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Reading 12 Risk Management for Individuals FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading 12 Risk Management for Individuals FinQuiz.com FinQuiz Level III 2018 – Item-set Solution Reading 12: Risk Management for Individuals Question ID: 72097 Correct Answer: A A is correct Lizzie is in the government sector which makes her annual income relatively stable On the contrary, Aaron’s income volatility is significantly higher as his compensation is based on the performance of the equity market Based on the expression for calculating human capital value (see below), higher income volatility translates into a lower human capital value B is incorrect Both Lizzie and Aaron not smoke Evidence has shown that non-smoking females have a lower mortality expectation (higher probability of survival) which translates into a higher human capital value as demonstrated by the expression below C is incorrect The medical condition which affects the women of Lizzie’s family is non-fatal Therefore, this factor will not affect any mortality expectation derived for the spouse On the other hand, if she is to become diagnosed with the condition, she will have to either stop or drastically reduce her working hours which will lead to a decline in the value of potential human and financial capital N HC = ∑ t =1 p (st )wt −1 (1 + g t ) (1 + rf + y )t where: p(st) = probability of surviving to a given year (or age) wt-1 = wage in the prior period gt = annual wage growth rate rf = nominal risk-free rate y = risk adjustment Question ID: 72098 Correct Answer: A Aaron is in the early career stage of the financial life cycle This is evident based on the following observations: • • • • this stage begins in the early 20s and lasts into the mid-30s – Aaron is 35 years of age; he has begun to save for his daughters’ university education; significant family expenses have not allowed him to generate retirement savings nor has he expressed a concern for retirement savings; and although he is developing skills for trading in emerging market securities, he has not yet experienced income growth and upward career mobility which is characteristic of individuals in the career development stage FinQuiz.com © 2018 - All rights reserved Reading 12 Risk Management for Individuals FinQuiz.com Question ID: 72099 Correct Answer: C C is correct The Strong’s household income barely covers their consumption needs With the added need to save for their daughters’ university education, invest in the brokerage business and pay premiums on the disability insurance plan, providing lifestyle and medical support to Lizzie’s father will put a considerable strain on the Strong’s financial resources A premature death will mean that Lizzie’s father’s consumption needs may not be satisfied, which in turn could threaten the quality of his life if he is unable to receive sound health care A is incorrect Earnings risk refers to the risk associated with the earnings potential of an individual There is no information which may indicate that an earnings risk can occur during the father’s remaining life expectancy of five years B is incorrect Longevity risk would have been a serious concern for the couple if Lizzie’s father had a long life expectancy and the couple was responsible for providing long-term care However, since her father has an estimated life expectancy of five years, this is no longer a source of risk Question ID: 72100 Correct Answer: B B is correct An ALDA will carry a very high premium given that Lizzie’s father has a remaining life expectancy of only five years Purchasing an ALDA to hedge against longevity risk is economical (with lower premiums) if purchased early during an annuitant’s life There are three reasons why an ALDA will be an expensive funding option for her father: 1) the insurance company will not have significant time to earn money on the amount tendered; 2) benefit payments will be few given his remaining life expectancy; and 3) because it is a deferred life policy, it is quite possible that he may die before any payments are made Although factors such as legacy goals and conservative investing preferences lower the demand for annuities, they not justify why an ALDA, in particular, is inappropriate for Lizzie’s father Question ID: 72101 Correct Answer: C The intrusion of squirrels into apartment complexes causing wiring damage is a frequent occurrence However, since the damage caused by the squirrels is low in severity risk reduction is a suitable risk management technique Risk reduction involves either lowering the likelihood that the risk will occur (deterring entry of squirrels into the building) or decreasing the magnitude of the resulting loss FinQuiz.com © 2018 - All rights reserved Reading 12 Risk Management for Individuals FinQuiz.com Question ID: 72102 Correct Answer: B Policy B is the most appropriate in light of Aaron’s circumstances The policy benefit represents only 62.5% ($50,000/$80,000) of his annual income This will be agreeable to any life insurance company as it means that the possibility of a moral hazard is low (see below) In addition, an elimination period of six months will coordinate well with the existing two-month elimination period offered on his employer’s disability insurance plan A policy with a longer elimination period is cheaper and will allow Aaron to cut down on premium costs Finally, a non-cancellable, non-renewable policy will be extremely beneficial to Aaron as premiums will not change over the plan’s term The latter protects Aaron against an unforeseen increase in premium costs Policy A is inappropriate because the elimination period does not coordinate well with the disability plan currently being provided by Aaron’s employer If Policy A is purchased, Aaron is only protected from disability risk over the short-term In addition, short-term disability insurance plans carry high premiums which are inappropriate given that Aaron has significant spending objectives and may not be able to afford high premium payments Although Policy C seems attractive because the annual benefit covers 87.5% of Aaron’s annual income and has a low insurance premium (or high deductible), the policy is unsuitable for him because it is highly likely that the insurance company will not issue the policy to prevent a moral hazard The occurrence of a moral hazard will occur if Aaron is motivated to abandon work by declaring a disability and claiming an annual benefit almost equal to his current salary A high annual benefit increases the chances of occurrence FinQuiz.com © 2018 - All rights reserved .. .Reading 12 Risk Management for Individuals FinQuiz. com FinQuiz Level III 20 18 – Item- set Solution Reading 12: Risk Management for Individuals Question ID: 720 97 Correct Answer:... decreasing the magnitude of the resulting loss FinQuiz. com © 20 18 - All rights reserved Reading 12 Risk Management for Individuals FinQuiz. com Question ID: 721 02 Correct Answer: B Policy B is the most... individuals in the career development stage FinQuiz. com © 20 18 - All rights reserved Reading 12 Risk Management for Individuals FinQuiz. com Question ID: 720 99 Correct Answer: C C is correct The
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