2018 Study Session # 5, Reading # 12 “RISK MANAGEMENT FOR INDIVIDUALS” INTRODUCTION Overview of potential risks to indvs & households Analysis of products & strategies to protect against those risks Selection of an appropriate product & strategy HUMAN CAPITAL AND FINANCIAL CAPITAL 2 Financial Capital Human Capital Dominant asset on an indv.’s B/S Value of an indv.’s HC today at Time 0: o Simple Model ܥܪ Net wealth = Net worth + claims to future assets that can be used for consumption (e.g HC & PV of pension benefits) ௐ = ∑ே ௧ୀଵ ሺଵାሻ o Expanded Model ܥܪ = ∑ே ௧ୀଵ (ௌ ) ௐషభ (ଵା ) (ଵା ା௬) where Net worth = diff b/w traditional assets & liab Future payout on HC is uncertain as reality is more complicated than models Later in lifecycle as HC diminishes, o Imp of other risks ↑ o Imp ↑ for strategies that reduce invst risks, protect against LT health-care exp & long-life spending needs 2.2.1 Personal Assets Net wealth HC = Human Capital FC = Financial Capital Indv = Individual Imp = Importance B/S = Balance sheet Mortg = Mortgage Invst = Investment LI = Life Insurance Adj = adjustment DVA = deferred variable annuity IFA = Immediate Fixed Annuity Pmt = Payment Exp = expense 2.2.6 Account Type 2.2.2 Investment Assets 2.2.3 Publicly Traded Marketable Securities Assets reflected on traditional B/S Include money market instruments, bonds, common and preferred equity Their value and risk characteristics are easier to estimate 2.2.5 NonMarketable Assets Varies materially by countries but Gen are of three types: i Taxable ii Tax-deferred iii Non-taxable …continue Assets (e.g automobile, furniture, clothes, personal residence) consumed/used by an indv Gen., not expected to appreciate in value Often worth more to an indv than their fair/mkt value [Mixed assets have both personal & invst features e.g real estate, jewelry, artwork etc.] 2.2.4 Non-publicly Traded Marketable Securities Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 12 2.2.4 Non-publicly Traded Marketable Securities 2.2.4.2 Annuities 2.2.4.1 Real Estate Among the largest assets owned by indvs Mortg pmts.→often the largest fixed obligations of indvs Mortg loans → recourse or nonrecourse Non-recourse loans →riskier for lenders, have ↑ interest rates &/or ↑ borrower credit standards 2.2.4.3 Cash-value Life Insurance A private definedbenefit pension guaranteed by an insurance co for life/ over some fixed period for the beneficiary Combines life insurance protection with some with some type of cash accumulation vehicle 2.2.5.1 Employer Pension Plans (Vested) 1) Employee-directed Saving Plan⇒ contribution amount & invst controlled by indv 2) Traditional Pension Plan⇒ guarantee some retirement benefits Value estimated by determining mortality wghtd NPV = mNPV0 = = ∑ே ௧ୀଵ 2.2.5 Non-Marketable Assets 2.2.4.4 Business Assets 2.2.4.5 Collectibles Indv’s (especially selfemployed) significant portion of total wealth Value estimated through recent sales of comparable businesses (multiple of NI or EBITDA) Value varies based on market conditions E.g stamps, paintings, wine, precious metals Value often set by auction/specialized dealers and involves ↑ transaction costs Also provide utility for the owner 2.2.5.2 Government Pensions Similar to employer pension plan but are more secure and considered as bond-like However, country’s financial health, legal framework and political stability matters (௦ ) (ଵା) Estimating pension discount rate is complex and should consider plan’s funded status, credit quality and additional credit support Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 12 A FRAMEWORK FOR INDIVIDUAL RISK MANAGEMENT 3.1 The Risk Management Strategy for Indvs 3.2 Financial Stages of Life 3.4 Indv Risk Exposures 3.3 The Indv B/S 3.2.1 Education Phase 3.1.1 Step Specify the objective 3.3.1 Traditional B/S • Assets are netted against liab • Includes recognizable marketable assets & liab • Ignores HC and pension benefits 3.2.2 Early Career 3.1.2 Step Identify Risks 3.2.3 Career Development 3.1.3 Step Evaluate risks & select appropriate methods to manage the risks 3.2.4 Peak Accumulation 3.2.5 Pre-retirement 3.1.4 Step Monitor