Risk Management for Individuals INTRODUCTION The objective of lifecycle finance is consumption smoothing In order to maintain a consistent living standard, households spread their resources over their lifetime This means saving for retirement while one is working, or spending less than they earn so that they can later spend more than they earn after they are HUMAN CAPITAL AND FINANCIAL CAPITAL Two primary components of individual’s assets: 1) Human capital: Human capital is the net present value of an investor’s future expected labor income weighted by the probability of surviving (also referred to as mortality-weighted) to each future age 2) Financial capital: Financial capital refers to the tangible and intangible assets (other than human capital) owned by an individual or household 2.1 Human Capital Human capital is usually the dominant asset on a household’s economic balance sheet For risk management purpose, it is important to understand the approximate total monetary value of an individual’s human capital, the investment characteristics of the individual’s human capital (i.e., whether the capital is more stock-like or bond-like), and relationship between the value of individual’s human capital with value of the individual’s financial capital The value of human capital can be estimated by discounting the future earnings using a discount rate that reflects the risk associated with the future cash flows (i.e., wages) • • retired Households may also use insurance to help smooth spending in face of the uncertainties related to health, disability, and death or decline in value of assets In order to avoid such risks, an individual should have an appropriate risk management strategy Lower discount rate can be used in estimating human capital value of individuals who have stable and secured future cash flows e.g government employees or teachers Higher discount rate should be used in estimating human capital value of individuals who have unstable and less secure future cash flows e.g investment bankers and race car drivers The value of an individual’s human capital today, at Time (HC0) can be estimated using following equation: Where, • wt: Income from employment in year t • r: Appropriate discount rate • N: Length of working life in years By using some adjustments, Human capital can be calculated by using the following formula: 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 In the above equation, the wage in a given period is equal to the previous year’s wage increased by g percent (the annual wage growth rate, in nominal terms) and the discount rate is presented as the sum of nominal risk-free rate rf and a risk adjustment ‘y’ based on occupational income volatility (i.e inherent stability of the income stream as well as the possibility that the income stream will be interrupted by job loss, disability, or death) The future payout on human capital, like the future payout on many financial assets, is not certain because it is difficult to accurately estimate growth rates, nominal risk-free rates, risk adjustment factor, and mortality etc Practice: Example 1, Volume 2, Reading 14 2.2 Financial Capital Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household, e.g home, a car, stocks, bonds, –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 14 Reading 14 Risk Management for Individuals a vested retirement portfolio, and money in the bank Financial capital can be subdivided into two components: i Personal assets: Personal assets are assets that are consumed or used by an individual E.g automobiles, clothes, furniture, and even a personal residence Generally, the value of personal assets not appreciate in value, and they are often worth more to the individual than their current fair market value ii Investment assets: Assets that are held for their potential to increase in value and fund future consumption are referred to as Investments assets Investment assets can be classified as tangible investment assets (i.e liquid portfolio) and intangible assets (i.e accrued defined benefit pension) Investments assets can also be subdivided into marketable assets (includes publicly traded and non-publicly traded) and non-marketable assets (assets without any ready market e.g human capital, pensions) Practice: Example 2, Volume 2, Reading 14 2.2.4.1.) Real Estate Real estate (or direct real estate) is typically among the largest assets owned by an individual and similarly, mortgage payments are often the largest fixed obligation of homeowners, especially during the early years of a mortgage loan Since mortgages create a leveraged exposure in a home, the change in equity of the home tends to be greater than the change in value of the home E.g a 20% down payment (80% mortgage loan) implies that for any given change in the value of the home, the change in the equity (value less the mortgage loan) of the home will be five times greater than the change in the value of the home Types of Mortgage Loans: a) Recourse: In recourse mortgages, the lender has the right to recover from the borrower any amount due on the loan if the borrower defaults on the mortgage b) Non-recourse: In non-recourse loans, the lender cannot recover any further amount from the borrower if the borrower defaults on the mortgage and the only available collateral for the loan is the home Nonrecourse loans are thus riskier for lenders and therefore, generally have higher interest rates and/or higher borrower credit standards than recourse loans Publicly traded marketable assets include money market instruments, bonds, and common and preferred equity Non-publicly traded marketable assets include real estate, some types of annuities, cash-value life insurance, business assets, and collectibles iii Mixed Assets: Mixed assets refer to assets that have both personal and investment characteristics, e.g real estate, can be used as both a personal asset (shelter, as an alternative to renting) and an investment asset (to help fund retirement) for an individual Another potential example of a mixed asset is collectibles (such as jewelry, wine, stamps, wine, precious metals, and artwork) Mixed assets provide satisfaction (i.e., utility) to individuals from their current value and at the same time have the potential to increase in value over time The value of collectibles is often set by auction markets or specialized dealers and involves substantial transaction costs Note: Accrued defined benefits and social security are considered as a form of human capital that is converted into a financial asset In this reading, accrued defined benefits and government pension benefits are defined as components of financial capital FinQuiz.com 2.2.4.3.) Cash-Value Life Insurance Cash-value life insurance – a type of life insurance – is a policy that not only provides protection upon a death but also contains some type of cash reserve 2.2.4.4.) Business Assets Business assets can represent a significant portion of the total wealth of an individual (e.g a self-employed individual) The value of business assets can be estimated using recent sales of comparable private businesses within the same industry as a multiple of net income or net income with various adjustments (e.g., EBITDA) The value of business assets vary depending on market conditions; The value of business assets usually correlate with other financial assets within a household portfolio 2.2.5.1.) Employer Pension Plans (Vested) Types of Retirement Plan: 1) Employee-directed savings plan: In this plan, contribution amounts and investments are Reading 14 2) Risk Management for Individuals controlled by the individual (and not guaranteed) Traditional pension plans: Such plans guarantee some level of retirement benefits, typically based on past wages Important to Note: Only vested pension benefits are considered as financial assets, because unvested pension benefits are typically contingent on future work and are thus considered to be part of human capital The value of a vested traditional defined benefit pension from an employer can be estimated by calculating the mortality-weighted net present value of future benefits The mortality-weighted net present value at Time (now), mNPV0, can be estimated as follows: Where, bt = The future expected vested benefit (bt) [p(st)] = Probability of surviving until year t, and r = Discount rate (r) The discount rate will be higher for riskier future benefit payments and should reflect whether the benefit is in nominal or real terms Pension discount rate depends on various factors, i.e • • • Health of the plan (e.g., its funding status); Credit quality of the sponsoring company; Any additional credit support 3.1 FinQuiz.com If the company in question has long-term bonds, the yield on the bonds can provide a proxy for an appropriate discount rate 2.2.5.2.) Government Pensions Government pensions are like employer plans but are more secure depending on degree of creditworthiness of a government, legal framework and any accompanying political risk at the country level Due to guaranteed nature of pension benefits, government pensions can be considered relatively bond-like 2.2.6.) Account Type Types of accounts for financial capital: a) A taxable account: Taxes are due annually on the realized gains, dividends, and/or interest income b) A tax-deferred account: Taxes on any gains are deferred until some future date, such as when a withdrawal is made from the account c) A non-taxable account: No taxes are applicable 2.3 Net Wealth Individual’s net worth = Traditional assets - Traditional liabilities Net wealth, other than difference between assets and liabilities, also include claims to future assets that can be used for consumption, i.e human capital and the present value of pension benefits A FRAMEWORK FOR INDIVIDUAL RISK MANAGEMENT The Risk Management