CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r12 risk management for individuals IFT notes

Risk Management for Individuals IFT Notes Risk Management for Individuals Introduction Human Capital and Financial 2.1 Human Capital 2.2 Financial Capital 2.3 Net Wealth A Framework for Individual Risk Management 3.2 Financial Stages of Life 3.3 The Individual Balance Sheet 3.4 Individual Risk Exposures Insurance and Annuities 11 4.1 Life Insurance 11 4.2 Disability Income Insurance 16 4.3 Property Insurance 17 4.4 Health/Medical Insurance 18 4.5 Liability Insurance 19 4.6 Other Types of Insurance 19 4.7 Annuities 19 Implementation of Risk Management for Individuals 25 5.1 Determining the Optimal Risk Management Strategy 25 5.2 Analyzing an Insurance Program 26 5.3 The Effect of Human Capital on Asset Allocation Policy 28 5.4 Asset Allocation and Risk Reduction 29 Summary 31 Examples from the Curriculum 35 Example Estimating Human Capital 35 Example Comparing Financial and Human Capital 36 Example Financial Stages of Life 36 Example Traditional vs Economic Balance Sheet 36 Example Changes in Human and Financial Capital 37 Example Individual Risk Exposures (1) 37 Example Individual Risk Exposures (2) 37 Example Elements of a Life Insurance Policy 37 Example Mortality Expectations 38 Example 10 Life Insurance Pricing 38 Example 11 Appropriateness of Life Insurance 38 Example 12 Comparing Annuities 39 Example 13 Risk Management Strategy 39 Example 14 Human Capital and Asset Allocation (1) 39 Example 15 Human Capital and Asset Allocation (2) 40 IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes Example 16 Human Capital and Asset Allocation (3) 40 Example 17 Asset Allocation and Risk Reduction 40 Appendix A: Life Insurance Calculations 42 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes Introduction Section of this reading outlines the concept of human capital Section presents a framework for individual risk management Section describes insurance and annuity products which can help individuals manage their risk Section discusses the implementation of risk management Human Capital and Financial An individual’s overall wealth has two primary components, human capital and financial capital 2.1 Human Capital Human capital is the “mortality-weighted net present value (NPV) of future expected labor income” In simple terms, it’s the present value of future cash flows which an individual is expected to generate from his labor income until he retires LO.a: compare the characteristics of human capital and financial capital as components of an individual’s total wealth; Human capital is a significant part of most working households’ total wealth From a risk management perspective, it is important to understand the following: The approximate total monetary value of an individual’s human capital The investment characteristics of an individual’s human capital i.e whether human capital is stocklike (in case of an equity trader) or whether it is bond-like (in case of a university professor) The relationship between the value of an individual’s human capital and the value of his financial capital Human capital can be estimated by using the following expression: HC0  N  wt  t 1  r t In the above expression, HCo is the value of human capital today, wt is the income from employment, r is the appropriate discount rate and N is the length of working life in years If a person is expected to retire after three years, then the value of his human capital can simply be estimated by discounting his wages for the next three years using an appropriate discount rate and the aggregate of these PVs will be the total monetary value of his human capital HC0  N  t 1 p st  wt 1 1  gt  1  r f   y t In order to refine our estimation further, elements such as probability of survival “p(st)”, annual wage growth rate “gt” and occupational income volatility “y” can be added to arrive at a more accurate IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes estimate for the value of human capital 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, what is the present value of Adam’s human capital? Solution: The first step is to calculate the relevant discount rate which is the risk-free rate plus the income volatility adjustment: 4% + 3% = 7% = 0.07 Also recognize that the income growth rate is 2% Hence the income at the end of Year will be 50,000 x 1.02, income at the end of Year will be 50,000 x 1.022, and so on Year 1: PV of annual wages = ($50,000 x 1.02)/1.07 = $47,664 Mortality-weighted PV of wages = $47,664 x 99% = $47,187 Year 2: PV of annual wages = ($50,000 x 1.022)/1.072 = $45,436 Mortality-weighted PV of wages = $45,436 x 98% = $44,527 Year 3: PV of annual wages = ($50,000 x 1.023)/1.073 = $43,313 Mortality-weighted PV of wages = $43,313 x 98% = $42,447 Year 4: PV of annual wages = ($50,000 x 1.024)/1.074 = $41,289 Mortality-weighted PV of wages = $41,289 x 97% = $40,050 Year 5: PV of annual wages = ($50,000 x 1.025)/1.075 = $39,359 Mortality-weighted PV of wages = $39,359 x 96% = $37,785 Total value of human capital = $47,187 + $44,527 + $42,447 + $40,050 + $37,785 = $211,996 2.2 Financial Capital Financial capital can be categorized as tangible versus intangible, or current versus non-current; but the most important categorization in the context of this reading is personal versus investment assets Personal assets are: • assets an individual consumes or uses in some form, such as a car, furniture, etc • not expected to appreciate in value The primary purpose of acquiring such assets is to derive benefit through usage/consumption • often worth more to the individual than their current fair market value IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes Investment assets: • include tangible investment assets (such as stock