1. Personal Finance Chapter 11

2. Risk defined Risk is the possibility of loss. implies a situation involving multiple possible outcomes, and at least one of the possible outcomes must be negative. preparations for those events range from insurance to quality control to worker safety campaigns and loss prevention.

3. Effects and types of risk Risk has two negative effects, the creation of uncertainty and the need to divert resources to offset possible losses, i.e., to create reserve funds. Pure risk involves only the possibility of loss. Pure risk can be from fires, hurricanes, workplace injuries, or “slip and fall” incidents involving customers. Speculative risk involves the possibility of gain, as well as the possibility of loss. The willing acceptance of risk, is normally taken because of the potential gain. That is a prime motivation of entrepreneurs and gamblers.

4. Risk management defined the identification, analysis, and treatment of exposures to loss. Those exposures may involve either pure risk or speculative risk. Risk management has been described as an art, a science, and as “structured common sense.”

5. Active and reactive Pre-loss planning is a core strategy for business continuity remediation and recovery are also important. procedures must be put in place to minimize the occurrence of loss and to minimize the financial impact of the losses that do occur.

6. The Risk Management Process Determination of risk management objectives Identification of exposures to loss Analysis of exposures to loss Selection and implementation of risk treatment methods Administration of the risk management program

7. Risk management objectives Risk management objectives are stated in two time frames, pre-loss and post-loss. Pre-loss objectives are those things that are to be accomplished in risk management before any losses occur. Typical objectives include cost effectiveness in risk management practices and minimization of losses or loss-producing “incidents.” Typical post-loss risk management objectives include survival of the firm, minimization of the impact of the loss, and maintenance of reputation.

8. Identification of exposures Exposure identification is the critical component of successful risk management. This is the part of the process that must be ongoing and systematic. There are many strategies for exposure identification, including periodic inspections, the use of checklists and exposure surveys, consultations with employees, analysis of financial statements, and the use of outside consultants.

9. Analysis of exposures to loss A critical exposure is one that would bankrupt the firm. An important exposure is one that would cause serious disruption to the firm, e.g., the need to borrow money. A bearable exposure is one that could be treated as a current expense with no material impact on financial results.

10. Risk treatment methods Risk management methods are divided into risk control methods and risk financing methods. Risk control methods are those activities that affect the frequency or severity of loss. Risk control methods include avoidance, loss reduction, and loss prevention. Risk financing methods are the strategies that are employed to pay for the losses that do occur. The fundamental risk financing methods are retention and insurance.

11. Administration Review and evaluation of the risk control and risk management methods that were chosen. Key questions: Did the chosen procedures work? Did they have the desired effect, i.e., the reduction of losses? Were they cost effective? Remediation, correction, and general monitoring of the risk management activities will be the emphases of this step in the risk management process.

12. Core Risk Management Principles Risk management is a process, not an event. Exposure identification is the key to successful risk management Loss control efforts will pay for themselves Pre-loss planning is the key to post- loss survival Bearing some loss can be rational

13. Loss control efforts Prevention and reduction of losses is often the most cost-effective approach to improving the overall risk management strategy of the firm. Controlling losses in the first place reduces indirect costs, such as supervisor time and time lost by “onlookers” at workplace incidents. These sometimes “hidden” costs are often greater than the direct costs of the loss. The most important reason for loss control, however, is that it can reduce insurance premiums markedly. Insurance companies reward “good behavior” in their premium structures.

14. Common Exposures to Loss Direct property exposures Consequential property exposures Liability exposures Human resources exposures Financial exposures Operational exposures Strategic exposures

15. Consequential / liability Consequential property exposures are those that arise as a result of a direct property loss. They come from the loss of use of the property that is a consequence of the direct physical loss to the property. Liability is a legal obligation that arises from negligence. Negligence is the failure to act as a “reasonably prudent” person, either by an act or by a failure to act. A finding of negligence results in the awarding of damages for bodily injury or property damage.

16. HR / financial Human resources exposures include worker health and safety, key person exposure, business continuation agreements, and employee benefits. Financial exposures are those exposures related to the financial system and financial instruments. These include credit risk, commodity risk, currency exchange risk, inflation risk, and liquidity risk.