Strategy for Individuals Risk management for individuals involves identifying threats to the value of household assets and developing an appropriate strategy for managing these risks Four key steps in the risk management process: 1) Specify the objective: Decrease in future spending caused by unexpected events (i.e a market crash, a physical disability, the premature death of a primary earner, or health care expenses etc) is a risk for individuals In order to manage such risks, an individual needs to decide the amount of risk he is willing to bear in order to achieve its long-run spending goals 2) Identify risks: There are different types of risk, i.e decline in earnings, premature death, longevity, property, liability, and health risks 3) Evaluate risks and select appropriate methods to manage the risks: Evaluation of risks involve considering the magnitude of the risk and the range of options available to manage that risk Methods to Manage Risks: a) Risk avoidance: It involves avoiding a risk altogether b) Risk reduction: It involves mitigating a risk by reducing its impact, either by lowering the likelihood of its occurrence or by decreasing the magnitude of loss (for example, by wearing a helmet when riding a motorcycle) c) Risk transfer: It involves transferring the risk, e.g by using insurance and annuities d) Risk retention: It involves retaining a risk by keeping funds aside to meet potential losses 4) Monitor outcomes and risk exposures and make appropriate adjustments in methods: After the selection of appropriate risk management method, Reading 14 Risk Management for Individuals risks must be continuously monitored and updated because individual’s goals and personal and financial situation change through its life cycle and these changes will affect risk exposures and optimal risk management strategies Life changes include birth, marriage, inheritance, job change, relocation, divorce, or death 1) Phase Education Phase • • • • • 2) Early career • • • • • • • 3) Career development • • • • • • • 4) Peak accumulation • • • • • • • • • • 5) Pre-retirement • • • • 6) Early retirement • • • • 3.2 FinQuiz.com Financial Stages of Life Financial stages of life for adults can be divided into the following seven periods: Characteristics Investment in knowledge (or human capital) through either formal education or skill development May be largely financially dependent on his or her parents or guardians Little focus on savings or risk management Accumulated financial capital is little, (if any) Could benefit from benefits of life insurance because of living with family at this stage Begin as early as age 18 (16 in some countries) or as late as the late 20s (or even early 30s), depending on the level of education attained, and generally lasts into the mid-30s Education has been completed and has entered the workforce Partially financially independent Focus on savings increase as start saving for their children’s college expenses Low retirement savings due to significant family and housing expenses Human capital is a large proportion of total wealth Tangible assets (i.e real estate and personal goods) tend to dominate a household’s portfolio Insurance is highly valuable due to greater proportion of human capital Occurs during the 35–50 age range Focus on specific skill development within a given field, upward career mobility, and income growth Largely financially independent Retirement saving tends to increase at a more rapid pace Increase in financial capital as higher earners will begin building wealth beyond education and retirement objectives Higher expenses as one may make large purchases, such as a vacation home, or travel extensively Human capital represents a large proportion of total wealth Occurs during the ages of 51–60 Focus on reducing investment risk to emphasize income production for retirement (particularly near the end of this period); Higher concerned about minimizing taxes, given higher levels of wealth and income Insurance is highly valuable due to high human capital risk 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 due to higher earnings Increased concern about losing employment because of difficulty to find new employment This phase includes few years preceding the planned retirement age; Focus on reducing risk for which portfolios may need restructuring; Prefer less volatile investments Emphasis on tax planning, including the ramifications of retirement plan distribution options First 10 years of retirement; Successful investors have comfortable income and sufficient assets to meet expenses in this phase An investment portfolio represents a significant portion of wealth Its proportion is less than 50% of total economic wealth if home equity, pension wealth, and human capital are also considered Total economic wealth is dominated by pension wealth (i.e., the remaining mortality weighted net present value of benefits) and the value of real estate (i.e., the Reading 14 Risk Management for Individuals FinQuiz.com Phase Characteristics individual’s personal residence) • For wealthier individuals, the value of defined benefit pension wealth will likely represent a low percentage of the total wealth portfolio in retirement • Most active period of retirement • No cognitive or mobility limitations • There is a need for asset growth • Need to take appropriate level of investment risk in retirees’ portfolios 7) Late • Unpredictable phase because the exact length of retirement is unknown retirement • Involves longevity risk (risk that retirement could be very short or very long); • Risk of depletion of financial asset reserves if an individual experiences long series of physical problems • Risk of financial mistakes due to decline in cognitive This risk can be hedged through a trusted financial adviser or through the use of annuities well as all liabilities (e.g consumption needs and bequests) besides traditional assets and liabilities The Two important concerns appropriate to any financial stage: i ii The need to provide for long-term health care, depending on the family situation The need to devote resources to care for parents or a disabled child for an extended period of time Practice: Example 3, Volume 2, Reading 14 3.3 The Individual Balance Sheet 3.3.1.) Traditional Balance Sheet The traditional balance sheet for an individual investor includes recognizable marketable assets and liabilities • • Assets include any type of investment portfolio, retirement portfolio (or plan), real estate, and other tangible and intangible items of value Liabilities include mortgage debt, credit card debt, auto loans, business debt, and student loans Value of Equity = Asset – Liabilities economic balance sheet helps individuals in determining the 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 It also helps an individual to anticipate how available resources can be used to fund consumption over the remaining lifetime • For setting consumption or bequest goals, an individual need to assess value of pension and human capital This implies that individuals with greater human capital (e.g younger households) can make more generous retirement savings goals than individuals with comparatively lower human capital Economic Wealth of Individuals: The total economic wealth of an individual changes throughout his or her lifetime • E.g if an individual owns a home worth $1 million with $900,000, then • Equity in Home = $1,000,000 - $900,000 = $100,000 • Note: In earlier life-cycle stages, human capital is larger than other assets on the balance sheet of an individual Limitation of Traditional Balance Sheet: A traditional balance sheet only provides information about marketable assets that are currently available It does not provide any information to maximize the expected lifetime satisfaction of the individual (“utility”) 3.3.2.) Economic (Holistic) Balance Sheet The economic (holistic) balance sheet includes the present value of all available marketable and nonmarketable assets (e.g human capital and pensions) as The total economic wealth of younger individuals is typically dominated by the value of their human capital The total economic wealth of older individuals is dominated by financial capital because of savings over time In later phases of life-cycle, importance of nontraditional balance sheet assets (i.e employer pension) increases as they represent an important source of stable consumption and affect the optimal allocation of securities within an investment portfolio Important to Note: The total value of human capital is inversely related with total value of financial capital If an individual does not save over his lifetime, then at retirement he may have a shortfall to adequately fund the lifestyle he or she will want at retirement Reading 14 Risk Management for Individuals associated with loss of income or reduction in income Major factors in earnings risk include unemployment, underemployment, and health issues The loss of income represents a reduction in both human and financial capital For individuals who work in dangerous occupations or have job that have a high likelihood of variability or disruption in earnings, the total value of human capital is estimated either by using lower future expected earnings or a higher discount rate or both The higher the earnings risk, the higher financial capital is required to make up for any loss of income Practice: Example 4, Volume 2, Reading 14 3.3.3.) Changes in Net Wealth Practice: Example, Page no 23-26 Volume 2, Reading 14 • The higher the value of pension wealth, the higher the level of expected remaining lifetime consumption The lower the value of human capital, the greater the impact of volatility in investment portfolio on expected remaining lifetime consumption Given the same level of risk tolerance, the higher