CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz curriculum note, study session 5, reading 12

Risk Management for Individuals

1.

INTRODUCTION

The objective of lifecycle finance is consumption
smoothing. In order to maintain a consistent living
standard, households spread their resources over their
lifetime. This means saving for retirement while one is
working, or spending less than they earn so that they
can later spend more than they earn after they are
.
2.

HUMAN CAPITAL AND FINANCIAL CAPITAL

Two primary components of individual’s assets:
1) Human capital: Human capital is the net present
value of an investor’s future expected labor income
weighted by the probability of surviving (also
referred to as mortality-weighted) to each future
age.
2) Financial capital: Financial capital refers to the
tangible and intangible assets (other than human
capital) owned by an individual or household.
2.1

Human Capital

Human capital is usually the dominant asset on a

household’s economic balance sheet. For risk
management purpose, it is important to understand the
approximate total monetary value of an individual’s
human capital, the investment characteristics of the
individual’s human capital (i.e., whether the capital is
more stock-like or bond-like), and relationship between
the value of individual’s human capital with value of the
individual’s financial capital.
The value of human capital can be estimated by
discounting the future earnings using a discount rate that
reflects the risk associated with the future cash flows (i.e.,
wages).
•

•

retired. Households may also use insurance to help
smooth spending in face of the uncertainties related to
health, disability, and death or decline in value of assets.
In order to avoid such risks, an individual should have an
appropriate
risk
management
strategy

Lower discount rate can be used in estimating
human capital value of individuals who have
stable and secured future cash flows e.g.
government employees or teachers.
Higher discount rate should be used in estimating

human capital value of individuals who have
unstable and less secure future cash flows e.g.
investment bankers and race car drivers.

The value of an individual’s human capital today, at
Time 0 (HC0) can be estimated using following equation:

Where,
•
wt: Income from employment in year t
•
r: Appropriate discount rate
•
N: Length of working life in years.
By using some adjustments, Human capital can be
calculated by using the following formula:

Where,
p(st) = the probability of surviving to year (or age) t
wt = the income from employment in period t
gt = the annual wage growth rate
rf = the nominal risk-free rate
y = occupational income volatility
N = the length of working life in years
In the above equation, the wage in a given period is
equal to the previous year’s wage increased by g
percent (the annual wage growth rate, in nominal
terms) and the discount rate is presented as the sum of
nominal risk-free rate rf and a risk adjustment ‘y’ based
on occupational income volatility (i.e. inherent stability

of the income stream as well as the possibility that the
income stream will be interrupted by job loss, disability,
or death).
The future payout on human capital, like the future
payout on many financial assets, is not certain because
it is difficult to accurately estimate growth rates, nominal
risk-free rates, risk adjustment factor, and mortality etc.
Practice: Example 1,
Volume 2, Reading 12.

2.2

Financial Capital

Financial capital includes the tangible and intangible
assets (outside of human capital) owned by an
individual or household, e.g. home, a car, stocks, bonds,
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Reading 12


Reading 12

Risk Management for Individuals

a vested retirement portfolio, and money in the bank.
Financial capital can be subdivided into two

components:
i.
Personal assets: Personal assets are assets that
are consumed or used by an individual. E.g.
automobiles, clothes, furniture, and even a
personal residence. Generally, the value of
personal assets do not appreciate in value, and
they are often worth more to the individual than
their current fair market value.
ii.
Investment assets: Assets that are held for their
potential to increase in value and fund future
consumption are referred to as Investments
assets. Investment assets can be classified as
tangible investment assets (i.e. liquid portfolio)
and intangible assets (i.e. accrued defined
benefit pension). Investments assets can also be
subdivided into marketable assets (includes
publicly traded and non-publicly traded) and
non-marketable assets (assets without any ready
market e.g. human capital, pensions).

Practice: Example 2,
Volume 2, Reading 12.

2.2.4.1.) Real Estate
Real estate (or direct real estate) is typically among the
largest assets owned by an individual and similarly,
mortgage payments are often the largest fixed
obligation of homeowners, especially during the early

years of a mortgage loan.
Since mortgages create a leveraged exposure in a
home, the change in equity of the home tends to be
greater than the change in value of the home. E.g. a
20% down payment (80% mortgage loan) implies that for
any given change in the value of the home, the change
in the equity (value less the mortgage loan) of the home
will be five times greater than the change in the value of
the home.
Types of Mortgage Loans:
a) Recourse: In recourse mortgages, the lender
has the right to recover from the borrower any
amount due on the loan if the borrower
defaults on the mortgage.
b) Non-recourse: In non-recourse loans, the
lender cannot recover any further amount
from the borrower if the borrower defaults on
the mortgage and the only available collateral
for the loan is the home. Nonrecourse loans
are thus riskier for lenders and therefore,
generally have higher interest rates and/or
higher borrower credit standards than recourse
loans.

Publicly traded marketable assets
include money market instruments,
bonds, and common and preferred
equity.
Non-publicly traded marketable
assets include real estate, some

types of annuities, cash-value life
insurance, business assets, and
collectibles.
iii.

Mixed Assets: Mixed assets refer to assets that
have
both
personal
and
investment
characteristics, e.g. real estate, can be used as
both a personal asset (shelter, as an alternative
to renting) and an investment asset (to help
fund retirement) for an individual. Another
potential example of a mixed asset is
collectibles (such as jewelry, wine, stamps, wine,
precious metals, and artwork). Mixed assets
provide satisfaction (i.e., utility) to individuals
from their current value and at the same time
have the potential to increase in value over
time.
The value of collectibles is often set
by auction markets or specialized
dealers and involves substantial
transaction costs.

Note: Accrued defined benefits and social security are
considered as a form of human capital that is converted
into a financial asset. In this reading, accrued defined

benefits and government pension benefits are defined
as components of financial capital.

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2.2.4.3.) Cash-Value Life Insurance
Cash-value life insurance – a type of life insurance – is a
policy that not only provides protection upon a death
but also contains some type of cash reserve.
2.2.4.4.) Business Assets
Business assets can represent a significant portion of the
total wealth of an individual (e.g. a self-employed
individual). The value of business assets can be
estimated using recent sales of comparable private
businesses within the same industry as a multiple of net
income or net income with various adjustments (e.g.,
EBITDA).
The value of business assets vary depending on
market conditions;
The value of business assets usually correlate with
other financial assets within a household portfolio.
2.2.5.1.) Employer Pension Plans (Vested)
Types of Retirement Plan:
1)

Employee-directed savings plan: In this plan,
contribution amounts and investments are


Reading 12

2)

Risk Management for Individuals

controlled by the individual (and not guaranteed).
Traditional pension plans: Such plans guarantee
some level of retirement benefits, typically based
on past wages.

Important to Note: Only vested pension benefits are
considered as financial assets, because unvested
pension benefits are typically contingent on future work
and are thus considered to be part of human capital.
The value of a vested traditional defined benefit pension
from an employer can be estimated by calculating the
mortality-weighted net present value of future benefits.
The mortality-weighted net present value at Time 0
(now), mNPV0, can be estimated as follows:

Where,
bt = The future expected vested benefit (bt)
[p(st)] = Probability of surviving until year t, and
r = Discount rate (r). The discount rate will be higher for
riskier future benefit payments and should reflect
whether the benefit is in nominal or real terms.
Pension discount rate depends on various factors, i.e.
•
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•

Health of the plan (e.g., its funding status);
Credit quality of the sponsoring company;
Any additional credit support.

3.

3.1

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If the company in question has long-term bonds, the
yield on the bonds can provide a proxy for an
appropriate discount rate.
2.2.5.2.) Government Pensions
Government pensions are like employer plans but are
more secure depending on degree of creditworthiness
of a government, legal framework and any
accompanying political risk at the country level. Due to
guaranteed nature of pension benefits, government
pensions can be considered relatively bond-like.
2.2.6.) Account Type
Types of accounts for financial capital:
a) A taxable account: Taxes are due annually on the
realized gains, dividends, and/or interest income.
b) A tax-deferred account: Taxes on any gains are
deferred until some future date, such as when a
withdrawal is made from the account.
c) A non-taxable account: No taxes are applicable.
2.3

Net Wealth

Individual’s net worth = Traditional assets - Traditional
liabilities
Net wealth, other than difference between assets and
liabilities, also include claims to future assets that can be
used for consumption, i.e. human capital and the
present value of pension benefits.

