R12 - Risk management for Individuals

Question 1

Define Human Capital (HC)

Answer 1

Present value of expected future labor income

Question 2

Define Financial Capital (FC)

Answer 2

Everything other than Human Capital

Question 3

Define Total Wealth (TW)

Answer 3

FC + HC

Question 4

Define Net Wealth

Answer 4

TW - individual’s liabilities

Question 5

What is the formula for calculating Human Capital

Answer 5

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

Question 6

Financial stages of life: List them

Answer 6

Education
Early career
Career development
Peak accumulation
Pre-retirement
Early retirement
Late retirement

Question 7

What is the Education stage of life?

Answer 7

Investing in your knowledge or HC

Question 8

What is the Early Career stage of life?

Answer 8

Formally completed education and entered the workforce.

Question 9

What is the Career Development stage of life?

Answer 9

Normally 35-50 years of age. Developing specialized skills in your field, moving up, income rising. Start becoming concerned with retirement savings.

Question 10

What is the Peak Accumulation stage of life?

Answer 10

Ages 51-60. Have reached, or are moving toward max earnings. Retirement savings and savings for other goals. Start emphasizing income production.

Question 11

What is the Pre-Retirement stage of life?

Answer 11

A few years before planned retirement. Max career income. Reducing risk in portfolio. Tax planning.

Question 12

What is the Early Retirement stage of life?

Answer 12

First 10 years of retirement. Comfortable income and sufficient assets to meet expenses. Primary objective is to use resources for entertainment.

Question 13

What is the Late Retirement stage of life?

Answer 13

Unpredictable length. Longevity risk. Decreased mobility. Possibility of cognitive dysfunction.

Question 14

Types of risks and their mitigants?

Answer 14

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

Question 15

When should you use insurance?

Answer 15

When risks are too large to accept or cannot be avoided/reduced.

Question 16

What is term insurance?

Answer 16

Make payments and are covered for that period.

Question 17

What is permanent insurance?

Answer 17

Lasts lifetime. Often includes build up of cash value that can be accessed prior to death.

Question 18

What is Whole Life Insurance?

Answer 18

You make the same premium always.

Question 19

What is Universal Life Insurance?

Answer 19

Premium can be changed over time. E.g. Scale up premium as you age and earn more.

Question 20

Factors required to price life insurance?

Answer 20

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

Question 21

What are the least expensive to the most expensive insurance types?

Answer 21

Cost increases assumes more risk on insurance company.

1. Annual term insurance - company can choose not to renew
2. Annual term with guaranteed renewal - renewed, but cost going up
3. 5-yr term with fixed premium - self-explanatory
4. Whole life
5. Universal life with guaranteed cash value build up

Question 22

What is the Net Payment Cost Index?

Answer 22

Assumes client dies at end of evaluation period and face value of policy is paid

Question 23

What is the Net Surrender Cost Index (NSCI)?

Answer 23

Assumes no death. Policy cashed at end of evaluation period.

Calculation: FV of premiums - FV of dividends - terminal cash value

Question 24

What is an annuity?

Answer 24

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.

Question 25

Cost of annuity for annuitant point of view?

Answer 25

higher payout = lower cost and vise versa

Question 26

Fixed vs variable payout pros

Answer 26

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

Question 27

Fixed vs variable payout cons

Answer 27

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

Question 28

Mortality credit?

Answer 28

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

Question 29

Self insuring pros/cons

Answer 29

Pros - avoid fees and premium; can withdraw principal and returns
cons - don’t receive mortality credits; taking on risk yourself

Question 30

Factors favoring an annuity over self insuring

Answer 30

• 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

Question 31

Options for dealing with risk

Answer 31

• 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

Question 32

How to allocate total wealth if you are higher risk and/or have equity-like HC?

Answer 32

Diversify with FC in bonds

Question 33

How to allocate total wealth if you are lower risk and/or have fixed income-like HC?

Answer 33

Diversify with FC in equity