outcomes & risk exposures & make suitable adj in methods 3.2.6 Early Retirement 3.3.2 Economic (Holistic) B/S • Provides indv’s overall financial condition based on his holistic wealth • Economic B/S + PV of nonmarketable assets (HC, pensions) & liab (consumption needs, bequests) 3.2.7 Late Retirement • • • • 3.4.1 Earning Risk Major factors include health, unemployment, underemployment Self-employed or professionals are also prone to earnings variability May ↓ HC & FC Need to seek additional training, education, skills 3.4.2 Premature Death Risk • Death of an indv earlier than expected • ↓ HC and –vely affect FC • For young family the effect can be tragic • A risk to consumption needs also occur if nonearning family member dies • • • • 3.4.3 Longevity Risk Risks associated with an extended retirement period Significant impacts on indv’s lifestyle even when pension benefits are substantial To calculate the sum needed at retirement, financial planners may use: i Monte Carlo Simulation ii Mortality Table (adj for health factors) Indv concerned about outliving his money intends to work longer, has ↑ HC but at possible exp of less desirable retirement stage • • • • • 3.4.4 Property Risk Loss that a person’s property may be lost, stolen, damaged or destroyed Direct loss⇒property’s $ loss value Indirect loss⇒exps incurred for property repairment Causes loss of FC Also cause loss of HC specially when property is used in business to create income Copyright â FinQuiz.com All rights reserved ã ã • • 3.3.3 Changes in Net worth Early in Lifecycle→Tangible assets dominate indv.’s portf Later in Lifecycle →Imp of Nontraditional B/S items ↑ In early retirement stage→Total economic wealth is dominated by pension and real estate Volatility in invst portf of Indv with ↓ HC → ↑ impact on variation in expected consumption 3.4.5 Liability Risk • Risk that an indv may be legally liable for costs associated with property damage/physical injury • Major causes involve automobile accidents; homeowner’s property may cause injury to a visitor/tenant • May affect an indv’s FC &/or HC 3.4.6 Health Risk • Related to illness or injury • Significant implications to HC and FC 2018 Study Session # 5, Reading # 12 INSURANCE & ANNUITIES 4.2 Disability Income Insurance On Next Page 4.2 Disability Income Insurance • To mitigate earning risk as a result of disability • Gen, insurance up to certain % • Other aspects include: o Benefit period o Elimination period o Rehabilitation clause o Waiver of premium o Option to purchase additional rider o Non-cancelable & guaranteed renewable o Non-cancelable policy o Inflation adj 4.3 Property Insurance 4.4 Health/Medical Insurance 4.4 Health/Medical Insurance • Highly dependent on countries (some govts fund health care) • Two tiered System: Govt coverage + upgraded coverage for more pmt • In U.S types of insurance approaches: o Indemnity plan o Preferred provider org (PPO) o Health maintenance org (HMO) • Comprehensive major medical insurance covers the vast majority of health care exp • Key terms of most health insurance plan includes: • Deductibles • Coinsurance • Copayments • Max out of pocket exp • Max yearly benefit • Max lifetime benefit • Preexisting conditions • Preadmission certification • 4.3.1 Homeowner’s Insurance: • Risks related to homeownership and personal property & liability • Policies may be specified as “all risks”, include all risks except those specified as “named risks” • To settle claim policy may be Replacement cost (more expensive) or Actual Cash Value (cost less dep.) • If ↑ deductible, then ↓ Insurance premium • Mortgage lenders require enough insurance to cover the outstanding mortgage amount • Insurance co want insurance at full value less land value and losses are reimbursed at ↓ rate if home is underinsured • Homeowners’ liability risks are gen addressed within the insurance policy • Homeowner can use other risk management techniques such as surveillance system, fire extinguishers, bank’s safe deposit box, installing surge protectors etc 4.5 Liability Insurance 4.6 Other Types of Insurance 4.5 Liability Insurance • If liability coverage