portfolio) and less tangible assets (such as an accrued defined benefit pension) • can be subdivided based on marketability i.e marketable and non-marketable assets • marketable assets can be further subdivided into publicly traded marketable assets (such as bonds, stocks etc.) and non-publicly traded marketable assets (such as real estate, some types of annuities, cash-value life insurance, business assets, collectibles etc.) • non-marketable assets include employer pension plan, government pensions etc • Specifically in terms of pension plans, only vested pension benefits are considered part of financial assets Non-vested benefits are based on services which are likely to be performed in future and therefore are part of human capital The value of vested defined benefit pension plan can be estimated by determining the mortalityweighted net present value of future benefits mNPV0  N p st bt t 1 1  rt  The expression given above is used to ascertain value of vested defined benefit pension plan such that, mNPV0 = mortality-weighted net present value at Time 0, bt = future expected vested benefit, p(st) = the probability of surviving until year t and r = discount rate Notice that the above expression is almost identical to the expression used to calculate the value of human capital The only one exception being that instead of discounting future wages, future benefits are being discounted here Mixed assets have characteristics of both personal assets and investment assets Examples include real estate, jewelry, artwork etc Refer to Example from the curriculum 2.3 Net Wealth LO.b: discuss the relationships among human capital, financial capital and net wealth The net worth of an individual is the difference between traditional assets and liabilities which are easy to measure Examples of easy to measure assets include investment assets and personal property Easy to measure liabilities include mortgages and other loans Net wealth expands the concept of net worth to include human capital and the present value of pension benefits This material will be covered in more detail in Section 3.3 A Framework for Individual Risk Management 3.1 The Risk Management Strategy for Individuals IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes Risk management for individuals is the process of identifying risks and then developing an appropriate strategy for dealing with those risks There are typically four key steps in the risk management process: 3.1.1 Specify the Objective The primary objective of risk management for individuals is to maximize their welfare This can only be achieved through an appropriate balance of risk and safety 3.1.2 Identify Risks Individuals/households face a number of risks such as earnings risk, premature death, longevity risk, property risk, liability risk, health risk etc 3.1.3 Evaluate Risks and Select Appropriate Methods to Manage the Risks This includes evaluating the magnitude and likelihood of a risk, and then in light of our assessment, selecting the most appropriate method for managing that risk There are four main techniques for managing risks: i ii iii iv Risk avoidance: involves avoiding a risk altogether Risk reduction: involves mitigating a risk by reducing its impact on an individual’s welfare (either by lowering the likelihood that it will occur or by reducing the magnitude of expected loss) Risk transfer: involves transferring the risk to a third party Risk retention: involves retaining a risk This is best suited where the cost of managing or reducing risks outweighs the benefits likely to be achieved from risk management 3.1.4 Monitor Outcomes and Risk Exposures and Make Appropriate Adjustments in Methods Once the appropriate risk management method has been selected, the risks should be continuously monitored and updated with changes in the individual’s circumstances and/or the external environment 3.2 Financial Stages of Life LO.c: Discuss the financial stages of life for an individual The financial stages of life for adults can be divided into seven periods: 3.2.1 Education Phase • • This stage occurs when an individual is investing in knowledge (building human capital) through either formal education or skill development At this stage an individual has very little or no financial capital and relies on parents/family for financial support IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes 3.2.2 Early Career • • • This stage normally begins when an individual has completed his or her education and enters the workforce At this stage, financial capital is typically low whereas human capital is high Insurance is very valuable as human capital constitutes such a large proportion of overall wealth at this stage 3.2.3 Career Development • • • This phase normally occurs during the 35-50 age range Income increases at a rapid pace Focus shifts more towards savings as individuals look to provide for children’s college education, as well as to plan for their own post-retirement needs 3.2.4 Peak Accumulation • • • • • • This phase generally occurs during the 51-60 age range Individuals’ earnings have either peaked or are close to their maximum level Focus continues to be towards retirement planning and wealth accumulation Investment strategies tend to become more conservative as investor preferences shift from income growth to income stability Minimizing taxes becomes a major concern Career risk is high If an individual loses his job, he may find it difficult to get another job which pays as well 3.2.5 Pre-retirement • • • • This stage spans the last few years before retirement Individuals are at the pinnacle of their career and therefore earnings are at their maximum Portfolios allocations continue to shift towards low volatility, safe investments Increased emphasis on tax planning 