A FRAMEWORK FOR INDIVIDUAL RISK MANAGEMENT

The Risk Management Strategy for Individuals

Risk management for individuals involves identifying
threats to the value of household assets and developing
an appropriate strategy for managing these risks.
Four key steps in the risk management process:
1) Specify the objective: Decrease in future spending
caused by unexpected events (i.e. a market crash,
a physical disability, the premature death of a
primary earner, or health care expenses etc) is a risk
for individuals. In order to manage such risks, an
individual needs to decide the amount of risk he is
willing to bear in order to achieve its long-run
spending goals.
2) Identify risks: There are different types of risk, i.e.
decline in earnings, premature death, longevity,
property, liability, and health risks.

3)

Evaluate risks and select appropriate methods to
manage the risks: Evaluation of risks involve
considering the magnitude of the risk and the range
of options available to manage that risk.
Methods to Manage Risks:
a) Risk avoidance: It involves avoiding a risk
altogether.
b) Risk reduction: It involves mitigating a risk by
reducing its impact, either by lowering the
likelihood of its occurrence or by decreasing
the magnitude of loss (for example, by wearing
a helmet when riding a motorcycle).
c) Risk transfer: It involves transferring the risk, e.g.
by using insurance and annuities.
d) Risk retention: It involves retaining a risk by
keeping funds aside to meet potential losses.

4)

Monitor outcomes and risk exposures and make
appropriate adjustments in methods: After the
selection of appropriate risk management method,


Reading 12

Risk Management for Individuals

risks must be continuously monitored and updated
because individual’s goals and personal and
financial situation change through its life cycle and
these changes will affect risk exposures and optimal
risk management strategies. Life changes include
birth, marriage, inheritance, job change, relocation,
divorce, or death.
1)

Phase
Education
Phase

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2)

Early career

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3)

Career
development

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4)

Peak
accumulation

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5)

Pre-retirement

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6)

Early
retirement

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3.2

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Financial Stages of Life

Financial stages of life for adults can be divided into the
following seven periods:

Characteristics
Investment in knowledge (or human capital) through either formal education or skill

development.
May be largely financially dependent on his or her parents or guardians.
Little focus on savings or risk management.
Accumulated financial capital is little, (if any).
Could benefit from benefits of life insurance because of living with family at this
stage.
Begin as early as age 18 (16 in some countries) or as late as the late 20s (or even
early 30s), depending on the level of education attained, and generally lasts into
the mid-30s.
Education has been completed and has entered the workforce.
Partially financially independent.
Focus on savings increase as start saving for their children’s college expenses.
Low retirement savings due to significant family and housing expenses.
Human capital is a large proportion of total wealth.
Tangible assets (i.e. real estate and personal goods) tend to dominate a
household’s portfolio.
Insurance is highly valuable due to greater proportion of human capital.
Occurs during the 35–50 age range.
Focus on specific skill development within a given field, upward career mobility, and
income growth.
Largely financially independent.
Retirement saving tends to increase at a more rapid pace.
Increase in financial capital as higher earners will begin building wealth beyond
education and retirement objectives.
Higher expenses as one may make large purchases, such as a vacation home, or
travel extensively.
Human capital represents a large proportion of total wealth.
Occurs during the ages of 51–60
Focus on reducing investment risk to emphasize income production for retirement
(particularly near the end of this period);

Higher concerned about minimizing taxes, given higher levels of wealth and
income.
Insurance is highly valuable due to high human capital risk.
Maximum earnings and opportunity for wealth accumulation.
Increased interest in retirement income planning.
Greater emphasis on stability and less emphasis on growth in the investment
portfolio
Greater concern about tax strategies due to higher earnings.
Increased concern about losing employment because of difficulty to find new
employment.
This phase includes few years preceding the planned retirement age;
Focus on reducing risk for which portfolios may need restructuring;
Prefer less volatile investments.
Emphasis on tax planning, including the ramifications of retirement plan distribution
options.
First 10 years of retirement;
Successful investors have comfortable income and sufficient assets to meet
expenses in this phase.
An investment portfolio represents a significant portion of wealth. Its proportion is less
than 50% of total economic wealth if home equity, pension wealth, and human
capital are also considered.
Total economic wealth is dominated by pension wealth (i.e., the remaining mortality
weighted net present value of benefits) and the value of real estate (i.e., the


Reading 12

Risk Management for Individuals

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Phase

Characteristics
individual’s personal residence).
•
For wealthier individuals, the value of defined benefit pension wealth will likely
represent a low percentage of the total wealth portfolio in retirement.
•
Most active period of retirement.
•
No cognitive or mobility limitations.
•
There is a need for asset growth.
•
Need to take appropriate level of investment risk in retirees’ portfolios.
7)
Late
•
Unpredictable phase because the exact length of retirement is unknown.
retirement
•
Involves longevity risk (risk that retirement could be very short or very long);
•
Risk of depletion of financial asset reserves if an individual experiences long series of
physical problems.
•
Risk of financial mistakes due to decline in cognitive. This risk can be hedged
through a trusted financial adviser or through the use of annuities.
well as all liabilities (e.g. consumption needs and

bequests) besides traditional assets and liabilities. The
Two important concerns appropriate to any financial
stage:
i.
ii.

The need to provide for long-term health care,
depending on the family situation.
The need to devote resources to care for
parents or a disabled child for an extended
period of time.

Practice: Example 3,
Volume 2, Reading 12.

3.3

The Individual Balance Sheet

3.3.1.) Traditional Balance Sheet
The traditional balance sheet for an individual investor
includes recognizable marketable assets and liabilities.
•
•

Assets include any type of investment portfolio,
retirement portfolio (or plan), real estate, and other
tangible and intangible items of value.
Liabilities include mortgage debt, credit card debt,
auto loans, business debt, and student loans.

Value of Equity = Asset – Liabilities

economic balance sheet helps individuals in
determining the optimal level of future consumption and
non-consumption goals (i.e. bequests or other transfers)
given the resources currently available and resources
expected in the future. It also helps an individual to
anticipate how available resources can be used to fund
consumption over the remaining lifetime.
•
For setting consumption or bequest goals, an
individual need to assess value of pension and
human capital. This implies that individuals with
greater human capital (e.g. younger
households) can make more generous
retirement savings goals than individuals with
comparatively lower human capital.
Economic Wealth of Individuals: The total economic
wealth of an individual changes throughout his or her
lifetime.
•

E.g. if an individual owns a home worth $1 million with
$900,000, then

•

Equity in Home = $1,000,000 - $900,000 = $100,000

•

Note: In earlier life-cycle stages, human capital is larger
than other assets on the balance sheet of an individual.
Limitation of Traditional Balance Sheet: A traditional
balance sheet only provides information about
marketable assets that are currently available. It does
not provide any information to maximize the expected
lifetime satisfaction of the individual (“utility”).
3.3.2.) Economic (Holistic) Balance Sheet
The economic (holistic) balance sheet includes the
present value of all available marketable and nonmarketable assets (e.g. human capital and pensions) as

The total economic wealth of younger
individuals is typically dominated by the value
of their human capital.
The total economic wealth of older individuals
is dominated by financial capital because of
savings over time.
In later phases of life-cycle, importance of nontraditional balance sheet assets (i.e. employer
pension) increases as they represent an
important source of stable consumption and
affect the optimal allocation of securities
within an investment portfolio.

Important to Note: The total value of human capital is
inversely related with total value of financial capital. If
an individual does not save over his lifetime, then at
retirement he may have a shortfall to adequately fund
the lifestyle he or she will want at retirement.

Reading 12

Risk Management for Individuals

associated with loss of income or reduction in
income. Major factors in earnings risk include
unemployment, underemployment, and health
issues. The loss of income represents a reduction in
both human and financial capital.
For individuals who work in dangerous
occupations or have job that have a high
likelihood of variability or disruption in earnings,
the total value of human capital is estimated
either by using lower future expected earnings
or a higher discount rate or both.
The higher the earnings risk, the higher financial
capital is required to make up for any loss of
income.