the human capital of an investor, the less conservative will be portfolio recommendations The risk associated with a pension from a private employer can be hedged by taking exposure in securities and derivatives in financial markets having a negative correlation with the value of the company • • • Example: Assume following two individuals: 1) 45-year-old with €1.5 million in combined human and financial capital He expects to spend approximately = 1.5mln / (85 -45) = €38,000 each year until age 85 His investment portfolio is €500,000 40% loss in the investment portfolio (0.4 × €500,000 = €200,000) will lead to a 13.2% loss in expected spending per year [(€200,000/40 years)/€38,000] 2) 45-year-old with €3.5 million in net wealth He expects to spend = 3.5mln / (85 – 45) = €88,000 each year until age 85 His investment portfolio is €500,000 40% investment loss to investment portfolio (0.4 × €500,000 = €200,000) will lead only to a 5.7% decrease in expected consumption [(€200,000/40 years)/€88,000] Premature Death Risk: Premature death risk (or mortality risk) refers to risk associated with the death of an individual earlier than anticipated, resulting in loss of human capital or reduction in the income of the surviving spouse This risk can also arise if a nonearning member of the family dies The loss of death of non-earning member of the family can be estimated as the discounted value of the services provided by the deceased family member plus any out-of-pocket death expenses Besides loss in human capital, the mortality risk also results in death expenses (including funeral and burial), transition expenses, estate settlement expenses, and the possible need for training or education for the surviving spouse 2) 3) Longevity Risk: Longevity risk refers to risk of outliving one’s financial assets due to extended retirement period that result in difficulty in meeting postretirement consumption needs The size of a fund an individual will actually have at retirement depends on the amount and timing of contributions, the nominal rate of return, and the amount of time until retirement 4) Property Risk: Property risk refers to the risk associated with a potential loss of financial capital as a result of damage, destruction, stealth, or loss of person’s property This implies that the higher the value of human capital, the lower the impact of volatility in investment portfolio on expected remaining lifetime consumption • • Practice: Example 5, Volume 2, Reading 14 3.4 Individual Risk Exposures Managing risks to financial and human capital is an essential part of the household financial planning process Following are some of individual risk exposures 1) Earnings Risk: Earnings risk refers to the risks FinQuiz.com 5) Direct loss refers to the monetary value of the loss associated with the property itself Indirect loss refers to monetary value of the loss indirectly associated with the damage or destruction of property E.g rental expenses incurred if the family live elsewhere while the damage is repaired, income lost during construction etc Liability Risk: Liability risk refers to the risk associated with a potential loss of financial capital as a result of an individual or household being held legally liable Reading 14 Risk Management for Individuals for the financial costs associated with property damage or physical injury 6) associated with diagnostics, treatments, and procedures Practice: Example & 7, Volume 2, Reading 14 Health Risk: Health risk refers to the risks and implications associated with illness or injury Direct costs associated with illness or injury may include coinsurance, copayments, and deductibles INSURANCE AND ANNUITIES Individual lifecycle planning involves assessing expected available resources and planning an optimal earning and spending path over a lifetime Risk exposure can be reduced either by altering portfolio allocation, changing behavior, or purchasing financial and/or insurance products However, there is a cost associated with risk reduction comes in form of loss of risk premium and a lower expected level of consumption over time 4.1 term insurance is Permanent Life Insurance: Permanent life insurance policy is non-cancelable and it lapses only upon death ii Policy premiums for permanent life insurance are usually fixed Generally, there is some underlying cash value associated with a permanent insurance policy Many permanent life insurance policies have a “non-forfeiture clause,” whereby the policy owner has the option to receive some portion of the benefits if premium payments are missed (i.e., before the policy lapses) The nonforfeiture clause is generally allowed in following scenarios: Cash surrender option, whereby the existing cash value is paid out Reduced paid-up option, whereby the cash value is used to purchase a single-premium whole life insurance policy Extended term option, whereby the cash value is used to purchase a term insurance policy, generally with the same face value as the previous policy Life Insurance 4.1.1.) Uses of Life Insurance • • FinQuiz.com Life insurance protects against the loss of human capital or the risk of the loss of the future earning power of an individual Life insurance can also be used as estate-planning tool as life insurance policy can provide immediate liquidity to a beneficiary without facing the delay related to legal process of settling an estate (especially if the estate contains illiquid assets or assets) The optimal amount of insurance to purchase depends on expenses of the insurance hedge and the magnitude of the difference in expected lifetime utility with and without that family member 4.1.2.) Types of Life Insurance There are following two main types of life insurance: i Temporary Life Insurance: Temporary life insurance (or “term” life insurance) provides insurance for a certain period of time specified at purchase Temporary life insurance policy is non-cancelable and it lapses only at the end of the term If the individual survives until the end of the period (e.g., 20 years), the policy will terminate unless it can be automatically renewed Term life insurance premiums either remain constant over the insured period or increase over the period as mortality risk increases Term insurance is less costly as compared with permanent insurance Because of increasing mortality risk, the shorter the insured periods, the less costly Types of Permanent Life Insurance: Two most common types of permanent life insurance include: i Whole life insurance: Whole life insurance provides protection for an insured’s entire life It requires regular, ongoing fixed premiums, which are typically paid annually1 • • It is preferred to buy at younger ages because it is non-cancelable Whole life insurance policies can be participating or non-participating In Participating life insurance policies, value grows at a higher rate than the guaranteed value, based on the profits of the insurance company In non-participating policy, value is fixed and not change based on the profits and Monthly, quarterly, and semiannual payment options also exist Reading 14 • ii Risk Management for Individuals experience of the insurance company Cash values (section 4.1.4.3): Whole life policies offer advantage of level premiums and an accumulation of cash value within the policy that (1) can be withdrawn by the policy owner when the policy endows (or matures) or when he or she terminates the policy or (2) can be borrowed as a loan while keeping the policy in force The cash values tend to increase very slowly in the early years because during that time, company is making up for its expenses As cash values increases and the insurance value decreases, the ongoing premium is paying for less and less life insurance (as shown below) As the individual’s working years tend to decrease, the need for life insurance decreases Universal life insurance: In universal life insurance, the insured has the ability to pay higher or lower premium payments and has more options for investing the cash value It is more flexible than whole life insurance Rider: A rider is an add-on provision to a basic insurance policy that provides additional benefits to the policyholder at an additional cost E.g • • • • Accidental death rider (also referred to as accidental death and dismemberment, or AD&D): It increases the payout if the insured dies or becomes dismembered from an accident Accelerated death benefit: It allows insured parties who have been diagnosed as terminally ill to collect all or part of the death benefit while they are still alive Guaranteed insurability: It allows the owner to purchase more insurance in the future at certain predefined intervals Waiver of premium: It provides waiver to future premiums if the insured becomes disabled The value of the rider will depend on the level of protection against an unexpected decline in consumption not otherwise provided by a basic FinQuiz.com policy Viatical settlement: A viatical settlement is the sale of a policy owner's existing life insurance policy to a third party for more than its cash surrender value, but less than its net death benefit Such a sale provides the policy owner with a lump sum After purchasing the policy, the third party becomes responsible for paying the premiums and will receive the death benefit when the insured dies 4.1.3.) Basic Elements of a Life Insurance Policy: The basic elements of a life insurance policy include a) Term and type of the policy (e.g., a 20-year temporary insurance policy) b) Amount of benefits (e.g., £100,000) c) Limitations under which the death benefit could be withheld (e.g., if death is by suicide within two years of issuance) d) Contestability period (the period during which the insurance company can investigate and deny claims), e) Identity (name, age, gender) of the insured