3.2.6 Early Retirement • • • This phase generally consists of the first 10 years after retirement As this is the most active period of post-retirement life, retirees either take part in activities that provide pleasure such as travelling and they may take on a job which they find enjoyable Individuals should continue to take some risk in order to continue asset growth in their portfolios This might be necessary as an individual’s retired life could extend to more than two decades, which may expose him/her to the risk of outliving resources (longevity risk) 3.2.7 Late Retirement • • • This phase is unpredictable because the exact length of retirement is unknown If the late retirement phase is long, then an individual faces longevity risk Risk of financial mistakes increases due to cognitive decline and other health related issues IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals • IFT Notes Appointing a trusted financial adviser or investing in annuities can help avoid financial missteps Refer to Example from the curriculum 3.3 The Individual Balance Sheet LO.d: Describe an economic (holistic) balance sheet 3.3.1 Traditional Balance Sheet The traditional balance sheet shows assets (house, car, investments, etc.) and liabilities (mortgages, car loans, student loans, etc.) that can be valued easily but ignores other individual assets that are material, such as human capital and pension benefits By subtracting traditional assets from traditional liabilities, we arrive at the “net worth” of an individual This is analogous to the equity of a company 3.3.2 Economic (Holistic) Balance Sheet The economic balance sheet provides a more accurate picture of an individual’s overall financial health by including all available marketable and non-marketable assets and liabilities on a balance sheet On the asset side it shows traditional assets as well as human capital and pension benefits On the liability side it shows traditional liabilities as well as the present value of future consumption needs and bequests The difference between an economic balance sheet’s assets and liabilities is called the “net wealth” of an individual The economic balance sheet is particularly useful for younger households where the total economic wealth is typically dominated by the value of human capital Refer to Example from the curriculum 3.3.3 Changes in Net Wealth As individuals age, the relative value of their assets changes Below we discuss how four main assets of an individual’s wealth portfolio (human capital, financial capital, real estate and pension wealth) are expected to change over time Human capital is highest when an individual enters the workforce It gradually decreases as he/she approaches retirement At retirement, the human capital of an individual is zero Financial capital is lowest when an individual begins his career as he has very little to no savings at that time As he continues to work and progress upwards in his career, savings tend to accumulate at a more rapid pace, and as a result his financial capital increases over time The financial capital of an individual is at its maximum when he is close to retirement There is an inverse relationship between financial capital and human capital At young age, where human capital is at its peak, financial capital is at its lowest, whereas at retirement, human capital is at its lowest and financial capital is at its maximum This concept is illustrated in Example and in the figure below Refer to Example from the curriculum IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes Real estate: As an individual goes through his lifecycle, the value of real estate in his economic balance sheet is likely to increase over time because of two reasons: i As an individual progresses in his career, earnings are likely to increase over time This will lead to higher savings which will enhance his ability to purchase a home ii The value of real estate appreciates over time Pension wealth accrues as long as an individual keeps working Once he retires and starts receiving benefits, pension wealth starts to decline 3.4 Individual Risk Exposures LO.e: Discuss risks (earnings, premature death, longevity, property, liability, and health risks) in relation to human and financial capital; 3.4.1 Earnings Risk Earnings risk refers to the risks associated with the earning potential of an individual In simple terms, it’s the risk that earnings in the future will be less than expected Health issues (such as illness, disability), unemployment, under-employment (receiving a lower salary than what an individual deserves based on his education and experience) are some of the factors which contribute to earnings risk Impact on human capital: Earnings risk leads to reduction in future earnings As expected future income drops, human capital also declines Impact on financial capital: Reduction in future earnings leads to decrease in savings as well Therefore, as savings decline, financial capital also deteriorates 3.4.2 Premature Death Risk Premature death risk is also referred to as mortality risk It’s the risk that an individual (whose future earnings were expected to fulfill some or all financial needs of a household) dies earlier than anticipated Premature death risk not only results in elimination of future earnings which the deceased individual was expected to earn, but it also leads to a reduction in the income of the surviving spouse as IFT Notes for the Level III Exam www.ift.world Page Risk Management for Individuals IFT Notes some responsibilities of the deceased individual must now be performed by the surviving spouse Impact on human capital: From an individual’s perspective, as a result of premature death, the human capital drops to zero whereas from a household’s perspective, when an earning