Practice: Example 4,
Volume 2, Reading 12.

3.3.3.) Changes in Net Wealth
Practice: Example, Page no 23-26
Volume 2, Reading 12.

•

The higher the value of pension wealth, the higher

the level of expected remaining lifetime
consumption.
The lower the value of human capital, the greater
the impact of volatility in investment portfolio on
expected remaining lifetime consumption.
Given the same level of risk tolerance, the higher the
human capital of an investor, the less conservative
will be portfolio recommendations.
The risk associated with a pension from a private
employer can be hedged by taking exposure in
securities and derivatives in financial markets having
a negative correlation with the value of the
company.

•
•
•

Example:
Assume following two individuals:
1) 45-year-old with €1.5 million in combined human
and financial capital. He expects to spend
approximately = 1.5mln / (85 -45) = €38,000 each
year until age 85. His investment portfolio is €500,000.
40% loss in the investment portfolio (0.4 ×
€500,000 = €200,000) will lead to a 13.2% loss
in expected spending per year
[(€200,000/40 years)/€38,000].
2) 45-year-old with €3.5 million in net wealth. He
expects to spend = 3.5mln / (85 – 45) = €88,000 each

year until age 85. His investment portfolio is €500,000.
40% investment loss to investment portfolio
(0.4 × €500,000 = €200,000) will lead only to a
5.7% decrease in expected consumption
[(€200,000/40 years)/€88,000].

Premature Death Risk: Premature death risk (or
mortality risk) refers to risk associated with the death
of an individual earlier than anticipated, resulting in
loss of human capital or reduction in the income of
the surviving spouse. This risk can also arise if a nonearning member of the family dies. The loss of death
of non-earning member of the family can be
estimated as the discounted value of the services
provided by the deceased family member plus any
out-of-pocket death expenses.
Besides loss in human capital, the mortality risk also
results in death expenses (including funeral and burial),
transition expenses, estate settlement expenses, and the
possible need for training or education for the surviving
spouse.
2)

3)

Longevity Risk: Longevity risk refers to risk of outliving
one’s financial assets due to extended retirement
period that result in difficulty in meeting postretirement consumption needs. The size of a fund an
individual will actually have at retirement depends
on the amount and timing of contributions, the
nominal rate of return, and the amount of time until

retirement.

4)

Property Risk: Property risk refers to the risk
associated with a potential loss of financial capital
as a result of damage, destruction, stealth, or loss of
person’s property.

This implies that the higher the value of human capital,
the lower the impact of volatility in investment portfolio
on expected remaining lifetime consumption.

•
•

Practice: Example 5,
Volume 2, Reading 12.

3.4

Individual Risk Exposures

Managing risks to financial and human capital is an
essential part of the household financial planning
process. Following are some of individual risk exposures.
1)

Earnings Risk: Earnings risk refers to the risks

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5)

Direct loss refers to the monetary value of the
loss associated with the property itself.
Indirect loss refers to monetary value of the loss
indirectly associated with the damage or
destruction of property. E.g. rental expenses
incurred if the family live elsewhere while the
damage is repaired, income lost during
construction etc.

Liability Risk: Liability risk refers to the risk associated
with a potential loss of financial capital as a result of
an individual or household being held legally liable


Reading 12

Risk Management for Individuals

for the financial costs associated with property
damage or physical injury.
6)

associated with diagnostics, treatments, and
procedures.
Practice: Example 6 & 7,
Volume 2, Reading 12.

Health Risk: Health risk refers to the risks and
implications associated with illness or injury. Direct
costs associated with illness or injury may include
coinsurance, copayments, and deductibles
4.

INSURANCE AND ANNUITIES

Individual lifecycle planning involves assessing expected
available resources and planning an optimal earning
and spending path over a lifetime. Risk exposure can be
reduced either by altering portfolio allocation, changing
behavior, or purchasing financial and/or insurance
products. However, there is a cost associated with risk
reduction comes in form of loss of risk premium and a
lower expected level of consumption over time.
4.1

term insurance is.
Permanent Life Insurance: Permanent life
insurance policy is non-cancelable and it lapses
only upon death.

ii.

Policy premiums for permanent life insurance
are usually fixed.
Generally, there is some underlying cash value
associated with a permanent insurance policy.

Many permanent life insurance policies have a
“non-forfeiture clause,” whereby the policy
owner has the option to receive some portion
of the benefits if premium payments are missed
(i.e., before the policy lapses). The nonforfeiture clause is generally allowed in
following scenarios:
Cash surrender option, whereby the
existing cash value is paid out.
Reduced paid-up option, whereby the
cash value is used to purchase a
single-premium whole life insurance
policy.
Extended term option, whereby the
cash value is used to purchase a term
insurance policy, generally with the
same face value as the previous
policy.

Life Insurance
4.1.1.) Uses of Life Insurance

•
•

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Life insurance protects against the loss of human
capital or the risk of the loss of the future earning
power of an individual.
Life insurance can also be used as estate-planning

tool as life insurance policy can provide immediate
liquidity to a beneficiary without facing the delay
related to legal process of settling an estate
(especially if the estate contains illiquid assets or
assets).

The optimal amount of insurance to purchase depends
on expenses of the insurance hedge and the magnitude
of the difference in expected lifetime utility with and
without that family member.
4.1.2.) Types of Life Insurance
There are following two main types of life insurance:
i.
Temporary Life Insurance: Temporary life
insurance (or “term” life insurance) provides
insurance for a certain period of time specified
at purchase. Temporary life insurance policy is
non-cancelable and it lapses only at the end of
the term. If the individual survives until the end of
the period (e.g., 20 years), the policy will
terminate unless it can be automatically
renewed.
Term life insurance premiums either remain
constant over the insured period or increase
over the period as mortality risk increases.
Term insurance is less costly as compared
with permanent insurance.
Because of increasing mortality risk, the
shorter the insured periods, the less costly

Types of Permanent Life Insurance: Two most common
types of permanent life insurance include:
i.
Whole life insurance: Whole life insurance
provides protection for an insured’s entire life. It
requires regular, ongoing fixed premiums, which
are typically paid annually1.
•
•

1

It is preferred to buy at younger ages because it
is non-cancelable.
Whole life insurance policies can be
participating or non-participating. In
Participating life insurance policies, value grows
at a higher rate than the guaranteed value,
based on the profits of the insurance company.
In non-participating policy, value is fixed and do
not change based on the profits and

Monthly, quarterly, and semiannual payment options also
exist.


Reading 12

•

ii.

Risk Management for Individuals

experience of the insurance company.
Cash values (section 4.1.4.3): Whole life policies
offer advantage of level premiums and an
accumulation of cash value within the policy
that (1) can be withdrawn by the policy owner
when the policy endows (or matures) or when
he or she terminates the policy or (2) can be
borrowed as a loan while keeping the policy in
force. The cash values tend to increase very
slowly in the early years because during that
time, company is making up for its expenses.
As cash values increases and the
insurance value decreases, the ongoing
premium is paying for less and less life
insurance (as shown below).

As the individual’s working years
tend to decrease, the need for
life insurance decreases.
Universal life insurance: In universal life
insurance, the insured has the ability to pay
higher or lower premium payments and has
more options for investing the cash value. It is
more flexible than whole life insurance.