in the homeowner’s and automobile insurance is less than one think is appropriate • Personal umbrella policy (relatively inexpensive) → pays claims if liability limit of homeowner’s or automobile policy is exceeded 4.6 Other Types of Insurance • Depending on the indv situation • Title insurance (when purchasing a home, to make sure ownership of the property is not in doubt) • Service contracts (extended warranty) →when purchasing automobile, home appliances, sizeable products to avoid repair cost • 4.3.2 Automobile Insurance: • Insurance rates are primarily based on vehicle value and driver’s age & driving record • Two parts of Coverage of damage i Collision Coverage (for damage from accident) ii Comprehensive Coverage (for damage from other sources glass, breakage, hail, theft) • There may also be coverage available if vehicle is damaged by uninsured/underinsured and passengers’ medical coverage • If repair cost > actual cash value insurance companies reimburse only the actual cash value • Liability risks (body injury, property damage) is gen covered within the policy • Indvs can use other safe driving techniques such as wearing seat belts, avoiding extreme weather, backup camera, lane-change warning system etc Copyright © FinQuiz.com All rights reserved 4.7 Annuities On Page 4.1 Life Insurance (LI) 2018 Study Session # 5, Reading # 12 4.1 Life Insurance (LI) • • • • 4.1.1 Uses of LI Provides hedge against earner’s death Imp estate planning tool→provides immediate illiquidity to beneficiary A tax-sheltered saving tool As mortality risk ↑, mortality charge ↑ 4.1.4.1 Mortality Expectations • Are based on historical data & future expectations • Actuaries make adj to general mortality table based on factors (e.g health history, smoking, excess weight etc.) • Large policies may require physical examination 4.1.2 Types of LI Temporary LI (TLI) • For certain specified time period • Premium either remain level or ↑ over time • Cost is less than PLI Permanent LI (PLI) • Life time coverage • Usually fixed policy premiums • May have non-forfeiture clause (e.g cash surrender option, reduced paid up option, extended term option) • Several types (e.g whole LI, universal LI) Whole LI: Universal LI: • Remains in force for an • More flexible insured’s whole life • Insured can pay ↑ ↓ ݎpremium • Cash value is associated • Non-cancelability • More options for feature appeals investing the younger indvs cash value • Participating (benefits ∆ due to co.’s profits) or Non-participating (fixed value) Common features of TLI & PLI • Non-cancelable • Potential riders can be added (e.g accidental death & dismemberment AD&D, accelerated death benefit, guaranteed insurability, waiver of premium) • Viatical settlement (option to sell the premium to a 3rd party) • • • • • 4.1.4.2 Calculation of the Net/Gross Premium Net Premium of LI policy is the discounted value of future death benefits Gross premium adds a load to the net premium Level Term Policies: Premiums are ↑ in early yrs and ↓ in later yrs Annually Renewable Policies: consumers have advantage of ‘loss leader’ but health issue or accident can make indv uninsurable Two groups of Life Insurers: i Stock Companies • Owned by shareholders • Have a profit motive • Add projected profit as a part of load in pricing policies ii Mutual Companies • Owned by policy owners • No profit motive • Charge a gross premium, which is ↑ than net premium + expenses This extra amount is paid back to policy owner as a policy dividend 4.1.3 Basic Elements of LI Policy • Term, type of policy • Amount of benefits • Limitations (to withhold benefits) • Contestability period • Identity, policy owner • Beneficiaries • Premium schedule • Riders (if any) to the policy • insurable interest • primary parties: i insured ii policy owner iii beneficiary iv insurer • documentation/proof of death 4.1.4.3 Cash value & Policy Reserves • In Whole LPs: i Premium → stays constant ii Face value → stays constant iii Cash value → ↑ iv Insurance value → ↓ • Cash value can be 1) withdrawn when policy terminate or 2) can be borrowed as a loan • Life insurers are required by regulators