32-1 risk management for individuals
1 introduction
2 human
capital and
fannacial
capital
3 a
framework
for
individual
risk
management
5 implementation
of risk
management
for individuals
determining the
optimal risk
management
strategy
analyzing an
insurance
program
the effect of
human capital
on asset
allocation policy
asset
allocation
and risk
reduction
the risk
management
strategy for
individual
financial
stages
of life
the individual
balance sheet
individual
risk
exposures
human
capital
financial
capital
economic
net worth
life-cycle finance:
helping achieve goals, by taking a holistic view of individual's financial situation as moves through life
human capital: net PV of future expected labor income
weighted by the probability of surviving to each future age
financial capital: tangbible and intangible assets owned by an individual or household
from a risk
management
perspective
the approximate total moentary value
the investment characteristics
relate to the value of the individual's financial capital
discount
rate
HC_0 = ∑ w_t / (1+r)^t
HC_0 = ∑ p(s_t) (w_t−1) (1+g_t) / (1+r_f+y)^t
a total wealth perspective:
combines human capital with financial capital and incorporetes the life-cycle planning to develop a strategy that max household welfare
the financial accounting approach:
different assets have different roles and may exposed to various types of risk
personal assets:
consumed
often worth more to individual
investment assets:
hold for potential increase in value fund future consumption
criterion - marketability
publicly traded marketable assets:
money market instruments, bonds, comon and perferred euiqty
non-publicly
traded
marketable
assets
real estate:
typically the largest assets owned by an individual
mortgages present unique risk - leveraged - recourse / non-recoures
annuities:
a private defined benefit pension
cash-value life insurance:
not only protection upon a death but also cash reserve
business asesets:
unique considerations
value vary based on market conditions
collectibles:
involves substantial transaction costs
non-
marketable
assets
employer
pension
plans (vested)
government
pensions
account
type
taxable
tax-deferred
non-taxable
the vested or accrued benefits amount:
the mortality-weighted net PV
relatively bond-like
the financial health of government entity
legal framework and accompanying political risk
unvested - contingent on future work - part of human capital
the value of vested traditonal DB:
the mortabilty-weighted net PV of future benefits
mNPV_0 = ∑ p(s_t) b_t / (1+r)^t
factors determing discount rate:
the health of the plan
the credit quality of sponsoring company
any additional credit support
extends net worth to include claims to future assets that can be used for comsumption
the process of identifying threats to value of household assets and developing an appropriate strategy for dealing with risk
four
key
steps
1 specify the objective
to max welfare through appropriate balance of risk and safety
2 identify risks:
earnings, premature death, longervity, property, liability and health risks
3 evaluate risks and select appropriate mothods to manage risks:
consider magnitude of risk and range of options available to address risk
risk avoidance / reduction / transfer / retention
4 monitor outcomes and risk exposures and make appropriate adjustments
as moves through its life cycle
annually review / every life change
1 education phase
generally ittle focus on savings or risk management
2 early career
significant family and housing expenses
insurance may especially valuable
3 career development
concern intensifies about retirement income planning and financial independence
4 peak accumulation
begin to reduce investment risk
increasing concerned min taxes
potential more career risk
5 pre-retirement
max career income
further emphasis on tax planning
6 early retirement
generally the most active period of retirement
primary objective - to use resources to produce activities provided enjoyment
7 late retirement
especially unpredictable
longevity risk
connitive decline - present a risk of financial mistakes
two additional concerns
to any financial stage
the need to provide for long-term health care may apparent
need to devote resources to care for parents or disabled child
to more comprehensively represent assets available to fund life-cycle cunsumption and for wealth preservation and transfer bequests
primary value of a balance sheet -
to illustrate the magnitude of risk exposures for an individual
traditional
balance sheet
human capital and retirement benefits extremely important
economic (holistic)
balance sheet
the primary goal - to arrive at an accurate depiction of overall financial health
the total economic wealth of individual changes throughout lifetime
to have either a surplus or a shortfall
changes in
economic net worth
in the early retirement stage -
dominated by pension wealth and real estate
earnings
risk
premature
death risk /
mortality risk
longevity
risk
property
risk
liability
risk
health
risk
events that negatively affect individual's human and financial capital
health issues / unemployment / underemployment
loss of income
represents a reduction in both human and financail capital
can be psychologically devastating to individual and family
death earlier than anticipated whose human capital expected to help pay for financial needs and aspirations of family
lead to reduction in income of surviving spouse
incalcalable emotional effect of the death
also effects on financial capital
uncertainty surrounding how long retirement will last
run a monte carlo simulation
can have a significant impact on lifestyle of individual
→ to work longer
the possibility that a person's property may
damaged, destroyed, stolen or lost
direct loss / indirect loss
both financial and human capital is at risk
the possibility may be held legally liable for financial costs associated with property damage or physical injury
illness or injury
direct costs:
coinsurance, copayments and deductibles
have an adverse impact on life expectancy, potentially resulting in death before planned retiremetn
loss control -
reduce or eliminate
the costs associated
with risks
risk avoidance
- purest form
loss prevention - reduce
the probability a loss event occur
loss reduction - reduce
the size of a loss if occurs
also through risk transfer
and risk retention
risk managemetn
techniques
frequency - severity
avoidance: high - high
transfer: low - high
reduction: high - low
retention: low - low
1 current insurance plan
2 program review
3 recommendations
two primary ways consider
different subcomponents affect
asset allocation - overall allocation to risky assets
underlying asset classes selected by individual
asset allocation should adjusted as value of the assets change over time:
older should shift more toward bonds
the economic
balance sheet
not consider
the stochastic nature of individual assets
value change with respect to other asset within portfolio
relative liquidity
human capital
a unique
asset class
require continued investment
more vulnerable to disability risk or premature death
more illiquid
manage wealth risk mainly to smooth spending over time
investment risk / property risk / human capital risk
either idiosyncratic or systematic
pooling risk - efficiently reduce idiosyncratic risk
first step - to identify idiosyncratic risk exposure that can efficiently reduced through eiversification or hedging
human capital correlated with market returns and at least partially hedged through holistic portfolio construction