Rider: A rider is an add-on provision to a basic insurance

policy that provides additional benefits to the
policyholder at an additional cost. E.g.
•

•

•
•

Accidental death rider (also referred to as
accidental death and dismemberment, or AD&D):
It increases the payout if the insured dies or
becomes dismembered from an accident.
Accelerated death benefit: It allows insured parties
who have been diagnosed as terminally ill to
collect all or part of the death benefit while they
are still alive.
Guaranteed insurability: It allows the owner to
purchase more insurance in the future at certain
predefined intervals.
Waiver of premium: It provides waiver to future
premiums if the insured becomes disabled. The
value of the rider will depend on the level of
protection against an unexpected decline in
consumption not otherwise provided by a basic

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policy.
Viatical settlement: A viatical settlement is the sale of a

policy owner's existing life insurance policy to a third
party for more than its cash surrender value, but less than
its net death benefit. Such a sale provides the policy
owner with a lump sum. After purchasing the policy, the
third party becomes responsible for paying the premiums
and will receive the death benefit when the insured dies.
4.1.3.) Basic Elements of a Life Insurance Policy: The
basic elements of a life insurance policy include
a) Term and type of the policy (e.g., a 20-year
temporary insurance policy)
b) Amount of benefits (e.g., £100,000)
c) Limitations under which the death benefit could
be withheld (e.g., if death is by suicide within
two years of issuance)
d) Contestability period (the period during which
the insurance company can investigate and
deny claims),
e) Identity (name, age, gender) of the insured
f) Policy owner
g) Beneficiary or beneficiaries
h) Premium schedule (the amount and frequency
of premiums due)
i) Modifications to coverage in any riders to the
policy
j) Insurable interest in the life of the insured: For a
life insurance policy to be valid, the policy
owner must have an insurable interest in the life
of the insured. The insurable interest means that
the policy owner must derive some type of
benefit from the continued survival of the

individual and the death of that individual
would have negative impact on the policy
owner.
Primary Parties involved in Life Insurance Policy:
i.
ii.

iii.

iv.

Insured: The individual whose death triggers
the insurance payment.
Policy owner: The person who owns the life
insurance policy and is responsible for paying
premiums.
Typically, the policy owner and the
insured are the same person.
When the insured is not the policy
owner, the policy owner must have an
“insurable interest” in the life of the
insured.
Beneficiary (or beneficiaries): The individual (or
entity) who will receive the proceeds from the
life insurance policy when the insured passes
away. The actual beneficiary of a jointly
owned life insurance policy may be
determined by the order of death of the
prospective beneficiaries (e.g., a husband and
a wife).

Insurer: The insurance company that writes the
policy and is responsible for paying the death


Reading 12

Risk Management for Individuals

benefit.
Face value of the life insurance policy: It is the amount
payable to the beneficiary.

Example: Assume premiums are collected at the
beginning of the year and death benefit payments
occur at the end of the year. Life insurance policy is
worth $100,000. An individual has a probability of 0.15%
of dying within the year and discount rate is 5.5%.

Payment of Life Insurance Benefits: Life insurance
benefits are payable to the beneficiary upon the death
of the insured. Typically, some kind of evidence (i.e.
death certificate) is required before benefits are paid to
the beneficiary.
Situations when Life Insurance Benefits are not paid:
1) If the insured commits suicide within some
predetermined period after purchasing the policy.
2) If the insured made material misrepresentations
relating to his or her health and/or financial
condition during the application process.
Important to Note: An insurer can deny the claim only

during maximum contestability period. If that period
lapses, then the insurer cannot deny the claim even if it
involves suicide and/or material misstatement.
Practice: Example 8,
Volume 2, Reading 12.

4.1.4.) How Life Insurance Is Priced
The pricing of life insurance is based on following three
key factors:
1) Mortality expectations: Expected mortality of the
insured individual refers to how long the person is
expected to live. Mortality is estimated based on
both historical data and future mortality
expectations. The underwriting process analyzes
applicants’ health history, particularly conditions that
are associated with shorter-than-average life
expectancy (i.e. cancer and heart disease). This
underwriting process reduces the likelihood of
adverse selection. Adverse selection is the risk that
individuals with higher-than-average risk are more
likely to apply for life insurance. Typically, the
individuals with lower expected probability of dying
in a given year tend to pay less for life insurance,
e.g. younger individuals, females, and non-smokers.
2) Discount rate: A discount rate, or interest factor
(based on assumed return on insurance company’s
portfolio) is used to discount the expected outflow.
•
•

Net premium of a life insurance policy
represents the discounted value of the future
death benefit.
Gross premium is the net premium plus load.

FinQuiz.com

Expected Outflow (life insurance benefit) = (Dying
probability × Life insurance policy value) + (Surviving
probability × Life insurance policy value) = (0.0015 ×
US$100,000) + (0.9985 × US$0) = US$150
Net Premium = US$150/1.055 = US$142.18
3)

Loading: Load is an amount that is built in to the
insurance cost. This amount covers the operating
cost of the insurer, as well as the chance that the
insurer's losses for that period will be higher than
anticipated, and the changes in the interest earned
from the insurer's investments. This is added to the
net premium to adjust the premium upward to allow
for expenses and profit. This adjustment is the load,
and the process is called loading.
Expenses associated with writing a life
insurance policy include the costs of the
underwriting process, e.g. sales commission
to the agent who sold the policy and the
cost of a physical exam. Ongoing
expenses include overhead and
administrative expenses associated with

monitoring the policy, ensuring that
premiums are paid on a timely basis, and
verifying a potential death claim.
Usually, companies provide a low percentage
“renewal commission” for the first years of the
policy to encourage the agent to try his best to
keep the policy owner from terminating the
policy.

Types of Life Insurers: Life insurers can be divided into
two groups:
1) Stock companies: Stock companies, like other
corporations, are owned by shareholders, have a
profit motive, and are expected to provide a return
to those shareholders. Stock life insurance
companies add a projected profit as a part of the
load in pricing their policies.
2) Mutual companies: Mutual companies are owned
by the policy owners themselves and there is no
profit motive.
Premium charged by mutual companies is
typically higher than the net premium plus
expenses.
Return of premium to the policy owner: If
expenses, and/or investment returns are better
than projected, the amount by which the gross
premium exceeds the net premium plus
expenses may be paid back to the policy
owners as a policy dividend.

Reading 12

Risk Management for Individuals

FinQuiz.com

Future value of Projected annual dividend =
Projected annual dividend × (1 + Discount rate)
Premiums for Level Term and Renewable Policies:
•
•

•

number of years

An ordinary annuity is used because
dividend payments are made at the end of
the period.
C. Calculate insurance cost as follows:
Insurance cost for “N” years = Future value of
Premium - Future value of projected annual
dividend
Insurance cost for a “N” year annuity due with a
future value = Premium Payments × (1 + Discount
rate) number of years
This amount is the interest-adjusted cost per
year. An annuity due is used because
premium payments occur at the beginning

of the year.
D. Net payment cost is calculated by dividing
Insurance cost by the number of thousand
dollars of face value.

In the early years, premiums for level term policies
tend to be higher than those for annually
renewable (one year) policies.
In the later years of the policies, premiums for level
term policies (particularly, for longer periods i.e. 20year level term) tend to be lower than those for
annually renewable (one year) policies because
premiums for annually renewable term policies
tend to increase rapidly. Therefore, often low initial
rates are offered on annually renewable policies.
People often buy an annually renewable term
policy to take advantage of low premium in early
years and then switching to another company in
later years. But, this strategy involves risk of
individual being uninsurable because of health
issue or accident.

Practice: Example 9 & 10,
Volume 2, Reading 12.
2)
4.1.4.3.) Policy Reserves
Life insurers are required by regulators to maintain policy
reserves. Policy reserves are reported as a liability on the
insurance company’s balance sheet.
•
In a whole life policy, the insurance company

specifies an age at which the policy’s face value will
be paid as an endowment to the policy owner if the
insured person has not died by that time. This makes
policy reserves highly important in whole life policies
so that the insurance company is able to make that
payment.
4.1.4.4.) Consumer Comparisons of Life Insurance Costs
There are two most popular indexes for comparison of
Life Insurance costs:
1) Net payment cost index: The net payment cost
index assumes that the insured person will die at the
end of a specified period, such as 20 years.
Calculation of the net payment cost index includes
the following steps:
A. Calculate the future value of premiums using
annuity due formula:
Future value of Premium = Premium × (1 +
Discount rate) number of years
An annuity due (whereby premium
payment is received at the beginning of the
period versus an ordinary annuity (whereby
premium payment is received at the end of
the period) is used because premiums are
paid at the beginning of the period.
B. Calculate the future value of Projected annual
dividend (if any) using ordinary annuity formula:

Surrender cost index: The surrender cost index
assumes that the policy will be surrendered at the
end of the period and that the policy owner will

receive the projected cash value. Calculation of the
surrender cost index includes the following steps:
A. Calculate the future value of premiums using
annuity due:
Future value of Premium = Premium × (1 + Discount
rate) number of years
An annuity due is used because premiums
are paid at the beginning of the period.
B. Calculate the future value of Projected annual
dividend (if any) using ordinary annuity formula:
Future value of Projected annual dividend =
Projected annual dividend × (1 + Discount rate)
number of years

An ordinary annuity is used because
dividend payments are made at the end of
the period.
C. Calculate insurance cost as follows:
Insurance cost for “N” years = Future value of
Premium - Future value of projected annual
dividend - Year “N” projected cash value
This amount is the interest-adjusted cost per
year. An annuity due is used because
premium payments occur at the beginning
of the year.
Future value of Insurance cost for a “N” year =
Premium Payments × (1 + Discount rate) number of
years

D. Surrender cost is calculated by dividing

Insurance cost by the number of thousand
dollars of face value.


