Reading 32: Risk Management for Individuals

Question 1

Life Insurance

Answer 1

HC and the need for life insurance is likely at its peak in the early career stage, followed by the career development stage when the expected work career and HC remain high.

Question 2

Net Discount Rate

Answer 2

1 + risk free rate and risk premium / 1 + expected growth. Then use this in the calculator to find the FV of the annuity. As long as the discount rate in numerator is greater than the growth rate, you can use this.

Question 3

Human Capital Volatility

Answer 3

Human capital volatility and demand for life insurance are negatively correlated. Life insurance acts as a substitute for human capital, so its face value depends on the perceived value of the human capital it replaces. If the human capital has high volatility (equity-like), a higher discount rate is used to estimate its present value. Thus, human capital with high volatility has a smaller present value than human capital with low volatility.

Question 4

Financial Capital

Answer 4

Financial wealth and the demand for life insurance have a negative relationship which means if a person has a lot of financial wealth their need for life insurance is small and visa versa.

Question 5

Health Maintenance Organisation Plan

Answer 5

Type of medical insurance that allows office visits at no or very little extra cost.

Question 6

Non-Forfeiture Clause

Answer 6

There is an option to receive some portion of the benefits if premium payments are missed (i.e. before the policy lapses).

Question 7

Long-Term Care Insurance

Answer 7

Covers a portion of cost of home care, assisted living, or nursing home expenses.

Question 8

Defined Benefits

Answer 8

These are on the economic but not traditional balance sheet (defined contribution is on both). Unvested benefits are typically contingent on future work and are considered a part of human capital. Vested benefits can be considered components of financial capital. Typically DBs are considered FC however.

Question 9

Fixed vs Variable

Answer 9

Most deferred variable annuities offer a diversified menu of potential investment options, whereas a fixed annuity locks the annuitant into a portfolio of bond- like assets at whatever rate of return exists at the time of purchase.

Question 10

Advanced Life Deferred Annuity

Answer 10

Payments begin later in life, say at 80 or 85. This would provide the greatest supplemental level income reliance to the cost because payments are made far into the future, life expectancy is shorter when payments begin, and some policy holders die without receiving payments (mortality credits).

Question 11

Human Capital

Answer 11

Estimated using projected future earrings as growth rate, mortality rates, real and nominal risk free discount rate plus appropriate risk premiums that are dependent are risk of income going forward.

Question 12

Types of Risk

Answer 12

Earnings risk (disability insurance); premature death risk (life insurance, high HC = high life insurance); longevity risk (insure with annuities); property risk (property insurance) is losing real value in property: liability risk (liability insurance) is being legally responsible; health risk (health insurance).

Question 13

Life Insurance

Answer 13

Can be used to to provide liquidity to meet death and estate expenses, more important if the assets in the estate are illiquid. Some life insurance provides tax benefits by accumulating cash value on a tax-sheltered basis.

Question 14

Temporary Vs Permanent Insurance

Answer 14

Temporary (term) covers a short period of time and is less costly as mortality risk is lower. Each year the policy is renewed however the cost will rise as mortality risk increases with age. Permanent insurance is most costly and last for life. The first few years costs will exceed the term cost however in later years, since the payment is fixed, the term costs tend to be higher than permanent. Permanent can be classified as whole life or universal.

Question 15

Permanent: Whole Life vs Universal

Answer 15

Whole life has fixed annual premium payments and cannot be cancelled if premiums are not paid (beneficial getting it young to maintain cheaper premium). Fully paid status can be reached, requiring no further premiums. Universal life is more flexible, premium can increase or decrease to change the amount of insurance or rate at which cash value grows. Investment choices for where premiums are invested. Non-forfeiture clauses apply as long as cash value and returns on cash value are sufficient. Universal has more options for investing the cash value than whole life policies.

Question 16

Riders

Answer 16

Additional benefits on the policy that include accidental death and dismemberment, accelerated death benefits (terminal illness), sale of policy to third party, waiver for premiums if disabled. There can be a rider on a fixed annuity to increase payments with inflation.

Question 17

Net Premium & Load

Answer 17

Net premium is the premium needed to pay future benefits (discounted at return from investing premiums). Load is net premium plus gross premium that covers operating costs and expenses from writing policy.

Question 18

Pricing Insurance

Answer 18

Uses net payment cost index or net surrender cost index. Net payment cost index assumes death at the end on period and does not include the cash value remaining at the end of policy. Find PV of premiums (annuity due begging of period) less PV of dividends (ordinary annuity end of period), find the PMT of this FV per $1,000 of policy. With net surrender do the same but less cash value remaining for the FV as it is included (only difference). When finding the monthly cost from netted FV, use annuity due as payment is at the start of year.

Question 19

Annuity Terms

Answer 19

Owner pays the premium, beneficiary receives the value remaining at death of annuitant. They are the opposite of life insurance. Annuities require immediate payment of premium but may not start paying until a future date. Life annuity lasts until death, period certain lasts for specific amount of time, life annuity with refund specifies refund if a minimum payout amount hasn’t been received, joint life carries on both payments even if one person dies.

Question 20

Deferred Fixed vs Variable

Answer 20

Deferred variable have payments that start at later date, they allow owner to select from list of investment options. Higher returns will increase future payments. Expenses are higher for variable. Minimum payouts can be insured. Annuity could be cashed out at future date with surrender charge. The payments track an investment. Fixed deferred pay a fixed amount, funds can still be invested which increase the fixed payments. Payouts on fixed are determined by initial bond market interest rates (higher in future = delay the purchase). Variables can cover inflation if the return is higher than inflation.

Question 21

Mortality Credits

Answer 21

These benefit people who live longer and receive more payments over those who die early and essentially pay the mortality credits to the longer living people.

Question 22

Risk Management

Answer 22

Risk avoidance (not owning the asset) when loss is very severe and occurs regularly. Loss prevention reduces the probability of the negative event occurring (keeping expensive car in storage). Risk reduction takes steps to reduce the amount of loss, if the loss is not severe and occurs frequently. Risk transfer if loss is severe and happens infrequently (insure). Risk retention (self insure) is infrequent and not severe.

Question 23

Human Capital

Answer 23

If human capital is high and income volatility is high, invest in assets that have lower correlation with the income (commodities worker has invests in stocks negatively correlated with commodities). If human capital and income is more stable then higher allocation to equities from financial capital can occur.

Question 24

Net Worth Statement

Answer 24

Human capital is not considered an asset in a net worth statement (although, it would be included in an economic balance sheet as an extended portfolio asset, but only in an asset allocation context). Only insurance policies with a cash value (e.g., savings component) would be included as an asset; term life insurance does not have a savings component, so there is no cash value.