R12 - Risk management for Individuals Flashcards
Define Human Capital (HC)
Present value of expected future labor income
Define Financial Capital (FC)
Everything other than Human Capital
Define Total Wealth (TW)
FC + HC
Define Net Wealth
TW - individual’s liabilities
What is the formula for calculating Human Capital
p(st) = probability of surviving to year t w_t = wage (income) at year t g_t = annual wage growth rate r_f = nominal risk free growth rate y = occupational income volatility N = length of working life in years
=Sum (from t=1 to N) of: (P(st)w_t-1(1+g)) / (1 + r_f + y)^t
Financial stages of life: List them
Education Early career Career development Peak accumulation Pre-retirement Early retirement Late retirement
What is the Education stage of life?
Investing in your knowledge or HC
What is the Early Career stage of life?
Formally completed education and entered the workforce.
What is the Career Development stage of life?
Normally 35-50 years of age. Developing specialized skills in your field, moving up, income rising. Start becoming concerned with retirement savings.
What is the Peak Accumulation stage of life?
Ages 51-60. Have reached, or are moving toward max earnings. Retirement savings and savings for other goals. Start emphasizing income production.
What is the Pre-Retirement stage of life?
A few years before planned retirement. Max career income. Reducing risk in portfolio. Tax planning.
What is the Early Retirement stage of life?
First 10 years of retirement. Comfortable income and sufficient assets to meet expenses. Primary objective is to use resources for entertainment.
What is the Late Retirement stage of life?
Unpredictable length. Longevity risk. Decreased mobility. Possibility of cognitive dysfunction.
Types of risks and their mitigants?
Earnings risk; disability insurance Premature death risk; life insurance Longevity risk - outliving assets; annuities and accurate retirement assumptions Property risk; homeowners/car insurance Liability risk; liability insurance
When should you use insurance?
When risks are too large to accept or cannot be avoided/reduced.
What is term insurance?
Make payments and are covered for that period.
What is permanent insurance?
Lasts lifetime. Often includes build up of cash value that can be accessed prior to death.
What is Whole Life Insurance?
You make the same premium always.
What is Universal Life Insurance?
Premium can be changed over time. E.g. Scale up premium as you age and earn more.
Factors required to price life insurance?
Mortality - how long will live
Net premium - charge based on rate of return on premiums and timing of payouts
Load - addition to net premium to cover company expenses and profit
Gross Premium - premium actually paid; = net premium + load
What are the least expensive to the most expensive insurance types?
Cost increases assumes more risk on insurance company.
- Annual term insurance - company can choose not to renew
- Annual term with guaranteed renewal - renewed, but cost going up
- 5-yr term with fixed premium - self-explanatory
- Whole life
- Universal life with guaranteed cash value build up
What is the Net Payment Cost Index?
Assumes client dies at end of evaluation period and face value of policy is paid
What is the Net Surrender Cost Index (NSCI)?
Assumes no death. Policy cashed at end of evaluation period.
Calculation: FV of premiums - FV of dividends - terminal cash value
What is an annuity?
pay initial premium and receive payouts in future.
can be join annuity (second to die).
payouts can be fixed or variable.
can designate when payouts begin.
Cost of annuity for annuitant point of view?
higher payout = lower cost and vise versa
Fixed vs variable payout pros
Pros:
Fixed - higher initial payout; simpler to analyze
Var - potentially higher total payout over time; more likely to increase and cover future inflation; more likely to allow cash out early
Fixed vs variable payout cons
Fixed - payouts determined by initial interest rates
Variable - shift more risk to annuitant so have potentially higher lifetime payout and inflation protection; flexible, but complexity carries higher fees and makes analyzing costs v benefits difficult
Mortality credit?
Insurance company pools all risks together and money received from clients who died before their time fund needs of clients who lived past their time.
Key to how insurance works. Risk shared and pooled. large diversified pool avoids adverse selection
Self insuring pros/cons
Pros - avoid fees and premium; can withdraw principal and returns
cons - don’t receive mortality credits; taking on risk yourself
Factors favoring an annuity over self insuring
- life expectancy longer than average
- more risk averse and want lifetime income
- less desire to leave state to others
- don’t have access to other life-time income streams, like a pension
Options for dealing with risk
- avoid risk if financially severe and frequent
- reduce risk if frequent but not financially severe
- transfer risk if infrequent and financially sever (i.e. insurance)
- retain risk if infrequent and not financially severe
How to allocate total wealth if you are higher risk and/or have equity-like HC?
Diversify with FC in bonds
How to allocate total wealth if you are lower risk and/or have fixed income-like HC?
Diversify with FC in equity