individual suffers premature death, the present value of future earnings of the household will reduce Impact on financial capital: Financial capital is also reduced by various expenses such as death expenses (funeral and burial), transition expenses, estate settlement expenses etc 3.4.3 Longevity Risk Longevity risk is the risk associated with living to an advanced age in retirement (e.g age 100), which leads to retiree’s resources depleting to the point where income and financial assets are not enough to meet his post-retirement consumption needs In simple terms, it’s the risk of an individual outliving his resources Impact on human capital: Individuals who are concerned about longevity risk may choose to work longer, which leads to them earning more than if they were to retire earlier As a result, their human capital increases as their future earnings increase Impact on financial capital: As individuals are likely to work for a longer period, the increase in earnings would lead to increase in financial capital 3.4.4 Property Risk Property risk relates to the risk that a person’s property may be damaged, destroyed, stolen, or lost Impact on human capital: If the property is used in business (such as car for a car rental company), then any potential loss to the business property will result in a decrease in future earnings, and this will lead to a reduction in human capital Impact on financial capital: As property represents a financial asset, property risk leads to a decline in financial capital The potential loss caused by property risk can be subdivided into direct loss (such as loss due to car theft) and indirect loss (such as rent expense or purchase cost of a replacement car) 3.4.5 Liability Risk Liability risk is the risk that an individual or household may be held legally liable for the financial costs associated with property damage, physical injury or other loss suffered by another person or entity Impact on human capital: If the liability exceeds an individual’s financial capital, then it may result in the confiscation of the wages or other income of the person found liable Impact on financial capital: When an individual is held liable for the loss endured by another person or entity, he is legally bound to compensate for that loss, which will lead to a reduction in his financial capital IFT Notes for the Level III Exam www.ift.world Page 10 Risk Management for Individuals IFT Notes Allocation to risky assets versus low-risk (or risk-free) assets Allocation across asset classes such as stocks and bonds Given that human capital is a component of overall wealth, the risk characteristics of human capital need to be considered when making asset allocation decisions Some basic characteristics of human capital are given below: • Human capital is a bond-like asset if future wage income in stable and predictable • Human capital is a stock-like asset if future wage income is unpredictable and somewhat correlated with equity markets • 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 • Human capital is illiquid The table below shows the risk characteristics of human capital impact asset allocation decisions Risk characteristic Riskiness of human capital Correlation between human capital and asset classes Age of investor Liquidity of asset category Impact on asset allocation Say asset allocation for an investor is 60% equity and 40% bonds without considering human capital If the investor’s human capital is bond-like, the equity allocation should be increased If the investor’s human capital is equitylike, the bond allocation should be increased Invest in asset classes which have low correlation with human capital For example, if an investor works in the oil and gas sector, he should avoid stocks from this industry For young investors, human capital represents a large percentage of overall wealth If an investor is young, and his human capital is bond-like, most of his financial capital should be allocated to equity As the investor grows older, the allocation to equity can be decreased slowly and the allocation to bonds can be increased Since human capital is illiquid, some percentage of financial capital needs to be in the form of liquid assets Refer to Example 14 from the curriculum Refer to Example 15 from the curriculum Refer to Example 16 from the curriculum 5.4 Asset Allocation and Risk Reduction LO.l: recommend and justify appropriate strategies for asset allocation and risk reduction when given an investor profile of key inputs Investors should strive to eliminate or minimize idiosyncratic risk In the case of financial capital this is IFT Notes for the Level III Exam www.ift.world Page 29 Risk Management for Individuals IFT Notes done by creating diversified portfolios In the human capital context, 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 These idiosyncratic human capital risks can be reduced through insurance and annuity products Given below are two investor profiles and suggestions for how their risks can be managed Investor Profile 1: A young doctor with lower earning spouse and two children For this investor, the risk reduction suggestions are as follows: • Investment portfolio should be well diversified • Investment portfolio should have a low correlation with income • Life insurance should be purchased to hedge against the risk of loss in human capital • Disability insurance should be purchased to hedge against earnings risk • Medical malpractice insurance should be purchased to protect against liability risk There is a small decrease in expected wealth due to insurance premiums and because the expected return of a diversified portfolio might be lower than the expected return of a non-diversified portfolio However, the small decrease in expected wealth is balanced by the fact that