17. Operational exposures Operational exposures are those that arise from the operational decisions made by the entity. two sub-categories: failures of persons and failures of systems. An example of a failure of a person is embezzlement Examples of failures of systems include problems with information systems or information technology and supply-chain or distribution-chain problems.

18. Strategic exposures those that arise from the strategic decisions made by the entity. An example of a strategic exposure is a failure in the research and development efforts, especially market research. Another example is failure in the identification of the threats to people, property, and profits/ revenues. There were some extreme examples of the latter in the events of September 11, 2001, especially in the case of a trading firm with all of its nearly 1,000 employees housed on the same floor of one of the destroyed office towers.

19. Fundamentals of Risk Control Avoidance is the decision not to conduct an activity or to discontinue a current activity Loss control is those activities that reduce the frequency of loss (loss prevention), or reduce the severity of loss (loss reduction), or improve predictability of loss Non-insurance transfer transfers the property or liability that creates an exposure to another entity. Examples of this include out-sourcing business functions, leasing business property, disclaimers, and formal legal strategies such as hold-harmless and indemnity agreements.

20. Overall risk control includes all of the following areas where the techniques mentioned above are applied. Personnel safety Industrial hygiene Compliance, e.g., with OSHA Security of people, property, and data Property conservation Liability prevention and defense, e.g., product quality control

21. Fundamentals of Risk Financing Retention involves absorbing losses within the entity’s own financial resources. Insurance involves sharing of losses within a group of entities that are “similarly situated.” Financial derivatives are used to offset the speculative risk involved in financial assets. Derivatives include futures and forward contracts and options contracts.

22. Types of Insurance Life insurance is a method of transferring risk from the insured to the insurance company. Two basic types are: Term insurance assumes that you pay the premium for pure life insurance. Permanent, or whole-life insurance allocates part of the premium to building equity or cash value that can be used upon retirement or borrowed against in case of an emergency.

23. Permanent and whole-life insurance variations: Universal Life Insurance is a policy where purchasers set the premium and the death benefit themselves. Variable life insurance allows the individual to buy insurance and at the same time make choices among investment options. Types of Insurance (continued)

24. Health insurance is purchased to alleviate the cost of an illness or other health problem. Health Maintenance Organizations (HMO) use their doctors, specialists and hospitals. Preferred Provider Organizations (PPO) choice of doctors, hospitals, laboratories and medical facilities within PPO network. Medicare is federal health insurance. All citizens 65 or older Disability for at least 24 months Types of Insurance (continued)

25. Medicare (continued) Medicare has four distinct parts. Part A covers most expenses and the hospital if medically necessary. Part B helps cover doctor services, outpatient care and other items not covered in Part A. Requires monthly premium. Part C consists of Medicare Supplemental insurance plans or Medicare Advantage Plans that provide coverage not covered by Part A & B. Part D is federal government’s prescription drug program.

26. Types of insurance (continued) Disability insurance is purchased to replace lost income when an employee is unable to do the job due to a physical or mental handicap. Long-term care insurance provides for all of the assistance one needs if one has a chronic illness or disability for an extended period of time. Liability insurance is used to transfer the risk of property damage and personal injury that might result from your business operation or individual actions.

27. Financial Planning Goals To achieve financial success in life, we must: Establish goals that are realistic and obtainable Begin with the acquisition stage of capital accumulation Preserve capital by investing in vehicles that provide us a return greater than the inflation rate Consider individual tolerance for risk Distribute capital through retirement income or estate transfer

28. Investments Investment vehicles are the specific financial instruments that we use to generate growth and income. Cash equivalents Certificates of deposit Bonds Stock Mutual funds Real estate Precious metals Collectibles

29. Cash equivalents are liquid assets that are invested in savings accounts or brokerage money market accounts. Money market consists of: Treasuries Banker’s acceptances Certificates of deposit Repurchase agreements Investments (continued)

30. Certificates of deposit, or CDs, are promissory notes whereby a bank promises to pay the purchaser the principal amount plus interest after a stipulated period of time. Investments (continued)