Reading 12

Risk Management for Individuals

Rule to Remember: The lower the index value is, the
better the value.
4.1.5.) How Much Life Insurance Does One Need?
Two different methods are used to calculate the amount
of life insurance needed.
i.
The human life value method: This method involves
estimating future income that would be generated
by the insured, offset by incremental expenses that
would be attributable to the insured. The amount of
insurance needed is calculated as the present value
of net amounts in each year. Additional amount to
cover “final expenses,” such as funeral and other
death expenses may also be added.
ii.
The needs analysis method: This method involves
estimating living expenses for survivors for an
appropriate amount of time, typically until
adulthood for surviving children and to projected life
expectancy for a surviving spouse. This method also
add education costs, final expenses, and any other
special expenses to the total amount of insurance

needed while any assets available are subtracted.
The amount of insurance needed is calculated as
the present value of net amounts in each year.
Reasons to consider life insurance: The primary purpose
of life insurance is to replace the present value of future
earnings. Other reasons to consider life insurance include
the following:
•

Immediate financial expenses: These include direct
costs associated with death, i.e. funeral and legal
expenses.
Legacy goals: These can include gifts to charities,
bequests to family members, and estate planning.

•

The value of life insurance should be equal to household
spending with human capital of the earner less
household spending without human capital of the
earner.

Disability income insurance is used to mitigate earnings
risk (or loss of income) as a result of a disability (e.g. due
to physical injury, disease, or other impairment). In
disability income insurance policy, the premium is
generally fixed and based on the age of the insured at
the time of policy issue, and the policy is underwritten for
the health and occupation of the insured.
The insurance companies typically use following

definition of disability:
•
•
•

The cost of the insurance.
Insurance company’s ability to meet its financial
obligations. It is evaluated by analyzing company’s
financial strength and its ratings.

Practice: Example 11,
Volume 2, Reading 12.

•

•

Disability Income Insurance

Partial disability means that individual can perform
enough to remain employed, albeit at a lower
income. Partial disability provisions pay a reduced
benefit.
Residual disability refers to the possibility the
individual cannot earn as much money as before
despite the fact that he can perform all the duties.

Typically, insurers provide compensation only up to
specific amounts (e.g. 60%–80%) for two reasons.
i.

ii.

When the insured becomes disabled, other
expenses also decrease (e.g. payroll taxes,
commuting costs, clothing, and food).
To avoid possibility of fraudulent claims if the
disability income payments are close to the normal
compensation.

Other aspects of disability income insurance include the
following:
•

•

•

•
4.2

Inability to perform the important duties of one’s
regular occupation: This definition is most
appropriate for professionals with specialized skills.
Inability to perform the important duties of any
occupation for which one is suited by education
and experience;
Inability to perform the duties of any occupation;

Disability income policies usually include provisions for

partial and residual disability.

Factors important to consider when purchasing life
insurance:
•
•

FinQuiz.com

Benefit Period: The benefit period specifies number
of years for which payments will be made. The
benefit period lasts until normal retirement age (e.g.
55 and 70). Usually, a minimum number of years of
benefits is five years. For example, a 62- year-old
who becomes disabled would receive benefits to
age 67.
Elimination Period: The elimination period, or waiting
period, specifies the number of days the insured
must be disabled before payments begin being
made (typically, 90 days). The shorter the elimination
period, the higher the premiums.
Rehabilitation clause: This clause provides payments
for physical therapy and related services to help the
disabled person rejoin the workforce as soon as
possible.
Waiver of premium clause: The waiver of premium
clause allows insured not to stop paying premiums if
he becomes disabled or to reimburse premiums
during the elimination period.

Reading 12

•

Risk Management for Individuals

Option to purchase additional insurance rider: The
option to purchase additional insurance rider allows
the insured to increase coverage without further
proof of insurability, albeit at the rate appropriate for
the insured’s current age.
Non-cancelable and guaranteed renewable policy:
A non-cancelable and guaranteed renewable
policy guarantees policy to be renewed annually as
long as premiums are paid and that there is no
changes to premiums or promised disability benefits
until, usually, age 65. Even if employment income
declines during the working life, the monthly benefit
will remain at the level specified in the policy.
Non-cancelable policy: A non-cancelable policy
cannot be canceled as long as premiums are paid,
but the insurer can increase premiums for the entire
underwriting class that includes the insured.
Inflation adjustments to benefits: Inflation
adjustments to benefits may be provided by a cost
of living rider, under which benefits are adjusted with
an accepted index or by a specified percentage
per year.

•

•

•

FinQuiz.com

US$2,000 deductible and there is a damage of $10,000,
the homeowner must pay the first $2,000 and the
insurance company would be liable for the remaining
$8,000.
The optimal deductible level is determined by cost–
benefit analysis. A high deductible is appropriate for
individuals with significant wealth, a relatively small
percentage of their net worth represented by home,
and who have adequate liquidity.
The larger the deductible, the lower will be the
premium.
Insurance companies prefers the house to be
insured for its full value less the value of the land
because the land will not be destroyed or at least a
high percentage of full value. If the home is
underinsured (e.g. less than 80% of its replacement
cost), losses are reimbursed at lower rate.
Homeowners’ liability risks exclude professional
liability, such as physicians’ malpractice insurance,
business liability, liability resulting from intentional
acts.
Other risk management techniques:

4.3

Property Insurance

Property insurance is insurance that provides protection
against property risk (loss related to his or her property)
associated with home/residence and the automobile.
4.3.1.) Homeowner’s Insurance
Homeowner’s insurance covers risks associated with
home ownership as well as risks associated with personal
property and liability. Renters insurance is for occupants
who do not own the property but want to protect their
personal belongings that are in the home or on the
property.
Homeowner’s policies can be specified as “allrisks,” which means that all risks are included
except those specified, or as “named-risks,”
which means that only those risks specifically
listed are covered. All-risks policies are generally
more expensive.
Homeowner’s insurance policy can be based
on replacement cost, which reimburses the
insured person for the amount required to repair
a damaged item or replace a lost, destroyed, or
stolen item with a new item of similar quality at
current prices. The replacement cost version is a
more expensive policy.
Homeowner’s insurance policy can be based
on actual cash value, which reimburses the
insured person for the replacement cost less

depreciation.
Deductible: The deductible is the amount of expenses
that must be paid out of pocket before an insurer will
pay any expenses. Deductibles represent a form of
active risk retention. E.g. if the homeowner’s policy has a

a) Risk of theft of valuable financial documents can be
avoided by keeping them in a bank’s safe deposit
box.
b) Risk of overall theft can be reduced through the use
of high-quality locks, alarms, and surveillance
systems.
c) Risk of loss or corruption of electronic data can be
avoided by storing backups offsite.
d) Risk of damage to electronic equipment from a
power surge can be reduced by installing surge
protectors.
e) Risk of loss from fire can be reduced through the use
of fire-resistant building materials and through the
easy availability of fire extinguishers.
4.3.2.) Automobile Insurance
Automobile insurance rates are primarily based on the
value of the automobile and the primary operator’s age
and driving record. There are two types of coverages
under automobile insurance:
1) Collision coverage, which is for damage from an
accident.
2) Comprehensive coverage, which is for damage
from other sources, i.e. glass breakage, hail, and
theft.

