Study Session 4, Reading 20. Schweser Book 2 Page 140 Negative Relationship for Human Capital Volatility and Life Insurance: “When Human Capital is bond like, Financial assets can be more aggressively allocated, therefore Demand for life insurance Increases” Positive Relationship for Risk aversion and Demand for Life Insurance: “The more risk averse, the less aggressive the financial portfolio and the higher the demand for life insurance” I’m confused with the level of aggressiveness here. In the first part, the portfolio is more aggressive, but in the second part its less aggressive, but in either case the demand for life insurance increases? Why?
If HC is bond-like then in order to diversify overall portfolio, you should be more agressive in financial investments to achieve diversification. I think when they say HC is bondlike, they mean it’s less volatile. In this case the PV of future earnings is determined with a lower disount rate than if HC is volatile. Since you discount at a lower rate, PV is higher so you should demand more life insurance to cover that higher amount. if you’re more risk averse, you’re more likely to want to insure your estate against loss of income because you’re dead and not earning anymore $. You also will tend to invest in safer financial assets.
I don’t use schweser but it seems like schweser makes it more confusing than it is. Life insurance and annuity are explained in simple terms in the CFA book. CFA book related then with mortality and longevity risks.
Thnaks Jbald. I think tom is right with this one. Schweser is great, but it seems this is one of a few topics where it would be wise to read the section in CFA. Jbald, are you saying that the determination here is “Diversification” ?
IH8FSA, there are two aspects here. One: you have to look at combination (portfolio) of human capital and financial capital. Diversification is definitely a factor here. If your human capital has no correlation to your financial capital (if you are a teacher in a public high school, etc), then you can be more aggressive with investing your portfolio. If your human capital has high correlation to stocks (you run a long-only fund), you have to be less aggressive in investing your financial assets. Two: there are two non-financial risks that should be addressed: mortality risk (if I die early my family will not be able to use my human capital we have been counting on to pay off the house and college education for kids, etc) and longevity risk (outliving my assets). Mortality risk can be hedged with life insurance (which I just did a month ago after reading this section of the CFA materials). Longevity risk can be hedged with annuities (even though I think it’s risky with so many financial companies going out of business).