CFA 2018 r12 risk management for individuals slides

Level III Risk Management for Individuals www.ift.world Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Introduction Human and Financial Capital A Framework for Individual Risk Management Insurance and Annuities Implementation of Risk Management for Individuals www.ift.world 2 Human Capital and Financial Capital An individual’s overall wealth has two primary components: Human capital: mortality-weighted net present value (NPV) of future expected labor income Financial capital: personal assets and investment assets www.ift.world 2.1 Human Capital Human capital is a significant part of most working households’ total wealth portfolio From a risk management perspective, it is important to understand: • the approximate total monetary value • the investment characteristics • the value of human capital relative to the value of financial capital HC0  HC0  N  wt  t 1  N  t 1 r t p st  wt 1 1  gt     rf  y t www.ift.world Example 1: Estimating the Present Value of Human Capital John Adam is 60 years old and plans on retiring in years Adam’s annual wage is currently $50,000 and is expected to grow 2% per year The risk-free rate is 4% Adam works in a job with a moderate degree of occupational risk; therefore, we assume a risk adjustment based on occupational income volatility of 3% There is a 99% probability that Adam survives the first year, a 98% probability that he survives the second year, and probabilities of 98%, 97%, and 96% for the following years, respectively Given this information and using Equation 2, what is the present value of Adam’s human capital? Year Wages (2% annual growth) Present Value of Wages Probability of Survival Probability Weighted Wages $51,000 $47,664 99% $47,187 $52,020 $45,436 98% $44,527 $53,060 $43,313 98% $42,447 $54,122 $41,289 97% $40,050 $55,204 $39,360 96% $37,786 Total value of human capital www.ift.world $211,997 2.2 Financial Capital Financial capital can be categorized as: tangible/intangible, current/non-current, personal/investment assets Personal assets are: • assets an individual consumes (or uses) in some form • not expected to appreciate in value • often worth more to the individual than their current fair market value Investment assets: • include tangible investment assets (such as a liquid portfolio) and less tangible assets (such as an accrued defined benefit pension) • can be subdivided based on marketability • publicly traded and non-publicly traded Mixed assets: • have characteristics of personal assets and investment assets www.ift.world Investment Assets Publicly Traded Marketable Assets: money market instruments, bonds, and common and preferred equity Non-Publicly Traded Marketable Assets: real estate, some types of annuities, cash-value life insurance, business assets, and collectibles Non-Marketable Assets: employer pension plans, government pensions Government pensions can be considered bond-like Only vested pension benefits are included in financial assets mNPV0  N  p st bt  t 1  r t Financial capital is often held in account types that have different tax attributes Taxable account Tax-deferred account A non-taxable account www.ift.world 2.3 Net Wealth Net worth is the difference between traditional assets and liabilities that are reasonably simple to measure Net wealth is the difference between traditional assets and liabilities, and it also includes claims to future assets that can be used for consumption, such as human capital and the present value of pension benefits Discuss the relationships among human capital, financial capital and net wealth www.ift.world Framework for Individual Risk Management 3.1 The Risk Management Strategy for Individuals 3.2 Financial Stages of Life 3.3 The Individual Balance Sheet 3.4 Individual Risk Exposures www.ift.world 3.1 The Risk Management Strategy for Individuals Specify the Objective • Maximize welfare • Balance risk and safety Evaluate Risks; Select Appropriate Methods Identify Risks • • • • Earnings risk Premature death Longevity risk Health risks • • • • Risk avoidance Risk reduction Risk retention Risk transfer www.ift.world Monitor and Adjust • Monitor outcomes and risk exposures • Make appropriate adjustments in methods 5.1 Determining the Optimal Risk Management Strategy High Risk Retention • High deductible • Buy little or no insurance Low Risk Transfer • Insurance • Annuities • Non-insurance Risk Tolerance Loss characteristics High frequency Low frequency High severity Risk avoidance Risk transfer Low severity Risk reduction Risk retention Risk avoidance Loss prevention Loss reduction Read Example 13 www.ift.world Loss Control 5.2 Analyzing an Insurance Program • Jacques Perrier: age 40, €100,000 annual earnings, €200,000 whole life insurance policy, €50,000 term life insurance policy, Jacques inherited home currently worth €165,000 • Marion Perrier: age 38, €20,000 annual earnings, plans to return to full-time