31. Bonds are contractual agreements that are made between a borrower and a lender of financial capital. U. S. Treasury bonds T-bills T-notes Federal bonds Municipal bonds General revenue bonds General obligation bonds Corporate bonds Investments (continued)

32. U. S. Treasury bonds T-bills (or treasury bills) are risk-free investments that mature in less than one year, typically in three or six months. T-notes are bonds that mature in 10 years or less, typically 10 years, 5 years and 2 years. Federal bonds mature in periods that are greater than 10 years and range up to 30 years. Investments (continued)

33. Municipal bonds are issued by a government agency other than the federal government. General revenue bonds are issued to build specific projects for the municipality that will use the income from the project to pay the bondholder. General obligation bonds are used to build projects that do not normally generate revenue such as public schools and roads. Investments (continued)

34. Corporate bonds are issued by a public corporation that wants to borrow money to invest in assets that will help it earn revenue. Secured debt refers to the fact that the corporation pledges specific assets to guarantee the bonds. When the bond is not backed by secured debt, it is referred to as a debenture. Debenture bondholders have a claim on the remaining assets of a company. Investments (continued)

35. Bond terminology: Par value (face value or principal value) of the bond. Denomination of $1,000, paid to the bondholder at maturity (the due date of the bond). Coupon rate (quoted rate or stated rate) is the rate of interest that the issuer agrees to pay to the lender on an annual basis. Current market interest rate the prevailing rate in the market on the date we decide to sell the bond. Investments (continued)

36. Bond terminology (continued): Premium: Bonds that are sold at a value above par ($1,000) Discount: Bonds that are sold at a value below par ($1,000) Junk bond (high-income yielding): A corporate bond having a rating of ‘B’ or less (this bond by definition is a high-risk investment) Investments (continued)

37. Bond valuation: Using current interest rates, find the present value of the bond’s interest payments paid over the remaining life of the bond. Using current interest rates, find the present value of the $1,000 maturity value (par) of the bond. Add the two together to get the price of the bond. Investments (continued)

38. Common stock is issued by public or private corporations to raise financial capital. Owners of corporation Votes for board of directors May or may not pay a dividend Investments (continued)

39. Stock terminology: Par value is an arbitrary dollar amount that is used for accounting purposes to determine the number of shares of stock that have been sold by the corporation. The book value of the stock is the total stockholder’s equity that is carried on the corporate balance sheet. Contains three factors: Stock at par Additional paid-in capital Retained earnings Investments (continued)

40. Factors affecting market value of a share of stock: Supply and demand for shares Actual earnings and anticipation of earnings Book value of stock and number of shares outstanding General economic conditions Investments (continued)

41. Preferred stock is issued by a corporation to raise financial capital but it occupies an intermediate position between common stock and bonds. Quasi-owners of corporation No voting rights Guaranteed a specific return on investment if corporation pays a dividend Investments (continued)

42. Types of preferred stock: Cumulative preferred stock has the following important feature: When the corporation decides to pay a dividend, the preferred stockholder will receive back dividends, or dividends in arrears. Convertible preferred stock is preferred stock that may be exchanged for shares of common stock. Callable preferred stock is preferred stock that can be called back by the company at some specified price. Investments (continued)

43. Stock terminology (continued): Dividend is a payment made by the corporation to each shareholder of a class of stock. Dividends are paid on a per-share basis. Preferred stock dividends are paid first, the remainder is paid to common shareholders. Investments (continued)

44. Mutual funds are companies that are involved in collecting the funds of investors and using these funds to purchase large blocks of stocks, bonds, or other investment vehicles. Each fund is established with a specific goal and risk objective. Investments (continued)

45. Types of mutual funds: Growth funds invest primarily in common stock of publicly held corporations and have capital appreciation as their objective. Income funds specialize in corporate and government bonds. Growth and income funds, or balanced funds, invest in both stocks and bonds.