Insurance companies normally insure automobiles only
up to the cost of replacing the automobile. If the cost to
repair the automobile is greater than its actual cash
value, only the amount of the actual cash value is
reimbursed. Like homeowner’s insurance, some risk can
be retained by automobile owner through the use of
deductibles or by avoiding collision and comprehensive
coverage.


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Risk Management for Individuals

Liability associated with automobiles is typically covered
under automobile insurance policy, with specified limits
for bodily injury and property damage. Liability limits vary
depending on different types of loss, e.g., higher limits to
cover the costs of physical injury and separate limits to
cover the loss of property. If actual liability in an
accident exceeds these amounts, the automobile
owner is responsible for the remainder.
4.4

•

•

•

Indemnity plan: It allows the insured to obtain
services from any medical service provider, but the
insured must pay a specified percentage of the
“reasonable and customary” fees.
Preferred provider organization (PPO) Plan: Under
this plan, physicians and other medical service
providers charge lower prices to individuals within
the plan than to individuals who do not have such
plans.
Health maintenance organization (HMO) Plan: It
allows the insured to obtain medical services, at
zero or very little, cost to encourage individuals to
seek help for small medical problems before they
become more serious.
Comprehensive major medical insurance: It covers
the vast majority of health care expenses, i.e.
physicians’ fees, surgical fees, hospitalization,
laboratory fees, X-rays, magnetic resonance
imaging (MRIs) etc.

Factors to consider in selecting Health Insurance Plan:
i.
ii.

Cost of the plan
Breadth and quality of the network of physicians
and hospitals available to the insured under the
plan.

Key terms of Health (medical) insurance plans:

•

•

•
•

•
•

Health/Medical Insurance

There are various types of health insurance plans, such
as
•

•

Deductibles: It is the amount that the insured must
pay for covered health care services before his
insurance plan starts to pay. E.g. with a $2,000
deductible, the insured has to pay the first $2,000
of covered services himself.
Coinsurance: Coinsurance refers to money that an
insured is required to pay for services, after a
deductible has been paid. Coinsurance is often
specified by a percentage. E.g., the insured pays
20% toward the charges for a service and the
insurance company pays 80%.
Copayments: Copayment is a fixed amount that

the insured pays for a covered health care service
after he has paid his deductible.
Maximum out-of-pocket expense: It is the total
amount of money an insured pay toward the cost
of his healthcare each year during policy period
before health insurance starts to pay 100% of
coverage. This concept is often referred to as a
stop-loss limit.

•

FinQuiz.com

Maximum yearly benefit: It refers to the maximum
amount that the insurance company will pay in a
year.
Maximum lifetime benefit: It refers to the maximum
amount that the insurance company will pay over
an individual’s lifetime.
Pre-existing conditions: Pre-existing conditions refer
to health conditions that the insured had at the
time of application of insurance. Such conditions
may or may not be covered by the insurance
company, depending on the policy, laws, and
regulations.
Pre-admission certification: It is the requirement for
the insured to receive approval from the insurer
before a scheduled (non-emergency) hospital stay
or treatment.

Example of out-of-pocket maximum with high medical
costs:
Let's an insured need surgery with allowable costs of
$20,000, and the following figures apply to his health
insurance plan.
•
Deductible: $1,300
•
Coinsurance: 20%
•
Out-of-pocket maximum: $4,400
The insured will pay the first $1,300 of covered medical
expenses (his deductible). His 20% coinsurance on the
rest of the costs ($20,000 - $1,300 = $18,700) comes to
$18,700 * 20% = $3,740.
His total costs would be $1,300 + $3,740 = $5,040.
But his out-of-pocket maximum is $4,400. His insurance
company will pay all covered costs above $4,400 for this
surgery and any covered care he gets for the rest of the
plan year.
Important to Note: Plans with lower (higher) monthly
premiums have higher (lower) out-of-pocket limits.
4.5

Liability Insurance

Personal umbrella liability insurance policy: This policy
defines a specified limit and pays claims only if the
liability limit of the homeowner’s or automobile policy is
exceeded. It provides an additional layer of security to

those who are at risk for being sued for damages to
other people's property or injuries caused to others in an
accident. . Umbrella policies are relatively inexpensive.
E.g. assume that an individual has automobile policy
which specifies a property damage liability limit of
US$100,000 and also has an umbrella policy with a
liability limit of US$1 million. If an automobile accident
causes US$300,000 of damage, the automobile policy
would pay the first US$100,000 and the umbrella policy
would pay the remaining US$200,000.


Reading 12

4.6

Risk Management for Individuals

payments are made.

Other Types of Insurance

Title Insurance: The title insurance provides insures
against financial loss from defects in title to real property
and from the invalidity or unenforceability of mortgage
loans.

2)

Service contracts: It is a type of insurance that insures

against repair costs of automobile, home appliance, or
other sizable product.
4.7

Annuities

4.7.1.) Parties to an Annuity Contract
There are four primary parties to an annuity contract:
i.
ii.
iii.

iv.

a.

Insurer: It is the entity that is licensed to sell the
annuity, i.e. insurance company.
Annuitant: It is the person who receives the
benefits.
Contract owner: It is the individual who
purchases the annuity and is typically the
annuitant. Sometime, the contract owner and
the annuitant may be different. E.g. if a
company purchases the annuity for a retiring
employee, then the company is the contract
owner and the employee is the annuitant.
Beneficiary: It is an individual or entity that will
receive any proceeds upon the death of the
annuitant.

Plain Vanilla Single-Premium Annuity: This annuity does
not provide any death benefit.
4.7.2.) Classification of Annuities
Following are the primary types of annuities:
Deferred Annuity: A deferred annuity is an annuity
where the payments received will start sometime in
the future, as opposed to starting when the annuity
is initiated. A deferred payment annuity allows the
investment to grow both by contributions and
interest before payments start coming back.
A deferred immediate life annuity is less
expensive as compared with immediate
life annuity because of three reasons:
i.
Deferred payments enable
insurance company to earn return
on the amount tendered.
ii.
The number of payments
decreases as the individual gets
older.
iii.
There is a possibility that an
annuitant may die before any

Immediate Annuity: An immediate payment annuity
is an annuity contract that is purchased with a single
lump-sum payment and in exchange, pays a
guaranteed income that starts almost immediately.

An immediate life annuities provide financial
protection in case the insured “lives too long” (risk of
outliving one’s savings). It is also known as singlepremium immediate annuities (SPIAs).

For both deferred and immediate annuities, the annuity
can be invested in a “fixed” account or a “variable”
account.

Period certain” option: It is variable annuity and/or
annuity with some kind of minimum guaranteed
payment period (e.g., 10 years). In such annuities, the
beneficiary may get death benefit in shape of some
residual value once the annuitant passes away.

1)

FinQuiz.com

2

Deferred Variable Annuities (section 4.7.2.1): In
deferred variable annuities, during the
accumulation period, the insurance company puts
the investor’s premiums (less any applicable
charges) into a separate account and the investor
has the flexibility to manage account as he/she
wants, e.g. can an invest in portfolios covering all
of the major asset classes (e.g. a pre-determined
target risk asset allocation consisting of a diversified
mix of securities managed by multiple investment

managers), can make tax-free exchanges
between the investment portfolios offered, have
right to exit (or sell) the contract, although there
can be considerable surrender charges for
withdrawing one’s money. These annuities can be
more expensive and have limited investment fund
options as compared with mutual funds.
Deferred variable annuity contracts may
include a death benefit. Death benefit
guarantees that the beneficiary will receive
the entire amount used to purchase the
annuity. To offset risk of death benefit, the
insurance company charges a fee.
Like mutual funds, a deferred variable annuity
does not guarantee lifetime income (a
guaranteed income stream for life for the
investor) unless the individual (1) adds an
additional feature (a contract rider) or (2)
annuitizes the contract by converting the
value of the deferred variable annuity into an
immediate payout annuity2. Typically,
insurance companies pay a fixed percentage
(e.g., 4%) of the initial investment value as
guaranteed benefit as long as the annuitant
lives and each payment is subtracted from the
current value of the deferred variable annuity
contract. If the markets continue to perform
well, the initial investment value rises and any
remaining value is provided to the investor’s
beneficiaries. If the market is down, the

investment value may be depleted and the
insurance company is contractually obligated
to continue to pay the investor the
guaranteed minimum benefit as long as the

Annuitizing the contract is not very common.