work in 10 years and expects to earn €60,000 per year as a full-time nurse at that time, no life insurance • Children: Henri, age and Émilie, age • Both of Jacques’s parents died at age 70 whereas Marion’s father died at age 80 Her mother, Franỗoise, is in good health at age 72, and women in her family have generally lived to very old ages Franỗoise has a pension but does not have much in assets • Condominium: €300,000 current value, €190,000 25-year remaining mortgage, exterior of building fully insured, contents insured for €20,000 • Automobile: which is 10 years old but in excellent condition • Rental home: €165,000 current value, no mortgage, insured for €100,000 www.ift.world Life Insurance Considerations Jacques: age 40, €100,000 annual earnings, €200,000 whole life insurance policy, €50,000 term life insurance policy, Jacques inherited home currently worth €165,000, Is life insurance needed? Yes He has a wife and young children who depend on his income Term versus permanent? A 20-year term life insurance should be appropriate At that time he will be close to retirement; will have accumulated sufficient financial capital and children will be grown up How much life insurance? According to the human life value method, the insurance requirement is about 1.36 million According to the financial needs method, the insurance requirement is about 1.49 million Subtract 250,000 of insurance which he already has Consider breakpoints www.ift.world Computing Life Insurance Value Using the Human Life Value Method Step Adjust actual pre-tax compensation for income tax (tax rate 30%) €100,000 – €30,000 = €70,000 Step Adjust for family expenses attributable to Jacques that will not exist after his death €70,000 – €20,000 = €50,000 income after expenses Step Add the value of any non-taxable employee benefits that the family will no longer receive €50,000 + €15,000 = €65,000 Step Estimate the amount of pre-tax income needed to replace that income on an aftertax basis (tax rate 20%): €65,000/(1 – t) = €65,000/(1 – 0.20) = €81,250 Step Apply an annual growth rate (3%) to consider the effects of inflation and career advancement over the full 20 years until retirement Step Discount all future cash flows back to the present at an appropriate rate (5%) Step The human life value calculation can be solved as the PV of an annuity due with growing payments: [(1 + Discount rate)/(1 + Growth rate)] – 1, or (1.05/1.03) – = 1.94% n = 20, payment = €81,250, i = 1.94% PV of annuity due = €1,362,203 Step Jacques already has €250,000 of life insurance, he should purchase an additional €1,112,203, according to this method www.ift.world The Needs Analysis Method Estimate the amount of cash that will be needed upon the death of the insured person This will include final expenses (funeral and burial), any taxes that may be payable, debt payments (including mortgages), funding future education costs and an emergency fund Estimate the capital needed to fund family’s living expenses i.e calculate the PV of future cash flow needs during multiple time frames Calculate total needs as the sum of cash needs and capital needs Calculate total capital available, which may include cash/savings, retirement benefits, life insurance, rental property, and other assets Calculate the life insurance need as the difference between the total financial needs and the total capital available Cash Needs Final expenses Taxes payable Mortgage retirement Other debt Education fund Emergency fund Total cash needs Euro (€) 10,000 5,000 190,000 10,000 200,000 30,000 445,000 Capital Needs Marion’s living expenses (60,000/year for 52 years) Children’s living expenses: Henri (10,000/year for 14 years) Émilie (10,000/year for 16 years) Transition period needs (10,000/year for years) Less Marion’s income: Until Émilie is 16 (20,000/year for 10 years) Age 48 - 60 (60,000/year for 12 years) Total capital needs Total Financial Needs 1,991,941 123,934 139,071 19,810 -183,713 -398,565 1,692,478 2,137,478 Capital Available Cash and savings Vested retirement accounts - present value Life insurance Rental property Total capital available Life insurance need www.ift.world 30,000 200,000 250,000 165,000 645,000 1,492,478 Health Insurance Considerations: Given: The Perrier family is covered by national health insurance Recommendation: Consider private health insurance as it provides quicker treatment, a wider choice of physicians, and a higher standard of care Disability Insurance Considerations: Given: Jacques’s employer provides short-term disability payments for up to six months; Marion’s employer does not Recommendation: • Consider long-term disability income insurance with own occupation coverage that specifies that they would be considered disabled if they could no longer perform the duties of their current positions • Select a benefit period that extends at least until their respective retirement ages • For Jacques, a 180-day elimination