The volatility of human capital and the demand for life insurance are correlated how: positive negative unrelated If vol is high, the PV of human capital is low (higher discount rate), so in my mind, the demand for life insurance would be high because you can’t depend on that human capital and need life insurance to “fill the gap”. Thoughts??
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I dont get that one bro
all of this from past posts on the forum on this topic: Post 1: 1) low volatility human capital (consistent cash flow): Bob works for the state as a garbage man and his salary is inflation adjusted and equal to $36,000 a year in today’s money. 2) high volatility human capital (less consistent cash flow): Joe is a plumber and works as an independent contractor and his income depends on how much business he gets. On average he can still make $36,000 but one year he makes $50,000 and another year $22,000. Bob’s family highly relies on his steady income. His wife consistently spends $200 a month at local Starbucks and his kids play soccer and baseball in park district leagues. Bob has all expenses calculated for the next 50 years. He knows when he will pay off his $200,000 house and how much money he will have to save for retirement. Since all the calculations are based on his steady income, he desparately needs life insurance. Joe, on the other hand, can not rely on his income as much. His wife hopes that they will go on vacation and buy a new couch if Joe has a good year but she knows that she can’t go out to Starbucks all the time because his income isn’t steady. They are not sure about enrolling their kids in a local soccer league because they might not have money to pay fees. They know they can only buy a $150,000 house and still consistently make mortgage payments. Since their expense calculations are not based on a steady income, need for life insurance is not as high as it is for Bob. Post 2: Life insurance (as defined in this reading) is a subsitute for human capital. It serves to replace prematurely lost human capital. Since it pays out on death, it only has utility if there is a desire to leave a bequest (estate) to an heir. This bequest will be made up of two parts - Financial captial and face amount of the life insurance at the date of death. So if human captail is volatile, portfolio theory demands that financial capital be invested using low volatility securities to get an optimal portfolio. Because human capital is more volatile we use a higher discount rate when calculating its present value (relative to financial capital). Since life insurance is a subsitute for human capital we use the same discount rate in figuring out the optimal amount. This higher discount rate leads to a lower need for life insurance.
Thanks CP… still a bit cloudy to me, but I know the explanations are correct and will just have to take it at face value. human cap vol is NEGATIVELY correlated with demand for life insurance. I would argue that if Bob was making 250k with a 5% raise each year and very low volitility, then he has visibility to plan for retirement w/o the use of life insurance. If the portfolio takes a hit this year, its not that big a deal because he can bank on 250k coming next year. And if Joe was making $250k average but volitility in those earnings was high, he doesn’t have great visibility and would rely more heavily on life insurance. financial assets go into low risk assets because if the portfolio takes a hit, he can’t rely on $250k next year. Maybe its only 100k next year…its that greater uncertainty that would make the life insurance a good idea. I’ll just remember to do the opposite of that. Right way, wrong way, CFA way.
“volatility” of human capital… if human capital is more volatile I say its “less” certain. If you have uncertain capital what can you do to offset that uncertain capital? You obtain more guaranteed capital via insurance.
I am not sure that the above is essentially correct = not according to CFA at least. the earlier statement - this is how CFA wants you to think 1. human capital is more volatile, so riskier - need to have a higher discount rate. life insurance is a substitute for hc -> so based on the higher discount rate - you would need to have lower of it. 2. your financial capital is less volatile, so need to have it invested in low volatile securities (bond).
Skip - I agree w/ you. You are saying volitility of human capital and insurance demand are positively correlated. However that is wrong. human capital volitility is NEGATIVELY correlated with demand for life insurance. My new thinking is: 1) assume everyone gets life insurance. life insurance substitutes for human capital. 2) High volitility human capital is discounted at higher rates. high rates make PV lower. 3) Low volitility human capital is discounted at lower rates. low rates make PV higher. 4) then just compare the PVs. If PV is lower, i need less of a substitute (insurance), and vice versa. That’s how they look at it to arrive at the negative correlation.
I agree June2009. All about the PV analysis since life insurance is a substitute for human capital. Lower PV of future earnings potential (caused by high volatility of income) = less demand for life insurance to protect the loss of these lower potential earnings.
nice lil lesson there fellas. what has two thumbs and a better understanding of this concept now??? this guy
That is so wrong, but CFA says: It has negative correlation – more bond-like capital = more aggressive in financial capital = more insurance.
so CFA is basically saying that since the income is volatile and uncertain, it should be worth less today. volatility = a higher discount rate = less PV of human capital to protect= lower life insurance need… sounds like a quant developed this who has never dealt with life insurance concerns of real people and families…whatever…I will hold it in until the exam and then let it out
I still dont get it bros.
