he volatility of human capital and the demand for life insurance are: A) positively correlated. B) uncorrelated. C) negatively correlated. Your answer: A was incorrect. The correct answer was C) negatively correlated. i thought the rule was If human capital is equity like, allocate more financial capital to bonds. Meaning there should be a lower need for life insurance?
smiley – this was discussed in the past as well… (also past threads on the forum). 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. — Part 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 capital 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.
I believe that your rationale is correct, as human capital is converted into financial capital allocate more to bonds inorder to reduce the overall risk. Also I think its reasonable to assume that if human capital is volatile it would be reasonable for investors to ensure that more of their total wealth was converted to financial capital as savings. Therefore given the relatively higher proportion of total wealth tied to financial capital human capital becomes less important thus the incentive to protect human capital through life insurance decreases.
thank you cp, you’re the best. I understand human capital much better now
This question is tricky. A family made of husband, wife and child depends on the steady income (low volatility) of the husband. If he dies, they are screwed, so he should buy life insurance. In a different prospective, if you have a portfolio with one bond and you use the interest generated by that bond to fund your living expenses, then if the bond defaults, you are screwed. So you’d better buy insurance on the bond.
mik82 ,I think , the key word is “depends on”. If your family depends on a single person or source , buy life insurance. If you’re used to alternating poverty and plenty , no need.
Yes I agree. Thanks
wow cpk is a beast!!! lengthy explanation but spot on…i think the confusion arises because all insurance is is a replacement for lost future wages …how do we know what the present value of these future wages are ? …we discount to present value ? using what rate…well it depends if the cahsflow stream is highly volatile well we need to use a higher discount rate resulting in a lower present value hence higher vol =======> lower demand for insurance
Smiley - I don’t think you have to adjust your thinking on this at all, you may just be over thinking the answer. as you said: “If human capital is equity like, allocate more financial capital to bonds. Meaning there should be a lower need for life insurance?” The question asks about the VOLATILITY of human capital. ie if human capital is equity like (which would be more volatile than bond like human capital) then there is a lower need for life ins. CPK’s Answer gives the rationality behind the rule, but I think you’ve got the rule correct anyway.
I dont really understand that explanation (Part 1 - bob etc). I thought that the point is that life insurance makes up for volatile financial capital. Volatile human capital increases the need to conservative financial capital. As such, the need for life insurance decreases. This is, obviously, what you said in part 2. So the exercise is about determining what the financial capital picture is like, which leads you to the life insurance answer. Am I missing the “lesson” in Part 1?
jmac01: Life insurance has an option like return . It is not a hedge that can replace the downside of human capital. It would be much too expensive if you treated it as a hedge ( it pays off only upon death , do you want death to be cheap?) But more seriously: The return from life insurance is not positively correlated to returns from human capital . Higher the volatility in human capital , the less is the need for life insurance because the beneficiaries have made adjustments to deal with low points of human capital return . If beneficiaries are used to steady returns ( low volatility in human capital returns) , the need for life insurance is much greater , because they have not made adjustments to do without it, insurance is their only way out , so they can pay the option premium of life insurance for ultimate payoff
It is most definitely a hedge - possibly the perfect hedge (an option is also a hedge). Yes, I do want death to be cheap. Do you not? The “adjustments” they are making are to their financial capital. The guy with volatile human capital will buy fixed income securities in the years he makes higher than average earnings (and whenever else he can). This will help them get by in the years he makes less. As his investments are less risky he will buy less insurance. The guy with steady income will play the equities since he knows what he is getting next year and knows he can cover the bills. However, since his financial capital is now a little more risky (i.e. he could pass away in a year that the stock market lost 50%), he needs to get a policy as well.
i concur gentlemen, i concur.
Interesting question and great answers although I got a bit confused by you different views so I decided to read the CFAI material on this. On page 332 I read that ‘the greater the value of human capital, the more life insurance is demanded’. This implies positive correlation. Also on page 332, ‘term life insurance and human capital have a negative 100 percent correlation with each other’. Reason: when someone dies, human capital = 0 and life insurance > 0. If not dead, then human capital > 0 and life insurance = 0. Hence negative correlation. Can I conclude that the need for life insurance is positively related but the expected cash flows are negatively related to human capital? Further reading on page 333 reveals ‘theoretical studies show a clear link between the demand for life insurance and the uncertainty of human capital’. This is not in line with some of the views posted so this is a tricky topic.
Volatility is a greater expected return which acts as a higher value for discounting. A stock broker with a volatile income expects a higher rate of return. When you discount life insurance with that rate of return, the value is much smaller.