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14 risk management for individuals life-cycle finance / a holistic view…
14 risk management for individuals
life-cycle finance / a holistic view
human capital and financial capital
economic balance sheet / holistic balance sheet
human capital
net PV of future exp labor income weighted by probability of surviving
total menetary value / investment characteristics / relates to financial capital
uncertain - risk
financial capital
personal assets
consumes or uses in some form
not exp to appreciate in value
investment assets
publicly trade marketable assets
money market instruments
bonds
common and preferred equity
non-publicly traded marketable assets
real estate
annuities
cash-value life insurance
business assets
collectibles
non-marketable assets
vested employer pension plans - mortality-weighted net PV
government pensions - more secure / relatively bond-like
account type
tax-deferred
taxable
non-taxable
net wealth
extend to include claims to future assets - human capital / pension
framework
strategy / process
1 specify the objective
max household welfare - balance of risk and safety - how much risk is willing to take
2 identify risks
3 evaluate risk and select methods
magnitude and range of options available
risk avoidance / reduction / transfer / retention
monitor outcomes / make appropriate adjustments
annually review / every life change
financial stages of life
1 education phase
little focus on saving or risk management
2 early career
insurance may be especially valuable
3 career development
may make large purchases
4 peak accumulation
begin to reduce investment risk
min tax
more career risk
5 pre-retirement
continue to restructure to reduce risk
6 early retirement
the need for asset growth not disappear
7 late retirement
especially unpredictable
individual balance sheet
→illustrate the magnitude of risk exposure for an individual
traditional balance sheet
recognizable marketable assets and liabilities
economic (holistic) balance sheet
accurate depiction of overall financial health
PV of all available marketable and non-marketable assets and all liabilities:
human capital and pensions
lifetime consumption and bequests goals
changes in net wealth
inversely related over time
individual risk exposures
earning risk
health issues
unemployment and underemployment
self-employed and professionals variability
→reduction in both human and financial capital
premature death risk
reduction in the income of the surviving spouse
a risk to consumption needs (family member services)
reduction in human capital
effects on financial capital
longevity risk
insufficient to meet post-retirement consumption needs
→Monte Carlo to calculate probability
→mortality table adjust for health factors and add years to be conservative
relying on a pension thus entails its own set of risks
relates primarily to financial capital
property risk
direct loss refers to the monetary value
indirect loss relative expenses incurred
liability risk
legally liable for the financial costs
health risk
manifest in different ways over the life cycle
have significant implications for human capital and financial capital
insurance and annuities
assessing possible loss exposures
considering market and non-market solutions to possibility of and reduce the magnitude of a loss
trade-off between exp total wealth and security
life insurance
→hedge the risk of premature death
→an important estate-planning tool
→provide immediate liquidity
→a tax-sheltered savings instrument - cash-value policies
types
temporary
-for a certain period-premiums remain level or increase over
permanent
-provides lifetime coverage
-policy premiums fixed and some underlying cash value
whole life insurance:
participating life insurance policy - allow potential grow
non-participating - fixed values
universal life insurance:
provide more flexibility
more options invest the cash value
non-forfeiture clause:
cash surrender option
reduced paid-up option
extended term option
riders:
accidental death
accelerated death benefit
waiver of premium
viatical settlement - sell to third party
basic elements
term and type of policy
amount of benefits
the face value of policy
lump sum or an annuity
limitations
contestability period
maximum
the identity of the insured
the policy owner
needs to have an insurable interest in the life of the insured
the beneficiary or beneficiaries
the premium schedule
modifications to coverage in any riders
priced
key considerations:
mortality expectations/discount rate/loading
mortality expectations
mortality table adjusted to additional factors
underwriting process reduce the likelihood of adverse selection
calculation of the premium
net premium - discounted value of the future death benefit
gross premium - adds a load to the net for expenses and projected profit
stock companies / mutual companies
cash values and policy reserves
policy reserves required by regulators - a liability on the balance sheet
consumer comparisons of cost
cost per year per thousand dollars of coverage
net payment cost index - assumes will die at the end of a specified period
surrender cost index - assumes the policy will be surrendered at the end of the period
the lower the index value the better
calculating life insurance needs
the human life value method - replacing the estimated net contribution to family finances
the needs analysis method - meet the financial need of the family
replace the PV of future earning
immediate financial expenses
legacy goals
cost and company's ability
disability income insurance
specify pre-injury and post-injury income
insurers will cover compensation only up to specific amounts
the benefit period
the elimination period / waiting period
the rahabilitation clause
the waiver of premium clause
the option to purchase additional insurance rider
a non-cancelable and guaranteed renewable
a non-cancelable policy but can increase premiums
a cost of living rider to inflation adjustments
property insurance
homeowner's insurance
all-risks / named-riks
based on replacement cost / actual cash value
deductible - form of active risk retention
losses reimbursed at lower rate (less 80%)
automobile insurance
based on the value and the age and driving record
collision coverage (accident) / comprehensive coverage
health / medical insurance
indemnity plan
preferred provider organization PPO
health maintenance organization HMO
comprehensive major medical insurance
key terms:
deductibles
coinsurance - percentage
copayments - fixed payments
max out-of-pocket expense
max yearly benefit
max lifetime benefit
pre-existing conditions
pre-admission certification
liability insurance
personal umbrella liability insurance policy
annuity
classification:
deferred variable annuities - similar to mutual fund - investment options
deferred fixed annuities - can cash out
immediate variable annuities - lump sum - income floor
immediate fixed annuities - a percentage of the initial purchase price
advanced life deferred annuities ALDA - deferred immediate payout annuities
parties:
the insurer - sell
the annuitant - receive the benefits
the contract owner - purchase
the beneficiary - receive proceeds upon the death
key factor:
the insured individual age
exp return on premiums
fixed and variable:
volatility of benefit amount
flexibility
future market expectations
fees
inflation concerns
payout methods:
life annuity - entire life
period-certain annuity - specified periods
life annuity with period certain - guarantee min years
life annuity with refund - guarantee total amount
joint life annuity - continue until both die
benefit taxation: tax deferred combined high marginal tax rate
appropriateness:
each payment = principal + interest + mortality credits
based on preference for wealth max and aversion to running out of money - retirement income efficient frontier
implementation
optimal risk management strategy
determined by household's risk tolerance
approaches to loss control:
risk avoidance - purest form
loss prevention - reduce probability
loss reduction - reduce the size of loss
analyzing an insurance program
1 current plan
2 program review
3 recommendation
the effect of human capital on asset allocation policy
tend to relatively conservative / relatively bond-like asset
→total allocation should be adjusted as the value changes
→allocation should coordinated with risk associated with non-marketable assets
each individuals has different human capital risks
human capital unique:
require continued investment
more illiquid
employer-specific
asset allocation and risk reduction
investment risk
property risk
human capital risk
idiosyncratic→pooling risk
systematic
young households have additional liquidity constraints
older couple risk to the investment portfolio are far more relevant than human capital risk
human capital risk correlated with market returns and can partially hedged through holistic portfolio construction