to maintain policy reserves 4.1.4 How LI is Price d 4.1.5 How Much LI Does One Need? • Vary from person to person and based on the no of dependents • Primary purpose: to replace PV of future earnings • Other factors include: immediate financial exp & legacy goals 4.1.4.4 Consumer Comparisons of LI Costs Two popular indexes for comparison are: 1) Net pmt cost index 2) Surrender cost index Calculation Comparison (assuming 5% discount rate & 20-yr period Steps Net Pmt Cost Index Surrender Cost Index Assumes insured Assumes policy will be person will die at surrendered at period period end end & policy owner will receive the projected cash flow A Calculate FV of Same Annuity Due of Premium B Calculate FV of Same ordinary annuity of projected annual dividends C 20-yr Insurance 20-yr Insurance Cost = Cost = A-B A-B-20 yr projected Cash Value D Interest adj cost Same per yr = Calculate Pmts for 20-yr annuity due with FV equal to C E Divide D by # of Same thousand dollars of face value Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 12 4.7 Annuities 4.7.1 Parties to an Annuity Contract Four primary parties: i Insurer ii Annuitant iii Contact owner iv Beneficiary 4.7.2 Classification of Annuities 4.7.3.1 Volatility of Benefit Amount • Retirees seeking ↑ level of assurance of benefit payouts select fixed annuity or variable annuity that limits ∆ in benefit over time • Risk tolerant retirees → opt for variable annuity 4.7.3 Advantages & Disadvantages of Fixed & Variable Annuities Imp considerations when selecting fixed/variable annuities 4.7.3.2 Flexibility • IFA (gen irrevocable) offer guarantee of income for life • Variable annuities (market performance based) provide guaranteed income and flexibility to access the funds 4.7.4 Payout Methods • Gen similar for fixed or variable annuities • Life Annuity: Pmt For annuitant’s entire life and cease at his death • Period-certain Annuity: Pmts for certain # of periods without regard to lifespan • Life Annuity with period certain: Pmts for annuitant’s entire life but guaranteed # of yrs even if he dies • Life Annuity with refund: similar to life annuity with period certain but guaranteed pmt = initial invst – fees • Joint Life Annuity: Pmt Continue until two/more members are no longer living • Payout methods are not mutually exclusive and frequencies may vary (e.g monthly, quarterly etc.) 4.7.3.3 Future Market Expectations Fixed Annuities: (bond-like assets) • have interest rate risk • Annuitant receives only market return on invst • no mortality credit Variable Annuities: • possibility of ↑ future pmts in up market • ↑ market risk and have mortality credit Copyright © FinQuiz.com All rights reserved 4.7.5 Annuity Benefit Taxation • Can offer attractive tax benefits (e.g in U.S offer tax deferred growth) • Actual tax method varies by countries 4.7.3.4 Fees Variable Annuities: • ↑ fees • opaque pricing cause reduced price competition Fixed Annuities: • ↓ fees • much easier to compare 4.7.6 Appropriateness of Annuities • Annual benefit pmt can be decomposed into i) interest ii) return of premium iii) mortality credit • How much annuitize →depends on indv’s preference for wealth max & longevity risk aversion 4.7.3.5 Inflation Concerns • Inflation can affect real income of fixed annuities • No of variable annuities and riders of fixed annuities allow ↑ ↓ ݎin pmts due to ∆in inflation 2018 Study Session # 5, Reading # 12 4.7.2.1 Deferred Variable Annuities (DVA) • Similar to mutual funds • Indvs can choose from a menu of potential invst options • Compared with mutual funds DVA are ↑expensive and have ↓ invst options • May include a death benefit (valuable to beneficiary when contract value < initial invst.) • Indv have the right to exit (sell) the contract • DVA does not guarantee lifetime income unless the indv 1)add contract rider → guaranteed pmt or 2) annuitize the contract by converting DVA into immediate payout annuity (few investors choose to annuitize) 4.7.2 Classification of Annuities • Two most critical dimensions to classify are: Deferred vs immediate Fixed vs variable • Joint life annuity (based on expected life span of