Volatility of Human Capital

The more volatile is one’s expected future labour income, the lower is its certainty equivalent. The lower the value of human capital … the less the demand for life insurance. Thus, the demand for life insurance is inversely related to the volatility of one’s human capital. Is my reasoning correct?

More simply, a steady and predictable stream of income is worth insuring. Professional income which is irregular in amount and timing is less valuable -> less likely to demand insurance for mortality risk.

Just wanna clear this up … because more life insurance is sought with increasing risk aversion (but this relates more to aversion to returns variance and mortality risk than it does to the variance of future income).

The way I read it is that your need for life insurance income is NPV of future earnings which is (annual income)/discount rate for the stream of payments. Since a risky stream of income would require a higher rate of return(equities) the NPV is lower. A more bond like stream of payments with lower volatility would have a higher NPV because the discount rate would be lower. 100k/0.07 is smaller than 100k/0.03

What’s the difference between “risk” and “variance of returns” (at least as explained by CFAI/CAPM)? None.

The difference I’m talking about is the variance of returns on the financial portfolio (financial wealth) versus the variance of future income (human capital).

  • The more averse you are to the former, the more life insurance is demanded (Volume 2, Page 351, Figure 15).

  • The more volatile is the latter, the less insurance is demanded (volume 2, Page 353, Figure 17).

Ah OK. Now I see what you were driving at.