Can anyone explain why human capital volatility (i.e. volatility of future earnings) and demand for life insurance are negatively related? There was some discussion here, but I dont think we’ve addressing the issue http://www.analystforum.com/phorums/read.php?13,891369,891369#msg-891369 In effect (and this is what the original poster was getting at), p.140 of Schweser is somewhat contradictary: for human capital volatility it states “…financial assets can be more aggressively allocated and the demand for life insurance increases” for risk aversion it states “…the less aggressive the financial portfolio the higher the demand for life insurance” However, I care less about the contradiction - in my mind, increasing risk aversion will increase the demand for any type of insurance, as people limit the downside risk, in the bad state. I want to understand the logic behind the first statement, i.e. why is human capital volatility inversely related to the demand for life insurance. Anyone know?
i think i remember seeing in the textbook something about someone with higher human capital, ie someone that makes more money, may have less need for insurance since they have more money and more of their own retirement savings, etc. someone like a teacher who makes less money and has less savings has a higher need for insurance to protect their family just in case something happens. but a doctor should have money in the bank to protect the family without insurance
try to think this way. one need a constant death benefit of FC + insurances and insurance is used to replace the HC (human capital) so if FC is more aggressive, a.k.a equity like, you need less insurance if FC is less aggressive, bond like (university professor), you need more insurance
Thanks, But I dont think we’re answering the question? - you cant infer anything definite about level of earnings from volatility of earnings. The suggestion (Mike) seems to be, higher volatility - e.g. equity like earnings somehow implies greater earnings - I cant see how this is true. Consider the huge amount of future earnings volatilty for someone who is presently unemployed.
> > Consider the huge amount of future earnings > volatilty for someone who is presently unemployed. then human capital is very low and they need more insurance. if an executive that has been getting paid well for 10 years and has saved and has a good 401k and money in the bank (all add up to high human capital) then they have less need for insurance. if they die RIGHT NOW there is plenty in the bank for family. if a teacher or unemployed person dies RIGHT NOW they dont have much in the bank to support the family so they want to have insurance to supplement
mike0021 Wrote: ------------------------------------------------------- > > > > Consider the huge amount of future earnings > > volatilty for someone who is presently > unemployed. > > > then human capital is very low and they need more > insurance. > Just because somebody is unemployed doesn’t mean that human capital is low. HC is the present value of all future earnings. If the person is reasonably skilled then they will find another job and if they are young HC probably far outweights financial capital.
I want to understand the logic behind the first statement, i.e. why is human capital volatility inversely related to the demand for life insurance. Anyone know? Human capital volatility goes up the demand for life insurance goes down. Weird, why? that’s because if human capital volatility goes up, you assume, that investors will invest their financial capitalin LESS risky assets, therefore you demand less life insurance since your financial assets are now riskless (bonds etc). Why do i need life insurance when my financial assets are nearly risk free? The book does a terrible job of explaining that concept.
Here is my interpretation: 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.
thanks maratikus. i’m developing a man crush.
maratikus should change his screen name to neo.
I bumped this thread because I needed a refresher here and I think I have a handle on this now. 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 captial 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 think I am saying the same thing as maratikus above. Sound right?
^ Good explanation I like it. Added to my “things to remember sheet”.
mwvt9: yes you are right. You hit it on the head.
Dwight: Did you do concept checkers in Schweser ?
GetSetGo Wrote: ------------------------------------------------------- > Dwight: Did you do concept checkers in Schweser ? Some, but many of the ones that you have to write out the answers I have skipped for now. I have done mostly m/c questions so far. Also I’m still working through Schweser not done covering everything yet. Why do you ask?
Dwight: Schweser has a similar (not exact) explanation to what mwvt9 wrote as an answer for one of their concept checkers. I am not taking any credit away from mwvt9 but just letting you know, so you can read that also. BTW it may be a good idea to do the writing questions also, as they help you to look at the material differently, when you read it. Cheers 
GetSetGo Wrote: ------------------------------------------------------- > BTW it may be a good idea to do the writing > questions also, as they help you to look at the > material differently, when you read it. Also because half of the test is written. Of this I am all too aware.
Dwight: I didn’t mean to come across in a negative way , hope you didn’t take it negatively.
GetSetGo Wrote: ------------------------------------------------------- > Dwight: I didn’t mean to come across in a negative > way , hope you didn’t take it negatively. No no not at all. In fact I am a bit impatient with myself for skipping over some of the writing questions. I’m spoiled with the 100% multiple choice from L1 and L2 because I like having that chance to game some of the answers even if only in a very small way.
GetSetGo Wrote: ------------------------------------------------------- > Dwight: Schweser has a similar (not exact) > explanation to what mwvt9 wrote as an answer for > one of their concept checkers. I am not taking any > credit away from mwvt9 but just letting you know, > so you can read that also. > Take it all away. I got it straight from schweser. I was merely restating my understanding of their thoughts to get some feedback. It is counter-intuitive to me for sure. I am just glad I am not totally perplexed by this anymore.