Optimal Insurance Demand and Rf Alloc. by Bequest Preference

I know this is probably a very insignificant portion of the exam, but I want to get my head around the reasoning for this chart. Case #2 on page 409 of the CFAI curriculum…

This case discusses how the allocation to the risk free asset doesn’t change as the insurance amount increases due to increased Bequest Preference, D. Here is my logic - if an investor has a greater bequest preference and elects for greater insurance, their premiums should increase. If their premiums increase, their need for current income should increase in order to pay the higher premiums. With a higher need for current income, the allocation to Rf should also increase in order to (better) guarantee that the income is available to pay the high premiums.

Figure 14 shows that the allocation to Rf stays the same throughout all of the bequest preferences. How is that the case?

Yes, the premiums will increase, but not by much: the default insurance type is one year term, which will have an extremely low premium rate per $ coverage. Even for large face amounts, the total premium paid won’t be material when compared to human capital and wealth level.

Ah - I forgot how each of the case studies assume a one-year term contract. That would explain it.


Another point that the CFAI makes is that the bequest preference is not related to capital market expectations and asset allocation. It is a personal decision that does not affect asset allocation and insurance premiums are insignificant, as breadmaker said.