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Risk management for individuals (Financial stages in life (Education phase…
Risk management for individuals
Human vs Financial capital
Human capital
PV of future earnings & wages
often dominate asset on a household economic balance sheet
some professions will receive higher wages and some will be more or LESS sensitive to the business cycle
Discount rate
= risk free rate + premium for occupational income volatility
Some professions are more bond-like in volatility while others may be stock like (business owner)
Factors contributing to riskiness
lower performance within career
lack of geographical mobility
single source of income
routine cognitive HC
HC with rapid decay rates
Financial capital
personal assets (auto, clothes)
mixed assets (residence, art work)
investment assets (stocks, bonds, DC plans)
non-marketable assets (employer pension plan)
Net worth
= tradition assets - liabilities
Net wealth
= HC + investment assets + PV future pension benefits - liabilities - PV future consumption needs
Financial stages in life
Education phase
Early career
Career development
Peak accumlation
Pre-retirement
Early retirement
Late retirement
longevity risk
Individual risk exposures
1. Earning risk
events that could negative affect HC and FC
health risks
unemployment & underemployment
loss of job later in life
inadequate HC investment
2. Premature death risk
3. Longevity risk
4. Property risk
5. Liability risk
legal liability property damage
6. Health risk
Insurance
Life insurance
a hedge against the risk of premature death of an earner
provide liquidity to a beneficaiary without the delay of probate
use a tax-sheltered saving instrument
Temporary
specified time
no cash value
lower cost
- premiums are fixed
Permanent
provides lifetime coverage
premiums are fixed
cash value
Whole life = remain in force for insured's entire life
Universal life = more flexible investment plans, can pay lower premiums and options for investing cash value
Pricing
mortality expectation (how long the insured is expected to live)
discount rate
Loading = other factor that add to the net premium
sales commission, physical exam, monitoring, verification of claims
Cash values & policy reserves
Cash value = accumulate within the policy
can be withdrawn when policy matures or terminated
can be borrowed against
since insurance is meant to replace HC -> unnecessary after policy holders working years are over
Policy reserves
insurance company liability
represents the future payment to be made
policy reserves increases to face value over time
Compare life insurance
net payment cost index
surrender costs index
Disability income insurance
offset risk of lost earnings ability to physical injury, disease or other impariment
property insurance
homeowner policy
auto insurance
Health/medical insurance
Liability insurance
Annuities
Immediate annuity
amount of money is paid to insurance company in exchange for specified future monthly payments over a specified period of time
can be # of years or life of annuitant
Deferred annuity
income stream begins at a later date
Deferred variable annuity
individual can choose investment option, then pays a level of income that is determined by the performance of the investments
can exit contract with penalty
Deferred fixed annuity
payout begins at some future date
any point prior, investor can cash out
once retirement can either cash out or begin payments (immediate fixed annuity)
Advanced life deferred annuities
pure longevity insurance
Advantages
fixed income stream
annuitant locks in rate of returns at the time of purchase
funds can be withdrawn (variable annuities)
tax deferred growth (only growth is taxed)
Disadvantages
variable can change in income
future market can be greater
variable fees are higher
inflation can be higher
payments ceases at death
if die early, subsidizing the rest in the pool
lower lifetime income
Insurance program
Risk avoidance
Loss prevention
Loss reduction
Risk management techniques