Reading 14 Flashcards
Risk Management for Individuals
Compare the characteristics of human capital and financial capital as components of an individual’s total wealth
HC = Discounted PV of expected future labour income. Estimation includes the:
- future amount,
- the probability the individual will be alive to earn it,
- a discount rate related to the riskiness of the amounts
FC = sum of all the other assets of an individual
Discuss the relationships among human capital, financial capital, and net wealth
Net wealth = sum of the individual’s FC and HC less any liabilities owed by the individual.
A typical individual might start an employment career with high HC and low FC. Generally reverses with time.
Discuss the financial stages of life for an individual
HC = highest in early career and declines until retirement FC likely to peak at retirement Life stages: - education - early career - career development - peak accumulation - pre-retirement - early retirement - late retirement
In all stages, there can be unpredicted needs for health care and/or to care for family
Describe an economic (holistic) balance sheet
An economic (holistic) balance sheet extends the traditional balance sheet assets to include HC.
Liabilities are extended to include:
- consumption
- bequest goals
Allows for better planning of resource consumption to meet remaining life goals
Discuss risks in relation to human and financial capital
Earnings Premature death Longevity Property Liability Health
Earnings: job loss and other career disruptions. reduced HC and potential early consumption of FC
Premature death risk: can be a serious risk early in the career when substantial HC could be lost and cause unexpected expenses that consume limited FC
Longevity: outlive FC
Property: loss in value of physical property (FC)
Liability: legally responsible for damages, leading to a reduction in FC
Health: direct loss of FC to pay illness or injury related expenses and may reduce HC through diminished or inability to work
Describe types of insurance relevant to personal financial planning
Life insurance protects survivors from adverse consequences of the insured’s premature death
Disability income insurance provides partial replacement of the insured’s income if job is lost
Property insurance provides compensation for losses in value of real property e.g. homeowners
Health and medical insurance covers health care expense
Liability insurance covers losses if the insured is found legally responsible for damages to another
Describe the basic elements of a life insurance policy and how insurers price a life insurance policy
Temporary Permanent Net premium Load Gross premium
Temporary life insurance: for a set period of time
Permanent life insurance: builds up value sufficient to pay for insuring the remaining lifetime of the insured
Pricing reflects mortality estimates that determine how many in the group are expected to die during the insurance period
This allows calculation of the NET PREMIUM to charge to make those payouts
Load is an estimate of company expenses and profit that added to determine the GROSS PREMIUM charged for the insurance
Discuss the use of annuities in personal financial planning
Immediate
Deferred
Fixed
Variable
Annuities = economic opposite to life insurance
Pay once and receive payouts for the remaining life to insurance against longevity risk
Immediate annuities being payout immediately
Deferred at a future time
Fixed annuities do not change in amount
Variable payouts are linked to change in a reference asset
Discuss the relative advantages and disadvantages of fixed and variable annuities,
VOLATILITY
- Lower risk investors may prefer the certainty of fixed payouts
- Higher risk investors may prefer the potential for increasing variable payouts
FLEXIBILITY
- Fixed annuities are generally irrevocable and payouts cannot be changed
- In variable annuities the future value of the annuity and payouts are linked to the performance of a reference asset
- Variable annuities are more likely to allow withdrawal of the funds at subsequent market value
FUTURE MARKET EXPECTATIONS
- payouts on a fixed annuity are largely determined by initial bond market interest rates
- Variable annuities shift risk to the annuitant from the company
FEES
- Higher for variable annuity
INFLATION
- Variable annuities link payout to an appreciating asset like the stock market and are more likely to provide long-term inflation protection
- Conventional fixed annuities offer no inflation protection
TAXES
- complex and vary by jurisdiction
MORTALITY CREDITS
Both fixed and variable annuities earn a mortality credit:
- For life insurance, the ultimate cost is lower if you die and the one-time payout occurs sooner, while those who live longer end up paying more for the same payout
- For annuities, the issue reverses; annuitants who live longer end up collecting more and are subsidized by those who die sooner and collect less
Discuss how asset allocation policy may be influenced by the risk characteristics of human capital
FC and HC
- If individual is employed in a high-risk profession, then they should opt for low FC
- If the HC is positively correlated with the stock market, then best to select asset classes other than equity for any risky assets that are used
- Individual should try and avoid FC tied directly to their employer
Recommend and justify appropriate strategies for asset allocation and risk reduction when given an investor profile of key inputs
Risk management strategies include:
- Determining and taking the appropriate amount of systematic (market) risk through an asset allocation of total wealth
- Reducing where appropriate idiosyncratic risks
i) through asset diversification
ii) use of insurance to transfer risks