there is substantial reduction in the level of risk Investor Profile 2: A 60-year old couple nearing retirement with grown, independent children and a large investment portfolio The situation of this couple is very different from the family described in Scenario Since the couple is nearing retirement, life insurance and disability insurance will have limited value The idiosyncratic risk exposures are related health and liability These can be mitigated through health, long-term care and liability insurance The risk of outliving assets can be mitigated through annuities Refer to Example 17 from the curriculum IFT Notes for the Level III Exam www.ift.world Page 30 Risk Management for Individuals IFT Notes Summary a compare the characteristics of human capital and financial capital as components of an individual’s total wealth; Human Capital Financial Capital  Mortality-weighted net present value (NPV) of future expected labor income  Dominant asset for young and middle-aged people  Like other assets, human capital can be risky and volatile (e.g., stockbroker), stable and low-risk (e.g., tenured professor), or somewhere in between  Personal assets  Investment assets i tangible investment assets (i.e liquid portfolio) ii intangible assets (i.e accrued defined benefit pension) Investment assets can be subdivided based on marketability, publicly traded and nonpublicly traded  Mixed assets: have characteristics of both personal assets and investment assets Value of human capital at Time 0: Value of vested defined benefit pension plan: 𝑤 𝑝(𝑠 )𝑏 𝑡 HC0 = ∑𝑁 𝑡=1 (1+𝑟)𝑡 HC0 = ∑𝑁 𝑡=1 𝑡 𝑡 mNPV0 = ∑𝑁 𝑡=1 (1+𝑟)𝑡 𝑝(𝑠𝑡 )𝑤𝑡−1 (1+𝑔𝑡 ) 𝑡 (1+𝑟𝑓 +𝑦) b discuss the relationships among human capital, financial capital, and net wealth;  Individual’s net worth = Traditional assets - Traditional liabilities  Net wealth also includes human capital and the present value of pension benefits  There is an inverse relationship between financial capital and human capital At a young age, human capital is high while financial capital low At retirement, human capital is low and financial capital is high IFT Notes for the Level III Exam www.ift.world Page 31 Risk Management for Individuals IFT Notes c discuss the financial stages of life for an individual; Phase Description Key characteristics Financial advice Education Building human capital; formal education or skill development Financially dependent; little focus on savings or risk management; very little financial capital Early career Education is completed; enters the workforce Partially financially independent; low financial capital; high human capital; focus on savings increases but savings are low due to high family & housing expenses Life insurance is valuable Career development Occurs between 3550 age range Income increases at a rapid pace; largely financially independent; focus on retirement saving increases Start saving for retirement Peak accumulation Occurs between 5160 age range Earnings at maximum level; focus on retirement planning and wealth accumulation; prefer stability (not growth) in portfolio; greater concern about tax strategies due to higher earnings Insurance is valuable Pre-retirement Last few years before retirement Earnings are at their maximum; prefer low volatility, safe investments; emphasis on tax planning Reduce investment risk; tax planning for retirement distributions Early retirement First 10 years after retirement Economic wealth is dominated by pension wealth and real estate Focus on asset growth but need to take appropriate level of investment risk Late retirement Unknown time period Involves longevity risk; cognitive decline and other health related issues may negatively impact financial decisions Need for financial advisor; prefer annuities to manage longevity risk d describe an economic (holistic) balance sheet; The economic (holistic) balance sheet includes:  Traditional assets  Traditional liabilities  Present value of all available marketable and non-marketable assets (e.g human capital and pensions)  All liabilities (e.g consumption needs and bequests) besides traditional assets and liabilities Use of economic balance sheet: IFT Notes for the Level III Exam www.ift.world Page 32 Risk Management for Individuals    IFT Notes Determine optimal level of future consumption and non-consumption goals (i.e bequests or other transfers) given the resources currently available and resources expected in the future High pension wealth  higher the level of expected remaining lifetime consumption High human capital  more aggressive portfolio e discuss risks (earnings, premature death, longevity, property, liability, and health risks) in relation to human and financial capital; f describe types of insurance relevant to personal financial planning; Risk Comment Human Capital Financial Capital Mitigation Earnings Risk Risks associated with loss/reduction of earnings: health, unemployment, underemployment Reduced because future earnings are lower Reduced because savings are lower Disability insurance Mortality Risk Risk of dying earlier than anticipated Down to zero Reduced due to death, transition and estate settlement expenses Life insurance Longevity Risk Risk of living to an advanced age in retirement More human capital but later retirement Increased accumulation Annuities Property Risk Risk associated with a potential loss of property Reduced because future income is lower Reduced because of direct loss and indirect loss Property insurance Liability Risk Risk of being held legally liable Impacted if liability exceeds financial capital Reduced Property insurance and liability insurance Health Risk Risks and implications associated with illness or injury Reduced if future earnings are lower Reduced because of higher health care costs and lower savings Health (medical) insurance