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Risk Management for Individuals

investor is alive.
Deferred variable annuities are not annuitized.
b.

Deferred Fixed Annuities (section 4.7.2.2): In deferred
fixed annuity, the investor’s money (less any
applicable charges) earns interest at rates set by the
insurance company or in a way as specified in the
annuity contract. The company guarantees a
minimum fixed rate of interest. Unlike deferred
variable annuities, deferred fixed annuities are
eventually annuitized.

Income Yield = Total amount of ongoing annual income
received / Initial purchase price
E.g. assume an individual purchases an immediate fixed
annuity for $100,000 and in exchange receives an
ongoing income of $8,000 per year for as long as the

individual is alive.
Income Yield = $8,000 / $100,000 = 8.00%
The shorter the longevity, the higher the
income yields. E.g. 65 year old man will
receive lower income yield than an 85
year old man. Similarly, a 65-year male will
have higher income yield than a 65-year
old female because females have a
longer average life expectancy than
males.
When current yields on bonds3 are lower
than historical bond yields and life
expectancies are increasing, payouts on
annuities will be relatively low.

Important to Note: The younger the individual is, the less
costly it is to purchase a dollar of income for life starting
at age 65.
Annuitization of Contract: Annuitization refers to
conversion of the investment into an annuity. At any
point of annuitization, the investor has two options:
i.

ii.

Cash out: This involves cashing out and
receiving the economic value of the
accumulated purchases less any applicable
surrender charges. In this case, the annuity
contract is terminated.

Withdrawal of the accumulated funds.

In both cases, “economic value” of the accumulated
purchases is annuitized, converting the deferred fixed
annuity into an immediate fixed annuity.
The annuity payment guaranteed by the insurance
company is based on following things:
o
o
o

Amount of money tendered
Age and gender of the annuitant, and
Insurance company’s required rate of return
(including its cost of funds and its expense and
profit factors).
4.7.2.3.) Immediate Variable Annuities:

FinQuiz.com

Life-only annuity: A life-only annuity pays benefits only as
long as the individual is alive, with no residual benefits.
This annuity is preferred if an individual is mainly
concerned with lifetime income maximization.
Life annuity with n-year certain payment: A life annuity
with n-year (say 10-year) certain payment pays benefits
for at least 10 years. The certain payments for specific
period reduces the payout (income yield). However, the
younger the individual is, the smaller is the effect on
income yield due to the inclusion of a period certain. This

feature is available in both fixed and variable immediate
annuities.
4.7.2.5.) Advanced Life Deferred Annuities:
Advanced life deferred annuity (ALDA) is often referred
to as pure longevity insurance. ALDAs are deferred
immediate payout annuities.

In an immediate variable annuity, the individual
permanently pays a lump sum for an annuity contract
which in turn make payments to the annuitant for life
lifetime. As the name implies, the amount of the
payments varies over time based on the performance of
the assets in the portfolios. An additional feature,
“income floor”, can be added to an immediate variable
annuity for an additional cost that protects the annuitant
against downside risk of market.

Like immediate fixed annuity, an ALDA makes
fixed payments to the annuitant for life lifetime
in exchange of a lump sum.
Like deferred immediate life annuity, ALDA’s
payments begin later in life rather than
immediately, e.g. when the individual turns 80
or 85.

Practice: Example 12,
Volume 2, Reading 12.

4.7.2.4.) Immediate Fixed Annuities:
In an immediate fixed annuity, the individual

permanently pays a lump sum for an annuity contract
which in turn make fixed payments to the annuitant for
life lifetime.
3

Insurance companies tend to invest conservatively, hence,
bonds yield can be used as proxy of expected return.


Reading 12

Risk Management for Individuals

4.7.3.) Advantages and Disadvantages of Fixed and
Variable Annuities
•
•

d) Life annuity with refund, whereby payments are
made for a specified number of periods without
regard to the lifespan or expected lifespan of
the annuitant and provide a refund guarantee
under which the annuitant (or the beneficiary)
receive payments equal to the total amount
paid into the contract.
Total amount paid into contract = Initial
investment amount - Fees
e) Joint life annuity, whereby payments are made
for the entire life of the both annuitants (say
husband and wife) until both members are no

longer living. The annuity payments cease when
the survivor passes away.

Benefits paid in fixed annuities are fixed (or known)
for life. It is preferred by annuitants who are risk
averse (i.e. require certainty of benefits payouts).
Benefits paid in variable annuities varies depending
on the performance of some underlying portfolio or
investment. It is preferred by annuitants who are risk
tolerant.

Important considerations in selecting between fixed and
variable annuities:
1)

2)

3)

4)

5)

6)

4

Volatility of Benefit Amount: Retirees who are risk
averse (tolerant) should choose fixed (variable)
annuity.

Flexibility: Retirees who prefer flexibility to certainty
should select variable annuity because variable
annuity payments are typically tied to the
performance of an underlying subaccount, which
can often be withdrawn by the annuitant, subject to
limitations4. Whereas, in fixed annuity, the payment
made as a lump sum is irrevocable.
Future Market Expectations: In variable annuities,
due to variable payments, the future payments may
increase if the market performs well. Hence, variable
annuities are preferred if retirees expect market to
perform well.
Fees: The fees in variable annuities tend to be higher
than in fixed annuities because variable annuities
involve costs of hedging market risk, administrative
expenses, and reduced price competition. An
immediate fixed annuities have transparent pricing
and thus are relatively easier to compare; whereas,
variable annuities have opaque pricing.
Inflation Concerns: Unlike variable annuities, fixed
annuities are nominal and do not provide hedge
against inflation; however, it is possible to create a
partial inflation hedge by making benefits “step up”
by some predetermined percentage each year
(e.g., 3%).
Payout Methods: The primary payout methods are
as follows:
a) Life annuity, whereby payments are made for
the entire life of the annuitant and cease at his
or her death.

b) Period-certain annuity, whereby payments are
made for a specified number of periods without
regard to the lifespan or expected lifespan of
the annuitant.
c) Life annuity with period certain, whereby
payments are made for the entire life of the
annuitant but are guaranteed for a minimum
number of years (commonly, 10 years) even if
the annuitant dies. E.g. if the annuitant dies after
8 years, a life annuity with 10 years period
certain will make payments to the annuitant’s
beneficiary for the remaining 2 years and then
cease.

Withdrawals may not be allowed (e.g., in the case of an
immediate variable annuity).

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Important to note:
Payout methods are not mutually exclusive.
Different methods can be combined into a single
annuity.
Annuity payments can also be made at different
frequencies, i.e. monthly (most common), quarterly,
or annually.
4.7.5.) Annuity Benefit Taxation:
•

•

•

In United States, annuity can provide tax deferred
growth because the growth in an annuity is taxed
only when the individual receives income from the
annuity.
The actual taxation of the benefits varies materially
by country and is based on some average of the
difference between the amount paid for the annuity
and the benefits received.
Annuities are appropriate for retirees having high
marginal tax rate on alternative investments.

4.7.6.) Appropriateness of Annuities:
Each payment received by the annuitant is a
combination of principal, interest, and mortality credits.
Mortality credits are the benefits that survivors receive
from those individuals in the mortality pool who have
already passed away. However, besides benefits of
income and certainty regarding lifetime income, there is
a cost associated with annuities because the expected
benefits of an annuity are generally not positive –
implying lower potential wealth at death.


Reading 12

Risk Management for Individuals

Retirement income efficient frontier: This frontier can be
used to decide the optimal amount of annuitization for
an individual – tradeoff between wealth maximization
and aversion to lower potential wealth at death. In
retirement income efficient frontier, vertical axis
represents wealth and horizontal axis represents shortfall
risk (risk associated with running out of money over one’s
lifetime).

5.