two annuitants) 4.7.2.2 Deferred Fixed Annuities (DFA) • Fixed annuity payout that begins at some future date • Less costly for young indvs • Prior to annuitization, investor can cash out and receive eco value less surrender charges • After retirement indv has options i Cash out ii Begin fund withdrawal • Most deferred fixed annuities are eventually annuitized 4.7.2.3 Immediate Variable Annuities (IVA) • Lump sum is exchanged for an annuity (income for life) • Pmt varies based on the portfolio performance • Income floor feature can be added for protection in down market 4.7.2.4 Immediate Fixed Annuities (IFA) • Indvs trade a sum of money today for promised life long income benefit ௧௧ ௨ • Income yield (payout) = ௧ ௨௦ • Payouts are ↑, when expected remaining longevity is shorter (i.e payout is ↑ for 85-yr.old compared to 65-yr old) • For same age, male has ↑ payout than female • Annuity pricing is affected by mortality and expected return insurance co earn on premium • Payout will be ↓ if current bond yields are ↓and life expectancy is ↑ 4.7.2.5 Advanced Life Deferred Annuities (ALDA) • Hybrid of deferred fixed (DFA) and immediate fixed annuity (IFA) • Refereed to pure longevity insurance • Permanent exchange of lump sum for income (like IFA) but pmt begin immediately (unlike IPA) • Cost ↓ than regular immediate life annuity bcz fewer pmts that begin far in the future Copyright © FinQuiz.com All rights reserved 2018 Study Session # 5, Reading # 12 IMPLEMENTAION OF RISK MANAGEMENT FOR INDIVIDUALS 5.1 Determining the Optimal Risk Management Strategy • Depends on household’s risk tolerance • approaches to loss control i Risk avoidance (remove loss event possibility) ii Loss prevention (taking actions to ↓ probability of loss event) iii Loss reduction (↓ the size of loss) • Indvs can manage risk through techniques of: i Risk transfer (insurance/ noninsurance transfers) ii Risk retention • Systematic risk mgmt approach →consider the optimal strategy for each risk exposure 5.2 Analyzing an Insurance Program i Current Insurance Plan ii Program Review iii Recommendations 5.3 The Effect of Human Capital (HC) on Asset Allocation Policy • Indv’s total economic wealth affects portfolio construction through: a Asset allocation b Underlying asset classes • Gen HC is bond-like • No hedging benefits → if asset performance is correlated with indv’s earnings • Within occupation each indv has different HC risks (job loss impact on long-term HC, Health shock etc.) • Overall riskiness of HC is ↓ if: o both spouses are employed (unless their HC is highly correlated) o non-working spouse can rejoin work force • Overall riskiness of HC is ↑: o if HC is tied to specific geographic location o if HC is vulnerable to disability/premature risk o if HC is very employer-specific o for Professions with ↑ income variance • Optimal invst policy→forms a target mix of risky vs risk-free assets, based on risk-tolerance & adj for ∆ in assets values over time: Copyright © FinQuiz.com All rights reserved 5.4 Asset Allocation & Risk Reduction Policy • Mainly to smooth spending over time • Invst risk, property risk & HC risk can be either idiosyncratic or systematic • Idiosyncratic risks include: o Specific occupation risk o Longevity risk o Pre-mature death risk o Long-term illness o Property loss • Idiosyncratic HC risks can be reduced through invst portfolio strategies & insurance products • Systematic risks include: o Overall market performance o Economic condition o Overall longevity due to healthcare improvements • Systematic risks affect all households ... 3. 2. 2 Early Career 3. 1 .2 Step Identify Risks 3. 2 .3 Career Development 3. 1 .3 Step Evaluate risks & select appropriate methods to manage the risks 3. 2. 4 Peak Accumulation 3. 2. 5 Pre-retirement 3. 1.4.. .20 18 Study Session # 5, Reading # 12 2 .2. 4 Non-publicly Traded Marketable Securities 2. 2.4 .2 Annuities 2. 2.4.1 Real Estate Among the largest assets... Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 5, Reading # 12 A FRAMEWORK FOR INDIVIDUAL RISK MANAGEMENT 3. 1 The Risk Management Strategy for Indvs 3. 2 Financial Stages of Life 3. 4