g describe the basic elements of a life insurance policy and how insurers price a life insurance policy; Basic element of a life insurance policy:  Term and type of the policy  Amount of benefits  Limitations under which the death benefit could be withheld  Contestability period  Identity (name, age, gender) of the insured  Policy owner  Beneficiary or beneficiaries  Premium schedule  Modifications to coverage in any riders to the policy IFT Notes for the Level III Exam www.ift.world Page 33 Risk Management for Individuals IFT Notes How insurers price a life insurance policy: Key factors involved in life insurance policy pricing  Mortality expectations  Future death benefits  Discount rate used to discount the expected outflow  Loading added to the net premium to allow for expenses and profit h discuss the use of annuities in personal financial planning; An annuity is a stream of periodic payments over regular intervals and it provides protection against ‘longevity risk” Immediate Fixed Annuity • Individual makes a payment and receives a promised income for the rest of his/her life Life-only, no residual Life annuity with 10-year certain payment • Income yield depends on Age Male/Female/Joint Life-Only or Life with 10-year certain payment Bond yields Deferred Fixed Annuity • Individual makes a payment but income begins at a future date • Lower cost for younger people • Prior to annuitization, the investor can cash out • Once in retirement, individual has two options Cash out Begin withdrawing accumulated funds Immediate Variable Annuity • Individual makes a payment and receives a variable income for the rest of his/her life • Return depends on investment returns • Might include a floor Deferred Variable Annuity • Individual makes a payment but income begins at a future date • Menu of potential investment options • May include death benefit (risk for insurance company) for which insurance company charges a fee • Basic contract does not guarantee lifetime income • Individuals can exit (sell) contract but for a fee i discuss the relative advantages and disadvantages of fixed and variable annuities; Volatility of Benefit Amount Flexibility Future Market Expectations Fees Inflation Concerns Fixed Annuities Constant income stream; suitable for investors with low risk tolerance Low; generally irrevocable Bond-like returns Interest rate risk Low Major concern IFT Notes for the Level III Exam www.ift.world Variable Annuities Variable income stream; suitable for investors with relatively high risk tolerance High; access to funds but at a cost Variation in payments but higher expected value of payments High Less of a concern Page 34 Risk Management for Individuals IFT Notes j analyze and critique an insurance program; This LO discusses about the case of Jacques and Marion Perrier Through this case we learn how to analyze insurance needs and design an insurance program k discuss how asset allocation policy may be influenced by the risk characteristics of human capital; Subcomponents of total economic wealth affect portfolio construction in two ways: (1) asset allocation which involves overall allocation to risky assets (2) underlying asset classes, i.e stocks and bonds, selected by the individual Factors to consider:  The overall volatility of one’s economic balance sheet can be reduced by selecting assets that correlate weakly (or even negatively) with human capital  If human capital is bond-like (equity-like), the equity (bond) allocation should be increased  If earnings have high correlation with stock market, portfolio should have low risk  Younger (older) investors should allocate more of their investment portfolio to stocks (bonds) because the value of human capital (which is bond-like) is highest early (gradually depletes) in the life cycle  Since human capital is illiquid, assets in financial portfolio should be liquid  If human capital is very employer-specific, then risk is high  lower present value l recommend and justify appropriate strategies for asset allocation and risk reduction when given an investor profile of key inputs  Investment risk, property risk, and human capital risk can be either idiosyncratic or systematic  Systematic risks affect all households by affecting the earnings through a recession or slow economic growth  Idiosyncratic human capital risks can be reduced through investment portfolio strategies and/or through insurance (or annuity) products o Life insurance and disability insurance provides protection against human capital risk o Medical malpractice insurance provides protection against idiosyncratic liability risk o Annuities provide protection against risk of outliving one’s assets Examples of idiosyncratic risks:  risks of a specific occupation  risk of living a very long life or experiencing a long-term illness  risk of premature death or loss of property Examples from the Curriculum Example Estimating Human Capital Identify the key assumptions required to estimate an individual’s human capital Solution: Human capital can be calculated by using the following formula: IFT Notes for the Level III Exam www.ift.world Page 35 Risk Management for Individuals HC0  N  t 1 IFT Notes p st  wt 1 1  gt  1  r f   y t where p(st) = the probability of surviving to year (or age) t wt = the income from employment in period t gt = the annual wage growth rate rf = the nominal risk-free rate y = occupational income volatility N = the length of working life in years Example Comparing Financial and Human Capital Describe human capital and financial capital Solution: Human capital is commonly defined as the mortality-weighted net present value of an individual’s future expected labor income Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household For example, a home, a car, stocks, bonds, a