f) Policy owner g) Beneficiary or beneficiaries h) Premium schedule (the amount and frequency of premiums due) i) Modifications to coverage in any riders to the policy j) Insurable interest in the life of the insured: For a life insurance policy to be valid, the policy owner must have an insurable interest in the life of the insured The insurable interest means that the policy owner must derive some type of benefit from the continued survival of the individual and the death of that individual would have negative impact on the policy owner Primary Parties involved in Life Insurance Policy: i ii iii iv Insured: The individual whose death triggers the insurance payment Policy owner: The person who owns the life insurance policy and is responsible for paying premiums Typically, the policy owner and the insured are the same person When the insured is not the policy owner, the policy owner must have an “insurable interest” in the life of the insured Beneficiary (or beneficiaries): The individual (or entity) who will receive the proceeds from the life insurance policy when the insured passes away The actual beneficiary of a jointly owned life insurance policy may be determined by the order of death of the prospective beneficiaries (e.g., a husband and a wife) Insurer: The insurance company that writes the policy and is responsible for paying the death Reading 14 Risk Management for Individuals benefit Face value of the life insurance policy: It is the amount payable to the beneficiary Example: Assume premiums are collected at the beginning of the year and death benefit payments occur at the end of the year Life insurance policy is worth $100,000 An individual has a probability of 0.15% of dying within the year and discount rate is 5.5% Payment of Life Insurance Benefits: Life insurance benefits are payable to the beneficiary upon the death of the insured Typically, some kind of evidence (i.e death certificate) is required before benefits are paid to the beneficiary Situations when Life Insurance Benefits are not paid: 1) If the insured commits suicide within some predetermined period after purchasing the policy 2) If the insured made material misrepresentations relating to his or her health and/or financial condition during the application process Important to Note: An insurer can deny the claim only during maximum contestability period If that period lapses, then the insurer cannot deny the claim even if it involves suicide and/or material misstatement Practice: Example 8, Volume 2, Reading 14 4.1.4.) How Life Insurance Is Priced The pricing of life insurance is based on following three key factors: 1) Mortality expectations: Expected mortality of the insured individual refers to how long the person is expected to live Mortality is estimated based on both historical data and future mortality expectations The underwriting process analyzes applicants’ health history, particularly conditions that are associated with shorter-than-average life expectancy (i.e cancer and heart disease) This underwriting process reduces the likelihood of adverse selection Adverse selection is the risk that individuals with higher-than-average risk are more likely to apply for life insurance Typically, the individuals with lower expected probability of dying in a given year tend to pay less for life insurance, e.g younger individuals, females, and non-smokers 2) Discount rate: A discount rate, or interest factor (based on assumed return on insurance company’s portfolio) is used to discount the expected outflow • • Net premium of a life insurance policy represents the discounted value of the future death benefit Gross premium is the net premium plus load FinQuiz.com Expected Outflow (life insurance benefit) = (Dying probability × Life insurance policy value) + (Surviving probability × Life insurance policy value) = (0.0015 × US$100,000) + (0.9985 × US$0) = US$150 Net Premium = US$150/1.055 = US$142.18 3) Loading: Load is an amount that is built in to the insurance cost This amount covers the operating cost of the insurer, as well as the chance that the insurer's losses for that period will be higher than anticipated, and the changes in the interest earned from the insurer's investments This is added to the net premium to adjust the premium upward to allow for expenses and profit This adjustment is the load, and the process is called loading Expenses associated with writing a life insurance policy include the costs of the underwriting process, e.g sales commission to the agent who sold the policy and the cost of a physical exam Ongoing expenses include overhead and administrative expenses associated with monitoring the policy, ensuring that premiums are paid on a timely basis, and verifying a potential death claim Usually, companies provide a low percentage “renewal commission” for the first years of the policy to encourage the agent to try his best to keep the policy owner from terminating the policy Types of Life Insurers: Life insurers can be divided into two groups: 1) Stock companies: Stock companies, like other corporations, are owned by shareholders, have a profit motive, and are expected to provide a return to those shareholders Stock life insurance companies add a projected profit as a part of the load in pricing their policies 2) Mutual companies: Mutual companies are owned by the policy owners themselves and there is no profit motive Premium charged by mutual companies is typically higher than the net premium plus expenses Return of premium to the policy owner: If expenses, and/or investment returns are better than projected, the amount by which the gross premium exceeds the net premium plus expenses may be paid back to the policy owners as a policy dividend Reading 14 Risk Management for Individuals FinQuiz.com Future value of Projected annual dividend = Projected annual dividend × (1 + Discount rate) Premiums for Level Term and Renewable Policies: • • • number of years An ordinary annuity is used because dividend payments are made at the end of the period C Calculate insurance cost as follows: Insurance cost for “N” years = Future value of Premium - Future value of projected annual dividend Insurance cost for a “N” year annuity due with a future value = Premium Payments × (1 + Discount rate) number of years This amount is the interest-adjusted cost per year An annuity due is used because premium payments occur at the beginning of the year D Net payment cost is calculated by dividing Insurance cost by the number of thousand dollars of face value In the early years, premiums for level term policies tend to be higher than those for annually renewable (one year) policies In the later years of the policies, premiums for level term policies (particularly, for longer periods i.e 20year level term) tend to be lower than those for annually renewable (one year) policies because premiums for annually renewable term policies tend to increase rapidly Therefore, often low initial rates are offered on annually renewable policies People often buy an annually renewable term policy to take advantage of low premium in early years and then switching to another company in later years But, this strategy involves risk of individual being uninsurable because of health issue or accident Practice: Example & 10, Volume 2, Reading 14 2) 4.1.4.3.) Policy Reserves Life insurers are required by regulators to maintain policy reserves Policy reserves are reported as a liability on the insurance company’s balance sheet • In a whole life policy, the insurance company specifies an age at which the policy’s face value will be paid as an endowment to the policy owner if the insured person has not died by that time This makes policy reserves highly important in whole life policies so that the insurance company is able to make that payment 4.1.4.4.) Consumer Comparisons of Life Insurance Costs There are two most popular indexes for comparison of Life Insurance costs: 1) Net payment cost index: The net payment cost index assumes that the insured person will die at the end of a specified period, such as 20 years Calculation of the net payment cost index includes the following steps: A Calculate the future value of premiums using annuity due formula: Future value of Premium = Premium × (1 + Discount rate) number of years An annuity due (whereby premium payment is received at the beginning of the period versus an ordinary annuity (whereby premium payment is received at the end of the period) is used because premiums are paid at the beginning of the period B Calculate the future value of Projected annual dividend (if any) using ordinary annuity formula: Surrender cost index: The surrender cost index assumes that the policy will be surrendered at the end of the period and that the policy owner will receive the projected cash value Calculation of the surrender cost index includes the following steps: A Calculate the future value of premiums using annuity due: Future value of Premium = Premium × (1 + Discount rate) number of years An annuity due is used because premiums are paid at the beginning of the period B Calculate the future value of Projected annual dividend (if any) using ordinary annuity formula: Future value of Projected annual dividend = Projected annual dividend × (1 + Discount rate) number of years An ordinary annuity is used because dividend payments are made at the end of the period C Calculate insurance cost as follows: Insurance cost for “N” years = Future value of Premium - Future value of projected annual dividend - Year “N” projected cash value This amount is the interest-adjusted cost per year An annuity due is used because premium payments occur at the beginning of the year Future value of Insurance cost for a “N” year = Premium Payments × (1 + Discount rate) number of years D Surrender cost is calculated by dividing