Mechanics are: human cap = PV of all your future earnings discounted back to today. insurance is a substitute for human cap if earnings are volitile you discount at a higher rate, making PV (human capital) lower if the PV (human capital) is lower, one would need less of a substitute to replace it - relative to someone with a higher PV. I hate it…but I accept it.
june2009 Wrote: ------------------------------------------------------- > Mechanics are: > human cap = PV of all your future earnings > discounted back to today. > insurance is a substitute for human cap > if earnings are volitile you discount at a higher > rate, making PV (human capital) lower > if the PV (human capital) is lower, one would need > less of a substitute to replace it - relative to > someone with a higher PV. > > I hate it…but I accept it. why do u hate it …explanation makes sense to me …human capital = pv of future earning ============> higher vol implies greater discount rate ==============> lower present value =========> lower need for insurance to replace the possible future earnings…also please note the premiums reduces the amount that can be invested in equities fixed and alternative investments dont forget high life insurance payouts come with higher premiums
its subjective… an assumption is made that higher volatility decreases PV of future earnings. would if it is a volatile industry with an overall upward trend??? or an industry with an overall downward trend? why even consider earnings volatility in 2011?? will anyone in this economy listen to you tell them they need less insurance because they have volatile earnings? show them your little math formula and explain the discount rate to them? i scoff at this…SCOFF SCOFF…that being said… there is a negative correlation. it doesnt matter why. it just is.
insurance only pays off to surviving fam memebers as a means to replace your lost earnings stream ( it is not a lotto ticket at least it is not modeled that way which is a fair trade off since you also have to pay higher premiums which by def you cannot include in your investable portfolio leading to lost opportunity
pimpin - the mechanics make sense. Yes. the logic is confusing. if earnings are volitile (equity-like), uncertainty is high, hedge uncertainty with insurance guarentee, avoid high risk assets for financial capital. If earnings are steady (bond-like), uncertainty is low, less of a need for the insurance guarentee, take on higher risk assets for financial capital.
I think what matters regarding this issue is how you interpret the “spirit” of insurance… Insurance should definetely not regarded as a means to “get rich”, it must be thought that it is there only to cover against what is at risk. So, what is at risk?-> your smaller human capital (due to high volatility, high discount rate etc.) -> you should look for less insurance in that case. In other words, it helps you to maintain what you already had prior to the decease, not to generate a gain on it.
revisor Wrote: ------------------------------------------------------- > I think what matters regarding this issue is how > you interpret the “spirit” of insurance… > Insurance should definetely not regarded as a > means to “get rich”, it must be thought that it is > there only to cover against what is at risk. > > So, what is at risk?-> your smaller human capital > (due to high volatility, high discount rate etc.) > -> you should look for less insurance in that > case. In other words, it helps you to maintain > what you already had prior to the decease, not to > generate a gain on it. +1 breh
The reading is basically a theoretical framework, and as such, you can take a few liberties with understanding it. Here’s my take: 1. Start from a total wealth perspective. Total wealth = financial wealth + human capital (PV of future earnings) 2. Think of your career as a continuum, whereby your goal is to convert human capital (or latent earnings potential) into financial capital. Over time your total wealth picture is less dependent on human (potential capital) and more on tangible/real/financial capital. 3. Human capital, and the income derived from it functions GENERALLY like a fixed income instrument, you receive regular distributions that IN GENERAL have low volatility. Year-over-year, human capital will perhaps increase in line with inflation and maybe bumps in pay based on promotions or larger bonuses. For most people, career income is more predictable than equity market returns…it functions more like a fixed income instrument than an equity instrument. 4. Think of the discount rate that you use to derive the PV of human capital as similar to a WACC calculation. The weighted average would be based on the percentage of your total wealth derived from human capital and financial capital. For the purposes of discounting, human capital should have a smaller required return than risky capital (or equity-like) capital. Early on in your career, you probably haven’t converted a lot of your latent potential into financial (riskier) capital, so your discount rate (WACC) would be dominated by the human capital impact to your total wealth. Intuitively, this makes sense - since in general human capital is less volatile, and the required rate of return is lower, your discount rate is lower. A lower discount rate generates a higher present value – insurance is a safety-net against that PV 5. Insurance is perfectly negatively correlated with human capital. If you die, you lose 100% of your future earnings - the PV of your future earnings potential. An appropriately purchased insurance policy would yield a distribution equal to exactly the same value of the PV lost … perfectly negatively correlated. CONCEPTUALLY, one wrinkle has to do with the nature of your work. Perhaps you manage a hedge fund. Your income (human capital) has a distinct equity-like component to it. In this case, as you convert human capital into financial capital, you need to be mindful that you have an implicit risky asset allocation based on the nature of your work; therefore, you should try to diversify your financial asset allocation into less risky assets. If I wanted to over think this, I could poke holes in what I’ve written above (i.e. the WACC argument), but directionally I think it encapsulates the intention of the reading.