vested retirement portfolio, and money in the bank are all examples of an individual’s financial capital (or financial assets) Example Financial Stages of Life From a personal financial planning standpoint, what are typical characteristics of someone in the “peak accumulation” phase? Solution: An individual in the peak accumulation phase of the life cycle would typically have the following characteristics: • Approximate age of 51–60 • Maximum earnings and opportunity for wealth accumulation • Increased interest in retirement income planning • Greater emphasis on stability and less emphasis on growth in the investment portfolio • Greater concern about tax strategies • Increased concern about losing employment because it may be more difficult to find new employment Example Traditional vs Economic Balance Sheet Contrast a traditional balance sheet with an economic balance sheet Solution: A traditional balance sheet includes assets and liabilities that are generally relatively easy to quantify An economic balance sheet provides a useful overview of one’s total wealth portfolio by supplementing IFT Notes for the Level III Exam www.ift.world Page 36 Risk Management for Individuals IFT Notes traditional balance sheet assets with human capital and pension wealth and including additional liabilities, such as consumption and bequest goals Example Changes in Human and Financial Capital Describe how the relative values of human capital and financial capital change over an individual’s lifetime Solution: The total value of human capital and the total value of financial capital tend to be inversely related over time as individuals attempt to smooth consumption through borrowing, saving, and eventual spending When human capital becomes depleted, without financial capital, an individual will have no wealth to fund his or her lifestyle Human capital is generally largest for a younger individual, whereas financial capital is generally largest when an individual first retires Example Individual Risk Exposures (1) Describe premature death risk with respect to financial and human capital Solution: Within a personal financial planning context, premature death means that an individual dies before fully providing for his or her financial needs (and, if applicable, those of the family) By definition, at that point human capital is eliminated because the deceased individual can no longer generate income To a lesser degree, there may also be an impact on financial capital In addition to expenses associated with a funeral and burial, there may be a need for significant transitional funds or even a requirement to settle certain debts or business obligations upon the individual’s death Funds may also be required for education and/or training of the surviving spouse to generate income Example Individual Risk Exposures (2) Describe longevity risk within the context of personal financial planning, and explain how it relates to human and financial capital Solution: Longevity risk refers to the possibility that an individual may live long enough to deplete his or her resources—to outlive one’s money Longevity risk relates primarily to financial capital—that is, spending one’s retirement portfolio But there is also an aspect of human capital in that one may address longevity risk, in part, by retiring later, thus expanding one’s retirement portfolio and reducing the number of years to draw it down while increasing one’s human capital Example Elements of a Life Insurance Policy Describe the concept of insurable interest for life insurance IFT Notes for the Level III Exam www.ift.world Page 37 Risk Management for Individuals IFT Notes Solution: An insurable interest means that the policy owner must derive some type of benefit from the continued survival of the insured that would be negatively affected should the insured pass away For example, an individual may rely on a spouse for his or her financial well-being If the spouse dies, income is no longer generated, leading to financial problems Another example is a business that may have an insurable interest in a key employee who generates large sales volumes The purpose of an insurable interest is to prevent individuals from gambling on the lives of others or from having a financial reason to arrange the death of the insured Example Mortality Expectations If a given male and female are the same age and have equivalent health profiles, evaluate which one should expect to pay more for life insurance Solution: A key pricing component of life insurance is expected mortality From Exhibit 5, one can see that the chance of death for females across the age spectrum is less than it is for males of the same age Therefore, all else being equal, females should expect to pay less than males for the equivalent life insurance Example 10 Life Insurance Pricing Discuss the three most relevant elements of life insurance pricing Solution: The three most relevant considerations in pricing life insurance are mortality expectations, the discount rate, and loading  Mortality expectations: The insurer is concerned about the probability that the insured will die within the term of the policy Actuaries evaluate mortality expectations based on historical experience, considering such factors as age and gender, the longevity of parents, blood pressure, cholesterol, whether the insured is a smoker, and whether the insured has had any diseases or injuries that are likely to lead to death during the policy term  Discount rate: A discount rate, or interest factor, representing an assumption of the insurance company’s return on its portfolio, is applied to the expected outflow  Loading: After calculating the net premium for a policy, which may be considered the pure price of the insurance, the insurance company adjusts the