Insurance cost by the number of thousand dollars of face value Reading 14 Risk Management for Individuals Rule to Remember: The lower the index value is, the better the value 4.1.5.) How Much Life Insurance Does One Need? Two different methods are used to calculate the amount of life insurance needed i The human life value method: This method involves estimating future income that would be generated by the insured, offset by incremental expenses that would be attributable to the insured The amount of insurance needed is calculated as the present value of net amounts in each year Additional amount to cover “final expenses,” such as funeral and other death expenses may also be added ii The needs analysis method: This method involves estimating living expenses for survivors for an appropriate amount of time, typically until adulthood for surviving children and to projected life expectancy for a surviving spouse This method also add education costs, final expenses, and any other special expenses to the total amount of insurance needed while any assets available are subtracted The amount of insurance needed is calculated as the present value of net amounts in each year Reasons to consider life insurance: The primary purpose of life insurance is to replace the present value of future earnings Other reasons to consider life insurance include the following: • Immediate financial expenses: These include direct costs associated with death, i.e funeral and legal expenses Legacy goals: These can include gifts to charities, bequests to family members, and estate planning • The value of life insurance should be equal to household spending with human capital of the earner less household spending without human capital of the earner Disability income insurance is used to mitigate earnings risk (or loss of income) as a result of a disability (e.g due to physical injury, disease, or other impairment) In disability income insurance policy, the premium is generally fixed and based on the age of the insured at the time of policy issue, and the policy is underwritten for the health and occupation of the insured The insurance companies typically use following definition of disability: • • • The cost of the insurance Insurance company’s ability to meet its financial obligations It is evaluated by analyzing company’s financial strength and its ratings Practice: Example 11, Volume 2, Reading 14 • • Disability Income Insurance Partial disability means that individual can perform enough to remain employed, albeit at a lower income Partial disability provisions pay a reduced benefit Residual disability refers to the possibility the individual cannot earn as much money as before despite the fact that he can perform all the duties Typically, insurers provide compensation only up to specific amounts (e.g 60%–80%) for two reasons i ii When the insured becomes disabled, other expenses also decrease (e.g payroll taxes, commuting costs, clothing, and food) To avoid possibility of fraudulent claims if the disability income payments are close to the normal compensation Other aspects of disability income insurance include the following: • • • • 4.2 Inability to perform the important duties of one’s regular occupation: This definition is most appropriate for professionals with specialized skills Inability to perform the important duties of any occupation for which one is suited by education and experience; Inability to perform the duties of any occupation; Disability income policies usually include provisions for partial and residual disability Factors important to consider when purchasing life insurance: • • FinQuiz.com Benefit Period: The benefit period specifies number of years for which payments will be made The benefit period lasts until normal retirement age (e.g 55 and 70) Usually, a minimum number of years of benefits is five years For example, a 62- year-old who becomes disabled would receive benefits to age 67 Elimination Period: The elimination period, or waiting period, specifies the number of days the insured must be disabled before payments begin being made (typically, 90 days) The shorter the elimination period, the higher the premiums Rehabilitation clause: This clause provides payments for physical therapy and related services to help the disabled person rejoin the workforce as soon as possible Waiver of premium clause: The waiver of premium clause allows insured not to stop paying premiums if he becomes disabled or to reimburse premiums during the elimination period Reading 14 • Risk Management for Individuals Option to purchase additional insurance rider: The option to purchase additional insurance rider allows the insured to increase coverage without further proof of insurability, albeit at the rate appropriate for the insured’s current age Non-cancelable and guaranteed renewable policy: A non-cancelable and guaranteed renewable policy guarantees policy to be renewed annually as long as premiums are paid and that there is no changes to premiums or promised disability benefits until, usually, age 65 Even if employment income declines during the working life, the monthly benefit will remain at the level specified in the policy Non-cancelable policy: A non-cancelable policy cannot be canceled as long as premiums are paid, but the insurer can increase premiums for the entire underwriting class that includes the insured Inflation adjustments to benefits: Inflation adjustments to benefits may be provided by a cost of living rider, under which benefits are adjusted with an accepted index or by a specified percentage per year • • • FinQuiz.com US$2,000 deductible and there is a damage of $10,000, the homeowner must pay the first $2,000 and the insurance company would be liable for the remaining $8,000 The optimal deductible level is determined by cost– benefit analysis A high deductible is appropriate for individuals with significant wealth, a relatively small percentage of their net worth represented by home, and who have adequate liquidity The larger the deductible, the lower will be the premium Insurance companies prefers the house to be insured for its full value less the value of the land because the land will not be destroyed or at least a high percentage of full value If the home is underinsured (e.g less than 80% of its replacement cost), losses are reimbursed at lower rate Homeowners’ liability risks exclude professional liability, such as physicians’ malpractice insurance, business liability, liability resulting from intentional acts Other risk management techniques: 4.3 Property Insurance Property insurance is insurance that provides protection against property risk (loss related to his or her property) associated with home/residence and the automobile 4.3.1.) Homeowner’s Insurance Homeowner’s insurance covers risks associated with home ownership as well as risks associated with personal property and liability Renters insurance is for occupants who not own the property but want to protect their personal belongings that are in the home or on the property Homeowner’s policies can be specified as “allrisks,” which means that all risks are included except those specified, or as “named-risks,” which means that only those risks specifically listed are covered All-risks policies are generally more expensive Homeowner’s insurance policy can be based on replacement cost, which reimburses the insured person for the amount required to repair a damaged item or replace a lost, destroyed, or stolen item with a new item of similar quality at current prices The replacement cost version is a more expensive policy Homeowner’s insurance policy can be based on actual cash value, which reimburses the insured person for the replacement cost less depreciation Deductible: The deductible is the amount of expenses that must be paid out of pocket before an insurer will pay any expenses Deductibles represent a form of active risk retention E.g if the homeowner’s policy has a a) Risk of theft of valuable financial documents can be avoided by keeping them in a bank’s safe deposit box b) Risk of overall theft can be reduced through the use of high-quality locks, alarms, and surveillance systems c) Risk of loss or corruption of electronic data can be avoided by storing backups offsite d) Risk of damage to electronic equipment from a power surge can be reduced by installing surge protectors e) Risk of loss from fire can be reduced through the use of fire-resistant building materials and through the easy availability of fire extinguishers 4.3.2.) Automobile Insurance Automobile insurance rates are primarily based on the value of the automobile and the primary operator’s age and driving record There are two types of coverages under automobile insurance: 1) Collision coverage, which is for damage from an accident 2) Comprehensive coverage, which is for damage from other sources, i.e glass breakage, hail, and theft Insurance companies normally insure automobiles only up to the cost of replacing the automobile If the cost to repair the automobile is greater than its actual cash value, only the amount of the actual cash value is reimbursed Like homeowner’s insurance, some risk can be retained by automobile owner through the use of deductibles or by avoiding collision and comprehensive coverage Reading 14 Risk Management for Individuals Liability associated with automobiles is typically covered under automobile insurance policy, with specified limits for bodily injury and property damage Liability limits vary depending on different types of loss, e.g., higher limits to cover the costs of physical injury and separate limits to cover the loss of property If actual liability in an accident exceeds these amounts, the automobile owner is responsible for the remainder 4.4 • • • Indemnity plan: It allows the insured to obtain services