause a company’s stock or bond price to decline