period is appropriate • For Marion, shorter elimination period is appropriate Long-Term Care Insurance Considerations: Given: Elderly individuals eligible for long-term care at cost equal to 75% of pension benefits; possible that facilities will be of a standard that will not satisfy the Perrier’s Recommendation: • Consider long-term care insurance for themselves, especially if there is a coordination provision with the national plan • At their current ages, rates would be reasonable and would be locked in at the time the policy is purchased • Long-term care insurance may also be appropriate for Marion’s mother www.ift.world Property Insurance Considerations: Given: The exterior of the condominium is insured through the condominium owners’ association The insured value is increased annually to consider current market and replacement values Jacques and Marion have a property insurance policy on the contents of their condominium for €20,000 Jacques’s parents insured the house for €100,000 15 years ago They never increased the coverage, and Jacques has maintained the same policy The automobile has coverage for liability and collision, as well as comprehensive coverage Recommendation: • Make sure that the condominium association’s insurance coverage is sufficient for the structure • Determine whether policy provides any coverage for contents and, if so, to what extent • Value personal property; obtain a sufficient amount of coverage • Review property insurance on the house • Auto insurance: ensure there is sufficient liability insurance Longevity Insurance: Given: Nothing in place Recommendation: • Marion’s mother may be an candidate for longevity insurance • Perform a cost-benefit analysis www.ift.world 5.3 The Effect of Human Capital on Asset Allocation Policy Portfolio Construction • Allocation to risky assets versus low-risk (or risk-free) assets • Allocation across asset classes such as stocks and bonds Risk Characteristics of Human Capital • For most individuals human capital is a bond-like asset • In some cases human capital is a stock-like asset • Occupations have different human capital risk  Within an occupation different individuals can have different human capital risks  Education/training might be needed to grow or sustain human capital • Riskiness of the household’s human capital will be reduced if both spouses are working • Illiquid Human Capital and Asset Allocation • Consider riskiness of human capital • Consider correlation between human capital and asset classes • Consider age of investor • Consider liquidity of each asset category www.ift.world Example 14: Human Capital and Asset Allocation (1) The riskiness of human capital, as well as that of other assets, should affect the allocation of an individual’s financial capital Consider three investors: George, John, and Sam Each investor owns only two assets—human capital and financial capital—and wants his total wealth (i.e human capital plus financial capital) to have a 45% stock allocation If human capital is assumed to be 30% stock-like, what is the optimal allocation for the financial capital of George, John, and Sam? Person Human Capital (HC) Financial Capital (FC) Total Wealth (TW) George John Sam $500,000 $800,000 $150,000 $150,000 $300,000 $150,000 $650,000 $1,100,000 $300,000 www.ift.world Example 14: Human Capital and Asset Allocation (1) The riskiness of human capital, as well as that of other assets, should affect the allocation of an individual’s financial capital Consider three investors: George, John, and Sam Each investor owns only two assets—human capital and financial capital—and wants his total wealth (i.e human capital plus financial capital) to have a 45% stock allocation If human capital is assumed to be 30% stock-like, what is the optimal allocation for the financial capital of George, John, and Sam? Person Human Capital (HC) Financial Capital (FC) Total Wealth (TW) George John Sam $500,000 $800,000 $150,000 $150,000 $300,000 $150,000 $650,000 $1,100,000 $300,000 Solution: the allocation is as follows: Person George John Sam (A) TW × 45% (B) HC × 30% (C) (A) – (B) (D) (C)/FC Target Equity $292,500 $495,000 $135,000 HC Equtiy $150,000 $240,000 $45,000 FC Equity $142,500 $255,000 $90,000 FC Equity Allocation % 95.00% 85.00% 60.00% www.ift.world Example 15: Human Capital and Asset Allocation (2) Describe how investment strategies can be modified to account for human capital risk Investment assets may be strongly or weakly correlated with the human capital value of a worker The overall volatility of one’s economic balance sheet can be reduced by selecting assets that correlate weakly (or even negatively) with human capital Sector investments may be particularly valuable if they are not a complement to the industry that employs the primary earner Workers with more volatile assets may also prefer more liquid investments Example 16: Human Capital and Asset Allocation (3) Compare investment