from any medical service provider, but the insured must pay a specified percentage of the “reasonable and customary” fees Preferred provider organization (PPO) Plan: Under this plan, physicians and other medical service providers charge lower prices to individuals within the plan than to individuals who not have such plans Health maintenance organization (HMO) Plan: It allows the insured to obtain medical services, at zero or very little, cost to encourage individuals to seek help for small medical problems before they become more serious Comprehensive major medical insurance: It covers the vast majority of health care expenses, i.e physicians’ fees, surgical fees, hospitalization, laboratory fees, X-rays, magnetic resonance imaging (MRIs) etc Factors to consider in selecting Health Insurance Plan: i ii Cost of the plan Breadth and quality of the network of physicians and hospitals available to the insured under the plan Key terms of Health (medical) insurance plans: • • • • • • Health/Medical Insurance There are various types of health insurance plans, such as • • Deductibles: It is the amount that the insured must pay for covered health care services before his insurance plan starts to pay E.g with a $2,000 deductible, the insured has to pay the first $2,000 of covered services himself Coinsurance: Coinsurance refers to money that an insured is required to pay for services, after a deductible has been paid Coinsurance is often specified by a percentage E.g., the insured pays 20% toward the charges for a service and the insurance company pays 80% Copayments: Copayment is a fixed amount that the insured pays for a covered health care service after he has paid his deductible Maximum out-of-pocket expense: It is the total amount of money an insured pay toward the cost of his healthcare each year during policy period before health insurance starts to pay 100% of coverage This concept is often referred to as a stop-loss limit • FinQuiz.com Maximum yearly benefit: It refers to the maximum amount that the insurance company will pay in a year Maximum lifetime benefit: It refers to the maximum amount that the insurance company will pay over an individual’s lifetime Pre-existing conditions: Pre-existing conditions refer to health conditions that the insured had at the time of application of insurance Such conditions may or may not be covered by the insurance company, depending on the policy, laws, and regulations Pre-admission certification: It is the requirement for the insured to receive approval from the insurer before a scheduled (non-emergency) hospital stay or treatment Example of out-of-pocket maximum with high medical costs: Let's an insured need surgery with allowable costs of $20,000, and the following figures apply to his health insurance plan • Deductible: $1,300 • Coinsurance: 20% • Out-of-pocket maximum: $4,400 The insured will pay the first $1,300 of covered medical expenses (his deductible) His 20% coinsurance on the rest of the costs ($20,000 - $1,300 = $18,700) comes to $18,700 * 20% = $3,740 His total costs would be $1,300 + $3,740 = $5,040 But his out-of-pocket maximum is $4,400 His insurance company will pay all covered costs above $4,400 for this surgery and any covered care he gets for the rest of the plan year Important to Note: Plans with lower (higher) monthly premiums have higher (lower) out-of-pocket limits 4.5 Liability Insurance Personal umbrella liability insurance policy: This policy defines a specified limit and pays claims only if the liability limit of the homeowner’s or automobile policy is exceeded It provides an additional layer of security to those who are at risk for being sued for damages to other people's property or injuries caused to others in an accident Umbrella policies are relatively inexpensive E.g assume that an individual has automobile policy which specifies a property damage liability limit of US$100,000 and also has an umbrella policy with a liability limit of US$1 million If an automobile accident causes US$300,000 of damage, the automobile policy would pay the first US$100,000 and the umbrella policy would pay the remaining US$200,000 Reading 14 4.6 Risk Management for Individuals payments are made Other Types of Insurance Title Insurance: The title insurance provides insures against financial loss from defects in title to real property and from the invalidity or unenforceability of mortgage loans 2) Service contracts: It is a type of insurance that insures against repair costs of automobile, home appliance, or other sizable product 4.7 Annuities 4.7.1.) Parties to an Annuity Contract There are four primary parties to an annuity contract: i ii iii iv a Insurer: It is the entity that is licensed to sell the annuity, i.e insurance company Annuitant: It is the person who receives the benefits Contract owner: It is the individual who purchases the annuity and is typically the annuitant Sometime, the contract owner and the annuitant may be different E.g if a company purchases the annuity for a retiring employee, then the company is the contract owner and the employee is the annuitant Beneficiary: It is an individual or entity that will receive any proceeds upon the death of the annuitant Plain Vanilla Single-Premium Annuity: This annuity does not provide any death benefit 4.7.2.) Classification of Annuities Following are the primary types of annuities: Deferred Annuity: A deferred annuity is an annuity where the payments received will start sometime in the future, as opposed to starting when the annuity is initiated A deferred payment annuity allows the investment to grow both by contributions and interest before payments start coming back A deferred immediate life annuity is less expensive as compared with immediate life annuity because of three reasons: i Deferred payments enable insurance company to earn return on the amount tendered ii The number of payments decreases as the individual gets older iii There is a possibility that an annuitant may die before any Immediate Annuity: An immediate payment annuity is an annuity contract that is purchased with a single lump-sum payment and in exchange, pays a guaranteed income that starts almost immediately An immediate life annuities provide financial protection in case the insured “lives too long” (risk of outliving one’s savings) It is also known as singlepremium immediate annuities (SPIAs) For both deferred and immediate annuities, the annuity can be invested in a “fixed” account or a “variable” account Period certain” option: It is variable annuity and/or annuity with some kind of minimum guaranteed payment period (e.g., 10 years) In such annuities, the beneficiary may get death benefit in shape of some residual value once the annuitant passes away 1) FinQuiz.com Deferred Variable Annuities (section 4.7.2.1): In deferred variable annuities, during the accumulation period, the insurance company puts the investor’s premiums (less any applicable charges) into a separate account and the investor has the flexibility to manage account as he/she wants, e.g can an invest in portfolios covering all of the major asset classes (e.g a pre-determined target risk asset allocation consisting of a diversified mix of securities managed by multiple investment managers), can make tax-free exchanges between the investment portfolios offered, have right to exit (or sell) the contract, although there can be considerable surrender charges for withdrawing one’s money These annuities can be more expensive and have limited investment fund options as compared with mutual funds Deferred variable annuity contracts may include a death benefit Death benefit guarantees that the beneficiary will receive the entire amount used to purchase the annuity To offset risk of death benefit, the insurance company charges a fee Like mutual funds, a deferred variable annuity does not guarantee lifetime income (a guaranteed income stream for life for the investor) unless the individual (1) adds an additional feature (a contract rider) or (2) annuitizes the contract by converting the value of the deferred variable annuity into an immediate payout annuity2 Typically, insurance companies pay a fixed percentage (e.g., 4%) of the initial investment value as guaranteed benefit as long as the annuitant lives and each payment is subtracted from the current value of the deferred variable annuity contract If the markets continue to perform well, the initial investment value rises and any remaining value is provided to the investor’s beneficiaries If the market is down, the investment value may be depleted and the insurance company is contractually obligated to continue to pay the investor the guaranteed minimum benefit as long as the Annuitizing the contract is not very common Reading 14 Risk Management for Individuals investor is alive Deferred variable annuities are not annuitized b Deferred Fixed Annuities (section 4.7.2.2): In deferred fixed annuity, the investor’s money (less any applicable charges) earns interest at rates set by the insurance company or in a way as specified in the annuity contract The company guarantees a minimum fixed rate of interest Unlike deferred variable annuities, deferred fixed annuities are eventually annuitized Income Yield = Total amount of ongoing annual income received / Initial purchase price E.g assume an individual purchases an immediate fixed annuity for $100,000 and in exchange receives an ongoing income of $8,000 per year for as long as the individual is alive Income Yield = $8,000 / $100,000 = 8.00% The shorter the longevity, the higher the income yields E.g 65 year old man will receive lower income yield than an 85 year old man Similarly, a 65-year male will have higher income yield than a 65-year old female because females have a longer average life expectancy than males When current