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