SS 4, Reading 20. (Schweser book 2, pg 140) If the investor’s human capital is bond like the financial assets can be more aggressively allocated and the demand for life insurance increases. When the investor’s human capital is equity-like the financial assets should be allocated towards low risk assets and the demand for life insurance decreases. Can anyone explain the above relationships to me. I understand human capital’s relationship with financial capital but not the consequent relationship with the need for life insurance. Thanks.
life insurance is loosely "securitised human capital’. If the human-capital is euity-like, then a higher discount rate is used and therefore the life insurance value decreases.
so first relationship human capital - financial capital is one of complements. When human capital is bond like - financial can be equity like and when human capital is equity like the financial needs to be bond like. second relationship between human capital and life insurance is one of substitution. you purchase insurance to replace the human capital. so if you have a bond like human capital, the volatility is small, therefore the present value is higher, and creates higher insurance needs. the opposite applies for equity like human capital ( higher volatility means higher risk, higher discount rate and that means lower present value)- so less need for life insurance. I think if you just think of 2 things. 1. Insurance needs to replace human capital 2. Higher discount rate for equity like, lower for bond like, you can’t miss the answer
that was very helpful florin … now it makes sense when i think of it in terms of compliments and substitutes. the need for insurance is high (low) when pv of human capital is high (low) as life insurance substitutes human capital
another also easy way to look at the second relationship is in terms of substitution…but not looking at present values… If your human capital is like bond life (secure) there would be a high demand for life insurance (security) If your human capital is equity life (insecure) there would be a low demand for life insurance (insecure) so I don’t go into discount rates/pvs (although those are just as good ways to remember) that way i free up a few brains cells for other fun cfa stuff
This topic is another great example of CFA not matching real life. Look at Schweser Vol 1 Exam 3 AM - 8Bii: Would anyone out there really tell Pollard, “Hey - good chance you’re going to be making less money in the future, and maybe even unemployed at some point (compared to government union Fisher over here). Since that cash flow is “risky”, there’s no need to buy life insurance.”
Totally agree. This makes no intuitive sense to me, I just had to memorize it as being that all else equal life insurance is akin to your human capital.
That’s exactly my thoughts too!!!Totally counterintuitive.
i didn’t read the entire thread. i think someone’s interest in life insurance might stay high, but the life co’s don’t want to see you too much. therefore, if your earnings are discounted at a higher level, then life co’s won’t give you as much and it will be harder for you to pay the premiums. but yes, i don’t see a guy saying, “human capital is equity-like, therefore i don’t care if my wife and kids are left destitute”