yields on bonds3 are lower than historical bond yields and life expectancies are increasing, payouts on annuities will be relatively low Important to Note: The younger the individual is, the less costly it is to purchase a dollar of income for life starting at age 65 Annuitization of Contract: Annuitization refers to conversion of the investment into an annuity At any point of annuitization, the investor has two options: i ii Cash out: This involves cashing out and receiving the economic value of the accumulated purchases less any applicable surrender charges In this case, the annuity contract is terminated Withdrawal of the accumulated funds In both cases, “economic value” of the accumulated purchases is annuitized, converting the deferred fixed annuity into an immediate fixed annuity The annuity payment guaranteed by the insurance company is based on following things: o o o Amount of money tendered Age and gender of the annuitant, and Insurance company’s required rate of return (including its cost of funds and its expense and profit factors) 4.7.2.3.) Immediate Variable Annuities: FinQuiz.com Life-only annuity: A life-only annuity pays benefits only as long as the individual is alive, with no residual benefits This annuity is preferred if an individual is mainly concerned with lifetime income maximization Life annuity with n-year certain payment: A life annuity with n-year (say 10-year) certain payment pays benefits for at least 10 years The certain payments for specific period reduces the payout (income yield) However, the younger the individual is, the smaller is the effect on income yield due to the inclusion of a period certain This feature is available in both fixed and variable immediate annuities 4.7.2.5.) Advanced Life Deferred Annuities: Advanced life deferred annuity (ALDA) is often referred to as pure longevity insurance ALDAs are deferred immediate payout annuities In an immediate variable annuity, the individual permanently pays a lump sum for an annuity contract which in turn make payments to the annuitant for life lifetime As the name implies, the amount of the payments varies over time based on the performance of the assets in the portfolios An additional feature, “income floor”, can be added to an immediate variable annuity for an additional cost that protects the annuitant against downside risk of market Like immediate fixed annuity, an ALDA makes fixed payments to the annuitant for life lifetime in exchange of a lump sum Like deferred immediate life annuity, ALDA’s payments begin later in life rather than immediately, e.g when the individual turns 80 or 85 Practice: Example 12, Volume 2, Reading 14 4.7.2.4.) Immediate Fixed Annuities: In an immediate fixed annuity, the individual permanently pays a lump sum for an annuity contract which in turn make fixed payments to the annuitant for life lifetime Insurance companies tend to invest conservatively, hence, bonds yield can be used as proxy of expected return Reading 14 Risk Management for Individuals 4.7.3.) Advantages and Disadvantages of Fixed and Variable Annuities • • d) Life annuity with refund, whereby payments are made for a specified number of periods without regard to the lifespan or expected lifespan of the annuitant and provide a refund guarantee under which the annuitant (or the beneficiary) receive payments equal to the total amount paid into the contract Total amount paid into contract = Initial investment amount - Fees e) Joint life annuity, whereby payments are made for the entire life of the both annuitants (say husband and wife) until both members are no longer living The annuity payments cease when the survivor passes away Benefits paid in fixed annuities are fixed (or known) for life It is preferred by annuitants who are risk averse (i.e require certainty of benefits payouts) Benefits paid in variable annuities varies depending on the performance of some underlying portfolio or investment It is preferred by annuitants who are risk tolerant Important considerations in selecting between fixed and variable annuities: 1) 2) 3) 4) 5) 6) Volatility of Benefit Amount: Retirees who are risk averse (tolerant) should choose fixed (variable) annuity Flexibility: Retirees who prefer flexibility to certainty should select variable annuity because variable annuity payments are typically tied to the performance of an underlying subaccount, which can often be withdrawn by the annuitant, subject to limitations4 Whereas, in fixed annuity, the payment made as a lump sum is irrevocable Future Market Expectations: In variable annuities, due to variable payments, the future payments may increase if the market performs well Hence, variable annuities are preferred if retirees expect market to perform well Fees: The fees in variable annuities tend to be higher than in fixed annuities because variable annuities involve costs of hedging market risk, administrative expenses, and reduced price competition An immediate fixed annuities have transparent pricing and thus are relatively easier to compare; whereas, variable annuities have opaque pricing Inflation Concerns: Unlike variable annuities, fixed annuities are nominal and not provide hedge against inflation; however, it is possible to create a partial inflation hedge by making benefits “step up” by some predetermined percentage each year (e.g., 3%) Payout Methods: The primary payout methods are as follows: a) Life annuity, whereby payments are made for the entire life of the annuitant and cease at his or her death b) Period-certain annuity, whereby payments are made for a specified number of periods without regard to the lifespan or expected lifespan of the annuitant c) Life annuity with period certain, whereby payments are made for the entire life of the annuitant but are guaranteed for a minimum number of years (commonly, 10 years) even if the annuitant dies E.g if the annuitant dies after years, a life annuity with 10 years period certain will make payments to the annuitant’s beneficiary for the remaining years and then cease Withdrawals may not be allowed (e.g., in the case of an immediate variable annuity) FinQuiz.com Important to note: Payout methods are not mutually exclusive Different methods can be combined into a single annuity Annuity payments can also be made at different frequencies, i.e monthly (most common), quarterly, or annually 4.7.5.) Annuity Benefit Taxation: • • • In United States, annuity can provide tax deferred growth because the growth in an annuity is taxed only when the individual receives income from the annuity The actual taxation of the benefits varies materially by country and is based on some average of the difference between the amount paid for the annuity and the benefits received Annuities are appropriate for retirees having high marginal tax rate on alternative investments 4.7.6.) Appropriateness of Annuities: Each payment received by the annuitant is a combination of principal, interest, and mortality credits Mortality credits are the benefits that survivors receive from those individuals in the mortality pool who have already passed away However, besides benefits of income and certainty regarding lifetime income, there is a cost associated with annuities because the expected benefits of an annuity are generally not positive – implying lower potential wealth at death Reading 14 Risk Management for Individuals Retirement income efficient frontier: This frontier can be used to decide the optimal amount of annuitization for an individual – tradeoff between wealth maximization and aversion to lower potential wealth at death In retirement income efficient frontier, vertical axis represents wealth and horizontal axis represents shortfall risk (risk associated with running out of money over one’s lifetime) FinQuiz.com Retiree’s demand for annuities is based on following factors: A Longer-than-average life expectancy implies greater demand for annuity B Greater preference for lifetime income implies greater demand for annuity C Less concern for leaving money to heirs implies greater demand for annuity D More conservative investing preferences (i.e., greater risk aversion) implies greater demand for annuity E Lower guaranteed income from other sources (such as pensions) implies greater demand for annuity IMPLEMENTATION OF RISK MANAGEMENT FOR INDIVIDUALS Determining the Optimal Risk Management Strategy Like portfolio selection, the decision to use insurance or annuities is determined by a household’s risk tolerance • At the same level of wealth, the higher the risk tolerance, the lower the demand for insurance (or higher insurance deductible) injuries caused by car accident can be reduced by an airbag in an automobile 5.1 The impact of a potential loss can be moderated by reducing or eliminating the costs associated with risks (refers to as loss control): There are three general approaches to loss control a) Risk avoidance: It refers to removing possibility of loss occurrence E.g risk of loss of a piece of jewelry can be avoided by selling the asset This strategy is preferred when the asset provides no utility or when the magnitude of the risk exposure rises because of price appreciation b) Loss prevention: Loss prevention involves reducing the probability of loss occurrence E.g., probability of a break-in can be prevented by installing a security system c) Loss reduction: It involves reducing the size of a loss if a loss event occurs E.g., the seriousness of Risk Management Techniques: Individuals can also manage risk through the techniques of risk transfer and risk retention as shown below in the table 5.2 Analyzing an Insurance Program Example: Jacques: age 40; €100,000 annual earnings; €200,000 whole life insurance policy; €50,000 term life insurance policy Marion: age 38; €20,000 annual earnings; no life insurance Children: