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Level III Risk Management for Individuals Summary Characteristics of human capital and financial capital Human Capital Financial Capital • Mortality-weighted net present value (NPV) of • Personal assets future expected labor income • Investment assets • Dominant asset for young and middle-aged i tangible investment assets (i.e liquid people portfolio) • Like other assets, human capital can be risky ii intangible assets (i.e accrued defined and volatile (e.g., stockbroker), stable and benefit pension) low-risk (e.g., tenured professor), or Investment assets can be subdivided based on somewhere in between marketability, publicly traded and nonpublicly traded • Mixed assets: have characteristics of both personal assets and investment assets www.ift.world Only vested pension benefits are included in financial assets Relationships between 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 If human capital represents a risk-free (risky) asset Portfolio should have relatively high (low) risk 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 Source: EAGLE STRATEGIES LLC www.ift.world 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 35-50 age range Income increases at a rapid pace; largely financially independent; focus on retirement saving increases Start saving for retirement Peak accumulation Occurs between 51-60 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 Preretirement 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 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: 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 www.ift.world Individual risk exposures and types of insurance Risk Comment Human Capital Reduced because future earnings are lower Financial Capital Mitigation Reduced because savings are lower Disability insurance Reduced due to death, transition and estate settlement expenses Life insurance Earnings Risk Risks associated with loss/reduction of earnings: health, unemployment, underemployment Mortality Risk Risk of dying earlier than anticipated Down to zero 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 www.ift.world Basic elements of a life insurance policy a) Permanent: provides lifetime coverage; non cancelable; fixed premiums i) Whole life: fixed, annual premiums and non-cancelable; cash value ii) Universal life: more flexible than whole life; variable premium payments b) Temporary/term: for a certain period of time; non-cancelable; policy specific premium; less costly Basic element of a life insurance policy “Life insurance protects against the loss of human capital for those who depend on an individual’s future earnings.” • 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 www.ift.world Two groups of life insurers: a) Stock companies: owned by shareholders Pricing driven by market dynamics b) Mutual companies: owned by policy holders Premium > net premium plus expenses How insurers price a life insurance policy Key factors involved in life insurance policy pricing 1)Mortality expectations 2)Future death benefits 3)Discount rate used to discount the expected outflow 4)Loading added to the net premium to allow for expenses and profit Consumer comparisons of life insurance costs Two term insurance policies of equal size can be compared by looking at the first-year premium Comparison of whole life insurance policies is harder • Often regulations require that life insurance companies provide consumers with cost data • Two popular indexes for comparison are the “net payment cost index” and the “surrender cost index” Both give the annual cost per $1,000 of face value • Net payment cost index assumes: insured person will die at the end of the specified period • Surrender cost index assumes: policy will be surrendered at the end of the period and that the policy owner will receive the projected cash value • The major benefit of these indexes is the ease of comparing policies of the same type • Limitation: policies not always perform as projected www.ift.world Which risk management technique is appropriate? Calculating Life Insurance Needs Two different methods are commonly used: Risk tolerance Human life value method Future income of insured Future expenses of insured Discount back High Needs analysis method Objective is to meet the financial needs of the family Factors to consider: Immediate financial expenses Number of dependents and their expenditures Bequest or legacy goals www.ift.world Low Risk management technique Risk retention Risk transfer Strategy • • High deductible Buy little or no insurance • • • Insurance Annuities Non-insurance Use of annuities in personal financial planning An annuity is a stream of periodic payments over regular intervals and provide 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 www.ift.world 10 Fixed Annuities Variable Annuities Volatility of Benefit Amount Constant income stream; suitable for investors with low risk tolerance Variable income stream; suitable for investors with relatively high risk tolerance Flexibility Low; generally irrevocable High; access to funds but at a cost Future Market Expectations Bond-like returns Interest rate risk Variation in payments but higher expected value of payments Fees Low High Inflation Concerns Major concern Less of a concern Factors which imply higher demand for annuities: A Longer-than-average life expectancy B Greater preference for lifetime income C Less concern for leaving money to heirs D More conservative investing preferences (i.e., greater risk aversion) E Lower guaranteed income from other sources (such as pensions) www.ift.world 11 The Effect of Human Capital on Asset Allocation Policy 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 www.ift.world 12 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  Life insurance and disability insurance provides protection against human capital risk  Medical malpractice insurance provides protection against idiosyncratic liability risk  Annuities provides protection against risk of outliving one’s assets www.ift.world Examples of idiosyncratic risks: • risks of a specific occupation • risk of living a very long life or experiencing a longterm illness • risk of premature death or loss of property 13 ... Earnings Risk Risks associated with loss/reduction of earnings: health, unemployment, underemployment Mortality Risk Risk of dying earlier than anticipated Down to zero Longevity Risk Risk of... 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 www.ift.world... then risk is high  lower present value www.ift.world 12 Appropriate strategies for asset allocation and risk reduction when given an investor profile of key inputs • Investment risk, property risk,