Tucker is 35, has average initial wealth, and has labor income that is highly correlated with the stock market. Max is 35, has average initial wealth, and has labor income that has very low correlation with the stock market. All else being equal, who has the greater optimal demand for life insurance, Tucker or Max?
Max. Low correlation with the market means it is more reliable, which makes the PV of future eanings greater
Tucker - HC is highly correlated with Stock Market - and HC and Insurance are linked closely. So since HC is more risky - it will be discounted at a higher rate - and will result in a lower PV. Given this low PV - Tucker need Life insurance more. (FC is the same for both Tucker and Max).
Max
Max
It is Max. High correlation to stock market means earnings more volatile, so PV of human capital is less . Hence less insurance is needed
wrong response… More volatility in HC - less need for Life insurance… So Max needs the Life Insurance more – since his entire life is planned around getting that much needed money in on a regular basis. HC and Life Insurance are negatively correlated.
nothing to do about needing it more, though that makes sense. It`s all about PV and the more steady the income the the lower the discount rate, higher the PV to insure.
you are right CP, more volatile earnings is Mr. Tucker not Mr. Max. More volatile earnings – less insurance, answer is Tucker
Where do they come up with this nonsense?
The right answer, the wrong answer, the CFA answer.
Max for the win
I guess answer depends on what OP meant by Optimal? More or less???
Well put darlia. Don’t try to find a justification, just use the PV approach. You could argue that both Tucker and Max need enough life insurance to meet their minimum expenses. Max has high earnings volatility, which means his family has the ability to live on low earnings. Tucker has lower earnings volatility, so his family is used to getting the same (median amount) of earnings. Therefore their minimum standard of living is higher. By that logic, he needs more life insurance for them to live normally. It’s a flawed argument, but it’s the best I can do. Hence, just stick with the PV approach with a higher discount rate.
Max
Max is the correct answer. Check out Vol 2, p340. re: CP, I hear where you’re coming from on the terminology, but that’s what the CFAI uses.
If an investor has a more demand on Life Insurance, can he also increase his allocation to risky asset?
The logic seems to be … the more you have to protect the higher the demand for life insurance.
CORRECTION: The more human capital you have to protect, the higher the demand for life insurance.