Henri, age 8, and Émilie, age Condominium: €300,000 current value; €190,000 25year remaining mortgage; exterior of building fully insured; contents insured for €20,000 Reading 14 Risk Management for Individuals Rental home: €165,000 current value; no mortgage; insured for €100,000 Income tax rate: 30% Rate of taxation of annual income generated from life insurance proceeds is 20% Family expenses attributable to Jacques that will not exist after his death, such as his transportation, travel, clothing, food, entertainment, and insurance premiums Here, we assume those expenses to be €20,000 Non-taxable employee benefits that the family will no longer receive, such as employer contributions to retirement plans, which we assume to be €15,000 Annual growth rate is 3% Discount rate is 5% 1) 2) Calculating the contributions involves the following steps: 1) 2) 3) 4) Calculate after-tax compensation that Jacques would receive from employment: €100,000 × (1 – 30%) = €70,000 post-tax compensation Calculate post-tax income after expenses = €70,000 – €20,000 = €50,000 Add the value of any non-taxable employee benefits that the family will no longer receive to income after expenses = €50,000 + €15,000 = €65,000 Estimate the amount of pre-tax income needed to replace that income on an after-tax basis = €65,000/(1 – t) = €65,000/(1 – 0.20) = €81,250 Human life value method: Human Life value can be estimated as the present value of an annuity due with growing payments (a so-called “growing annuity due”) as follows: 3) 4) 5) 6) FinQuiz.com Estimate the total amount of cash (including final expenses (funeral and burial) as well as any taxes payable) that will be needed upon the death of the insured person It may also include debt payments (including mortgages), future education costs, and an emergency fund Estimate the capital needed to fund family living expenses by calculating the present value of future cash flow needs during multiple time frames as follows: i Estimate the surviving spouse’s living expense needs (say for 52 years until Marion is 90 years old) ii Estimate the children’s living expense needs (say until they are 22 years old) This amount does not include the education fund iii Include an additional amount for extra expenses (e.g car lease) during a transition period after Jacques’s death, say for two years Consider Marion’s future income (earnings) Calculate total needs, i.e cash needs plus capital needs Calculate total capital available, which may include cash/savings, retirement benefits, life insurance, rental property, and other assets Calculate the life insurance needed as follows: Life Insurance Needed = Total financial needs - Total capital available Financial Needs: Life Insurance Worksheet Adjusted rate “i” = [(1 + Discount rate)/(1 + Growth rate)] – = (1.05/1.03) – = 1.94% Set the calculator for beginning-of-period payments; n = 20 (the number of years until retirement); payment = €81,250; and i = 1.94% Solve for present value of an annuity due, i.e €1,362,203 Thus, the human life value method recommends €1,362,203 of life insurance for Jacques Because Jacques already has €250,000 of life insurance, he should purchase an additional = €1,362,203 - €250,000 = €1,112,203 This amount would likely be rounded to €1.1 million Important to Note: Adjusted rate “i” can be calculated as long as the discount rate is larger than the growth rate Need Analysis Method: The needs analysis method focuses on meeting the financial needs of the family rather than replacing human capital Needs analysis typically includes the following steps: Capital Needs [present value of annuity due]: growth rate = 3%, discount rate = 5%, adjusted rate (as above) = 1.94% Marion’s living expenses = (60,000/year for 52 years) = 1,991,941 Children’s living expenses: Henri = (10,000/year for 14 years) = 123,934 Émilie = (10,000/year for 16 years) = 139,071 Transition period needs = (10,000/year for years) = 19,810 Less Marion’s income: Until Émilie is 16 = (20,000/year for 10 years) –183,713 Age 48–60 (60,000/year for 12 years) –398,565* Total capital needs 1,692,478 Total Financial Needs 2,137,478 Reading 14 Risk Management for Individuals Capital Available Cash and savings 30,000 Vested retirement accounts—present value 200,000 Life insurance 250,000 Rental property 165,000 Total capital available 645,000 Life insurance need (Total financial needs less total capital available) = 1,492,478 or ~€1.5 million Because Jacques already has €250,000 of life insurance, he should purchase an additional €1.25 million, according to this method *This amount is calculated in two steps: i ii Compute the amount needed in 10 years, when Marion will begin earning €60,000 per year Assuming 12 years of earnings from age 48 to age 60, a 3% annual growth in earnings, and a 5% discount rate (1.94% adjusted discount rate), a present value of an annuity due calculation shows that €649,220 will be needed in 10 years Calculate present value of €649,220, with n = 10 years at the unadjusted discount rate of 5% PV = €398,565 The discount rate is not adjusted during this period because there are no payments to which a growth rate would be applied Important to Note: If Jacques dies prematurely, there will be an increased need for life insurance for Marion while Henri and Émilie are still children 5.2.3.) Recommendations (Continuation of section “5.2 Analyzing an Insurance Program: Example”) • • • • Health Insurance: Although the Perrier family is covered by national health insurance, they may want to seek private health insurance Disability Insurance: Both Jacques and Marion should consider long-term disability income insurance that guarantees the option to purchase additional coverage without underwriting They should also consider taxation while purchasing a disability income policy Long-Term Care Insurance: The Perriers should consider long-term care insurance for themselves It would be prudent to purchase a policy that does not have a time limit and the amount selected should be appropriate for the local cost structure as well as adjusted for inflation adjustment Longterm care insurance may also be appropriate for Marion’s mother Property Insurance: Property insurance on the house should be reviewed The Perriers should make a thorough valuation of their personal property They should also determine whether the rental house’s contents are included in the policy The Perriers should also make sure that they have • 5.3 FinQuiz.com substantial liability insurance coverage with regard to auto insurance If they drive relatively little, they may consider to self-insure As a nurse, Marion should also consider professional liability insurance if it is not provided by her employer Longevity Insurance: Longevity insurance should be considered for Marion’s mother The Effect of Human Capital on Asset Allocation Policy The subcomponents of an individual’s total economic wealth affect the portfolio construction in two primary ways: (1) asset allocation which involves overall allocation to risky assets; (2) underlying asset classes, i.e stocks and bonds, selected by the individual This implies that an individual whose job (earnings) has high correlation with the stock market, should first choose a less aggressive (less allocation to risky assets) portfolio and then select less risky individual stocks and bonds (or asset classes) The human capital of a less mobile household will have a lower present value and greater volatility If human capital is very employer-specific (difficult to earn the same wage from a different employer), then it is also less valuable and more risky A household with a nonworking spouse tends to be in a less vulnerable position than a singleperson household if the non-working spouse can exercise the option to rejoin the workforce Younger investors should allocate more of their investment portfolio to stocks because the value of human capital (which is bond-like) is highest early in the life cycle Older investors should allocate more of their wealth toward bonds because their bond-like human capital is gradually depleted as they approach retirement Since human capital is illiquid, assets in financial portfolio should be liquid (i.e marketable securities) so that they help optimizing overall risk characteristics of an individual’s total wealth The overall volatility of one’s economic balance sheet can be reduced by selecting assets that correlate weakly (or even negatively) with human capital Practice: Example 14, 15 & 16, Volume 2, Reading 14 Reading 14 5.4 Risk Management for Individuals Asset Allocation and Risk Reduction Investment risk, property risk, and human capital risk can be either idiosyncratic or systematic Idiosyncratic risks include the risks of a specific occupation, the risk of living a very long life or experiencing a long-term illness, and the risk of premature death or loss of property • • Idiosyncratic human capital risks 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 Systematic risks affect all households by affecting the earnings through a recession or slow economic growth Practice: Example 17, Volume 2, Reading 14 End of Reading Practice Problems: Practice all the questions given at the end of Reading FinQuiz.com ... Example 4, Volume 2, Reading 14 3. 3 .3. ) Changes in Net Wealth Practice: Example, Page no 23- 26 Volume 2, Reading 14 • The higher the value of pension wealth, the higher the level of expected remaining... a disabled child for an extended period of time Practice: Example 3, Volume 2, Reading 14 3. 3 The Individual Balance Sheet 3. 3.1.) Traditional Balance Sheet The traditional balance sheet for... correlate weakly (or even negatively) with human capital Practice: Example 14, 15 & 16, Volume 2, Reading 14 Reading 14 5.4 Risk Management for Individuals Asset Allocation and Risk Reduction