planning for a young family with investment planning for a newly retired couple A younger household will hold most of its wealth in human capital For most households, human capital is a bond-like asset that returns a relatively stable income over time This fact increases the optimal allocation to risky assets within the investment portfolio for younger households For a newly retired couple, the value of human capital declines relative to the value of the investment portfolio To balance the total risk of the older household’s portfolio, investment portfolio risk should be reduced because investment assets are a larger share of the economic balance sheet (ignoring the impact of charitable bequests and other obligations) www.ift.world 5.4 Asset Allocation and Risk Reduction • Appropriate Investments • Insurance products • Other risk management tools Highest level of spending at an acceptable level of risk Investment risk, property risk, and human capital risk can be either idiosyncratic or systematic • Idiosyncratic risks include the risks of a specific occupation, the risk of living a very long life or experiencing a long-term illness, and the risk of premature death or loss of property • Idiosyncratic human capital risks are reduced through investment portfolio strategies and/or through insurance Consider a young doctor with lower earning spouse and two children • Investment portfolio should be well diversified • Investment portfolio should have a low correlation with income • Life insurance to hedge against loss in human capital • Disability insurance to hedge against earnings risk • Medical malpractice insurance to protect against liability risk www.ift.world Small decrease in expected wealth but a major decrease in risk Consider a 60-year old couple nearing retirement with grown, independent children and a large investment portfolio • Life insurance and disability insurance will have limited value • Idiosyncratic risk exposures: health and liability • These can be mitigated through health, long-term care and liability insurance • Risk of outliving assets can be mitigated through annuities Consider a 50-year-old couple, Jennifer and Wade Jennifer earns US$75,000 a year working as a tenured college professor, and Wade earns US$100,000 selling drilling parts to the oil industry Jennifer participates in the state public employee pension system, which is currently in good enough financial condition to cover promised benefits for the next 40 years Wade has US$300,000 saved in a 401(k), half in employer stock Both are eligible to receive Social Security benefits www.ift.world Example 17: Asset Allocation and Risk Reduction Consider two 35-year-old couples, each of which earns a combined US$150,000 per year One couple consists of an individual who is employed as a petroleum engineer and a non-working spouse The other couple consists of two high school teachers Compare asset allocation and risk reduction strategies for each couple The human capital value of the couple consisting of the petroleum engineer and the non-working spouse is likely lower than the combined human capital value of the high school teachers, although the combined lifetime cumulative wages of the teachers is likely lower than those of the engineer and the spouse Earnings for the engineer are highly correlated with oil prices, and either rising or falling prices will affect the household’s available income in the future The impact of a disability on employability may be more severe for the engineer than for a teacher The engineer should thus likely consider a less risky portfolio and should overweight securities that have a low correlation with oil prices Conversely, the teachers should select a riskier portfolio as a result of their higher human capital and low correlation with individual market sectors www.ift.world Conclusion • Financial capital versus human capital • Net worth versus net wealth • Traditional balance sheet versus economic balance sheet • Financial stages of life: education, early career, career development, peak accumulation, preretirement, early retirement, late retirement • Risks faced by investors • Insurance and annuities • Asset allocation and risk characteristics of human capital • Asset allocation and risk reduction for investors with different profiles www.ift.world ... Individual Risk Management 3.1 The Risk Management Strategy for Individuals 3.2 Financial Stages of Life 3.3 The Individual Balance Sheet 3.4 Individual Risk Exposures www.ift.world 3.1 The Risk Management. .. Introduction Human and Financial Capital A Framework for Individual Risk Management Insurance and Annuities Implementation of Risk Management for Individuals www.ift.world 2 Human Capital and Financial... Strategy for Individuals Specify the Objective • Maximize welfare • Balance risk and safety Evaluate Risks; Select Appropriate Methods Identify Risks • • • • Earnings risk Premature death Longevity risk