premium upward to allow for expenses and profit This adjustment is the load, and the process is called loading Example 11 Appropriateness of Life Insurance Consider two potential life insurance candidates: (1) a 40-year-old doctor who is married with two young children, substantial student loans, and sizable earnings; and (2) a 35-year-old single person with a moderate amount of financial wealth Based on the information presented, which person would be a IFT Notes for the Level III Exam www.ift.world Page 38 Risk Management for Individuals IFT Notes more appropriate candidate for life insurance and why? Solution: The first individual is a much more appropriate candidate for life insurance Given that the doctor has substantial debt and high earnings, the value of this individual’s earnings potential (human capital) is significant Likewise, with two young children, there is a high dependence on future earnings, representing another reason the earnings potential should be hedged with life insurance In contrast, the 35-year-old does not have any beneficiaries that would need to be supported But the younger individual may want to consider purchasing insurance while he or she is still insurable Example 12 Comparing Annuities Compare fixed immediate annuities and variable immediate annuities Solution: Both fixed and variable immediate annuities represent an irrevocable exchange of money for an insurance contract (the annuity contract) With a fixed immediate annuity, payments are “fixed” in either nominal terms or, in some cases, real terms, providing certainty about payment streams With both fixed and variable immediate annuities, a common feature is a “period certain,” whereby the payments continue to a designated beneficiary for a specified period, typically 10 years Example 13 Risk Management Strategy Describe loss control in risk management Solution: Loss control refers to efforts to reduce or eliminate costs associated with risks A simple method of loss control is to avoid risks (risk avoidance)—for example, by not engaging in high-risk hobbies, such as rock climbing Another approach to loss control is loss prevention, in which one attempts to reduce the likelihood of a risky event For example, one may install an alarm system to discourage burglars Loss reduction refers to approaches that attempt to minimize the size of the loss if a risky event does occur For example, an airbag in an automobile does not reduce the likelihood of an accident, but it may reduce the seriousness of injuries sustained by those involved in an accident 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 $500,000 $150,000 $650,000 IFT Notes for the Level III Exam www.ift.world Page 39 Risk Management for Individuals John Sam $800,000 $150,000 $300,000 $150,000 IFT Notes $1,100,000 $300,000 Solution: The allocation is as follows: (A) TW × 45% Person Target Equity George $292,500 John $495,000 Sam $135,000 (B) HC × 30% HC Equtiy $150,000 $240,000 $45,000 (C) (A) – (B) FC Equity $142,500 $255,000 $90,000 (D) (C)/FC FC Equity Allocation % 95.00% 85.00% 60.00% Example 15 Human Capital and Asset Allocation (2) Describe how investment strategies can be modified to account for human capital risk Solution: 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 Solution: 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) 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 IFT Notes for the Level III Exam www.ift.world Page 40 Risk Management for Individuals IFT Notes Solution: 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 IFT Notes for the Level III Exam www.ift.world Page 41 Risk Management for Individuals IFT Notes Appendix A: Life Insurance Calculations Computing Life Insurance Value Using the Human Life Value Method for Jacques 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 after-tax 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 Jacques already has €250,000 of life insurance, he should purchase an additional €1,112,203, according to this method Step Computing Life Insurance Value Using the Needs Analysis Method for Jacques Step Step 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 Step Calculate total needs as the sum of cash needs and capital needs Step Calculate total capital available, which may include cash/savings, retirement benefits, life insurance, rental property, and other assets Step Calculate the life insurance need as the difference between the total financial needs and the total capital available The calculations associated with these steps are shown below: IFT Notes for the Level III Exam www.ift.world Page 42 Risk Management for Individuals IFT Notes Cash Needs Euro (€) Final expenses Taxes payable Mortgage retirement Other debt Education fund Emergency fund 10,000 5,000 190,000 10,000 200,000 30,000 Total cash needs 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 Capital Available Cash and savings Vested retirement accounts - present value Life insurance Rental property Total capital available -183,713 -398,565 1,692,478 2,137,478 Life insurance need 1,492,478 IFT Notes for the Level III Exam www.ift.world 1,991,941 123,934 139,071 19,810 30,000 200,000 250,000 165,000 645,000 Page 43 ... 3. 3 A Framework for Individual Risk Management 3. 1 The Risk Management Strategy for Individuals IFT Notes for the Level III Exam www .ift. world Page Risk Management for Individuals IFT Notes Risk. .. frequency: Most appropriate risk management strategy is risk transfer” For IFT Notes for the Level III Exam www .ift. world Page 25 Risk Management for Individuals IFT Notes example, buying home insurance... in individual risk IFT Notes for the Level III Exam www .ift. world Page 19 Risk Management for Individuals IFT Notes management in that they hedge against the risk of ‘longevity’ Individuals have