46. Types of mutual funds (continued): A mutual fund family is an investment group that may have mutual fund portfolios in all of the preceding categories. No-load funds do not charge commissions on the amount invested. Load funds charge a commission on the initial investment, but have no sales charges when you sell the shares. Investments (continued)

47. Types of mutual funds (continued): Global and international funds are funds that invest in stocks and bonds of companies primarily outside of the United States. Money market funds primarily invest in short-term, highly liquid investments such as CDs, short-term government treasuries, commercial paper, repurchase agreements, and banker’s acceptances. Investments (continued)

48. Types of mutual funds (continued): Real estate is an investment in land and buildings. Owner-occupied residential real estate is any kind of building in which people live. It is limited by law to your primary residence and one additional vacation home. Non-owner–occupied residential real estate is property that can be leased by the owner to the tenant for the purpose of generating income. Property may be in the form of houses, apartments, motels, or hotels.

49. Real estate: Commercial real estate is both land and improved property that is used by the owner to generate income. Examples are commercial office buildings, shopping centers, factories, and warehouses. Investments (continued)

50. Real estate (continued): Real estate investment trusts (REITs) provide the investor with the opportunity to participate in the commercial and nonresidential real estate market. A REIT is a pooling of individual investor funds, much like a mutual fund. Investments (continued)

51. Precious metals fall into the area of commodity trading. They are primarily gold, silver, and platinum. Considered to be hedges against inflation. Collectibles are items that become valuable or appreciate with time because of their scarcity. Examples include coins, paintings, sculptures, antiques, stamps, and even baseball cards and comic books.

52. Investments (continued) Short-Term Investment Strategies include: Buying stock on margin Selling short Option trading Long-Term Investment Strategies include: Buy and hold Dollar cost averaging

54. Pension Planning Pension planning consists of making plans to guarantee a system of conserving future income for the time when you choose to retire or are forced into retirement due to circumstances beyond your control. Three main sources of retirement income Social Security Employee Sponsored Retirement Plans Personal savings

55. Pension Planning (continued) Types of retirement plans: Contribution-oriented plans provide benefits to the retiree based on the account balance that has been accumulated during the working life of the pensioner.

56. Benefit-oriented plans provide a defined benefit to the retiree at retirement, which is generally a percentage of the compensation paid to the employee during the last several years of employment and the total term of employment. An example would be military retirement pay. Combined plans are retirement plans designed by individuals or employers. Deferment of salaries into a retirement plan Employer contributions into a retirement plan Pension Planning (continued)

57. Individual retirement accounts, or IRAs, are plans that allow us to contribute current annual income into retirement accounts. Deductible IRAs Non-deductible IRAs Roth IRAs Educational IRAs Pension Planning (continued)

58. IRAs (continued):  Deductible IRAs are those in which you can contribute pretax dollars up to an amount specified by current law.  Nondeductible IRAs allow you to contribute the same amounts as do deductible IRAs, but the contribution is after-tax dollars. For both of the above, returns accumulate tax-free until withdrawn.

59. Roth IRAs will allow you to contribute up to $5,000 of after-tax dollars by 2008 as shown in Table 11-2. If the funds are held in the account for at least five years, there are no taxes due. Your original contributions can be withdrawn tax-free at any time. Can roll a current IRA into a Roth IRA provided you pay tax on current IRA. Can withdraw $10,000 tax-free and penalty- free to purchase first home if IRA is more than 5 years old. Pension Planning (continued)

60. Roth IRAs (continued): Does not have age limit with regard to mandatory withdrawal. Traditional IRAs have an age 70 1/2 mandatory withdrawal age limit. All gains are tax-free forever. Roth IRAs can be passed on to heirs tax-free. Pension Planning (continued)

61. Coverdell Education Savings Account (Educational IRAs) allow for an non- deductible contribution of up to $2,000 for any child under the age of 18. Income accumulates tax-free and remains tax- free as long as it is used for the child’s higher educational expenses. Funds must be used before the student is 30. The account can be transferred between family members. Pension Planning (continued)

62. Section 529 plans include both prepaid tuition and savings plans. Funds in both prepaid and savings plans grow tax- free. Contribution limit depends on plan and vary from state to state ($100,000 to $305,000). Withdrawals are tax-free if used for qualified expenses: Tuition, fees, and room and board at qualified higher educational institutions. Accounts can be assigned to any family members including cousins. Penalty to non-qualified withdrawals is that withdrawal is taxed as ordinary income and there is a 10 percent penalty.

63. Simplified Employee Pension (SEP) Plans are pension plans that are funded by employers. Employer-established All employees must agree Common for self-employed Contributions can be up to the lesser of $46,000 or 25 percent of the participants’ compensation. Pension Planning (continued)

64. SIMPLE plan. SIMPLE (Savings Incentive Match Plan for Employees) is a pension plan established by an employer who has fewer than 100 employees. Current legislation defines contribution limits as shown below: Match employee contribution dollar for dollar to 3 percent of salary. Maximum: $10,500 for 2007 & 2008 If age 50+ $12,500

65. Tax-sheltered annuities (TSAs 403b plans) are plans that allow employees of not-for-profit organizations (churches, public schools, charitable organizations, etc.) to establish a retirement fund that is purchased and approved by the employer. Pension Planning (continued)

66. Keogh plans are for self-employed individuals in sole proprietorships, partnerships, and LLCs. Contribute up to the lesser of 100% of earned income or $46,000 for 2008. Maximum deductible contribution is up to 25% of compensation. Define both contribution and benefit amounts derived from the account. $185,000 limit on annual retirement benefit for 2008. Pension Planning (continued)

67. Profit-sharing plans are established by employers who have determined that a portion of each dollar in profit will be allocated to the employees of the company. Annual contributions to these plans vary drastically because profits fluctuate due to economic, industry, and specific company health. Never stand alone but are incorporated into other types of retirement plans. Pension Planning (continued)

68. 401k plans are retirement plans established to accept employee contributions. Based on salary reduction Employer may match a portion of employee contribution on some basis Allows for pretax contributions up to $15,000 per year. $20,000 for individuals 50 and above. Cannot favor highly compensated employees Pension Planning (continued)

69. SIMPLE 401k is a modification of the 401k plan Limited to firms with fewer than 100 employees Employee contribution limited to $15,000 per year, $20,000 if age 50 or older. Employer can contribute up to 3% of worker’s compensation Plan has to be the only plan the business offers Employers are spared from discrimination testing Pension Planning (continued)

70. Roth 401k plan. Must be established by an employer. Grows tax-free. Uses after-tax money. Max contribution is $15,000 in 2006 and $20,000 if age 50 or older. All funds passed on the beneficiaries tax- free.

71. Money purchase plans are defined contribution plans that are established by the employer to contribute a fixed percentage of payroll into a retirement fund for the employees. Maximum contribution is 25% of payroll Employee does not contribute Employer must contribute even if company makes no profit Pension Planning (continued)

72. Stock bonus plans are similar to profit-sharing plans, except that the employer contributes shares of stock, rather than money, into the retirement account. Employer gets a deduction for the value of the stock. Contribution is pre-tax dollars. Pension Planning (continued)

73. Retirement Strategies Establish a goal, or minimum, income level that you desire when you retire. Do not wait until you believe you can afford to start a retirement account. Plan for capital preservation and continued growth. Invest in instruments that provide you with a degree of risk that is comfortable to you.

74. Try to invest the maximum amount, but never less than the amount that the employer uses to calculate profit- sharing or matching contributions. Consider opening a Roth IRA even if you have an employer-sponsored plan. Retirement Strategies (continued)

75. Estate Planning Estate planning a method of planning for use, conservation, and transfer of wealth as efficiently as possible. Wills are written documents that provide direction to others as to how you want your wishes carried out after death. Probate is a legal court process that addresses and focuses in on the will and the probate estate.

76. Trusts are legal arrangements that actually divide legal and beneficial interests among two or more people. When a trust is set up during the life of the trustor, it is referred to as a living trust. When a trust is established at death, it is referred to as a testamentary trust. A revocable trust is one in which the trustor has the right to cancel the trust during his or her lifetime. An irrevocable trust is one that is unalterable during a person’s lifetime. Estate Planning (continued)