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Retiree’s demand for annuities is based on following
factors:
A.

Longer-than-average life expectancy implies
greater demand for annuity.
B. Greater preference for lifetime income implies
greater demand for annuity.
C. Less concern for leaving money to heirs implies
greater demand for annuity.
D. More conservative investing preferences (i.e.,
greater risk aversion) implies greater demand for
annuity.
E. Lower guaranteed income from other sources (such
as pensions) implies greater demand for annuity.

IMPLEMENTATION OF RISK MANAGEMENT FOR INDIVIDUALS

Determining the Optimal Risk Management
Strategy
Like portfolio selection, the decision to use insurance or
annuities is determined by a household’s risk tolerance.
•
At the same level of wealth, the higher the risk
tolerance, the lower the demand for insurance (or
higher insurance deductible).

injuries caused by car accident can be reduced
by an airbag in an automobile.

5.1

The impact of a potential loss can be moderated by
reducing or eliminating the costs associated with risks
(refers to as loss control): There are three general
approaches to loss control.
a) Risk avoidance: It refers to removing possibility of
loss occurrence. E.g. risk of loss of a piece of
jewelry can be avoided by selling the asset. This
strategy is preferred when the asset provides no
utility or when the magnitude of the risk
exposure rises because of price appreciation.
b) Loss prevention: Loss prevention involves
reducing the probability of loss occurrence. E.g.,
probability of a break-in can be prevented by
installing a security system.
c) Loss reduction: It involves reducing the size of a

loss if a loss event occurs. E.g., the seriousness of

Risk Management Techniques: Individuals can also
manage risk through the techniques of risk transfer and
risk retention as shown below in the table.

5.2

Analyzing an Insurance Program

Example:
Jacques: age 40; €100,000 annual earnings;
€200,000 whole life insurance policy; €50,000 term
life insurance policy
Marion: age 38; €20,000 annual earnings; no life
insurance
Children: Henri, age 8, and Émilie, age 6
Condominium: €300,000 current value; €190,000 25year remaining mortgage; exterior of building fully
insured; contents insured for €20,000


Reading 12

Risk Management for Individuals

Rental home: €165,000 current value; no
mortgage; insured for €100,000
Income tax rate: 30%.
Rate of taxation of annual income generated from
life insurance proceeds is 20%.

Family expenses attributable to Jacques that will
not exist after his death, such as his transportation,
travel, clothing, food, entertainment, and
insurance premiums. Here, we assume those
expenses to be €20,000.
Non-taxable employee benefits that the family will
no longer receive, such as employer contributions
to retirement plans, which we assume to be
€15,000.
Annual growth rate is 3%.
Discount rate is 5%.

1)

2)

Calculating the contributions involves the following
steps:
1)

2)
3)

4)

Calculate after-tax compensation that Jacques
would receive from employment: €100,000 × (1 –
30%) = €70,000 post-tax compensation.
Calculate post-tax income after expenses =
€70,000 – €20,000 = €50,000.

Add the value of any non-taxable employee
benefits that the family will no longer receive to
income after expenses = €50,000 + €15,000 =
€65,000.
Estimate the amount of pre-tax income needed to
replace that income on an after-tax basis =
€65,000/(1 – t) = €65,000/(1 – 0.20) = €81,250

Human life value method:
Human Life value can be estimated as the present value
of an annuity due with growing payments (a so-called
“growing annuity due”) as follows:

3)
4)
5)

6)

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Estimate the total amount of cash (including final
expenses (funeral and burial) as well as any taxes
payable) that will be needed upon the death of
the insured person. It may also include debt
payments (including mortgages), future education
costs, and an emergency fund.
Estimate the capital needed to fund family living
expenses by calculating the present value of future
cash flow needs during multiple time frames as

follows:
i.
Estimate the surviving spouse’s living
expense needs (say for 52 years until
Marion is 90 years old).
ii.
Estimate the children’s living expense
needs (say until they are 22 years old). This
amount does not include the education
fund.
iii.
Include an additional amount for extra
expenses (e.g. car lease) during a
transition period after Jacques’s death,
say for two years.
Consider Marion’s future income (earnings).
Calculate total needs, i.e. cash needs plus capital
needs.
Calculate total capital available, which may
include cash/savings, retirement benefits, life
insurance, rental property, and other assets.
Calculate the life insurance needed as follows:
Life Insurance Needed = Total financial needs - Total
capital available

Financial Needs: Life Insurance Worksheet

Adjusted rate “i” = [(1 + Discount rate)/(1 + Growth rate)]
– 1 = (1.05/1.03) – 1 = 1.94%
Set the calculator for beginning-of-period payments; n =

20 (the number of years until retirement); payment =
€81,250; and i = 1.94%. Solve for present value of an
annuity due, i.e. €1,362,203. Thus, the human life value
method recommends €1,362,203 of life insurance for
Jacques. Because Jacques already has €250,000 of life
insurance, he should purchase an additional =
€1,362,203 - €250,000 = €1,112,203. This amount would
likely be rounded to €1.1 million.
Important to Note: Adjusted rate “i” can be calculated
as long as the discount rate is larger than the growth
rate.
Need Analysis Method:
The needs analysis method focuses on meeting the
financial needs of the family rather than replacing
human capital. Needs analysis typically includes the
following steps:

Capital Needs [present value of annuity due]: growth
rate = 3%, discount rate = 5%, adjusted rate (as above) =
1.94%
Marion’s living expenses = (60,000/year for 52 years) =
1,991,941
Children’s living expenses:
Henri = (10,000/year for 14 years) = 123,934
Émilie = (10,000/year for 16 years) = 139,071
Transition period needs = (10,000/year for 2 years) =
19,810
Less Marion’s income:
Until Émilie is 16 = (20,000/year for 10 years) –183,713
Age 48–60 (60,000/year for 12 years) –398,565*

Total capital needs 1,692,478
Total Financial Needs 2,137,478


Reading 12

Risk Management for Individuals

Capital Available
Cash and savings 30,000
Vested retirement accounts—present value
200,000
Life insurance 250,000
Rental property 165,000
Total capital available 645,000
Life insurance need (Total financial needs less total
capital available) = 1,492,478 or ~€1.5 million.
Because Jacques already has €250,000 of life insurance,
he should purchase an additional €1.25 million,
according to this method.
*This amount is calculated in two steps:
i.

ii.

Compute the amount needed in 10 years,
when Marion will begin earning €60,000 per
year. Assuming 12 years of earnings from age
48 to age 60, a 3% annual growth in earnings,
and a 5% discount rate (1.94% adjusted

discount rate), a present value of an annuity
due calculation shows that €649,220 will be
needed in 10 years.
Calculate present value of €649,220, with n =
10 years at the unadjusted discount rate of 5%.
PV = €398,565. The discount rate is not adjusted
during this period because there are no
payments to which a growth rate would be
applied.

Important to Note: If Jacques dies prematurely, there will
be an increased need for life insurance for Marion while
Henri and Émilie are still children.
5.2.3.) Recommendations (Continuation of section “5.2.
Analyzing an Insurance Program: Example”)
•
•

•

•

Health Insurance: Although the Perrier family is
covered by national health insurance, they may
want to seek private health insurance.
Disability Insurance: Both Jacques and Marion
should consider long-term disability income
insurance that guarantees the option to purchase
additional coverage without underwriting. They
should also consider taxation while purchasing a

disability income policy.
Long-Term Care Insurance: The Perriers should
consider long-term care insurance for themselves.
It would be prudent to purchase a policy that does
not have a time limit and the amount selected
should be appropriate for the local cost structure
as well as adjusted for inflation adjustment. Longterm care insurance may also be appropriate for
Marion’s mother.
Property Insurance: Property insurance on the
house should be reviewed. The Perriers should
make a thorough valuation of their personal
property. They should also determine whether the
rental house’s contents are included in the policy.
The Perriers should also make sure that they have

•

5.3

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substantial liability insurance coverage with regard
to auto insurance. If they drive relatively little, they
may consider to self-insure. As a nurse, Marion
should also consider professional liability insurance
if it is not provided by her employer.
Longevity Insurance: Longevity insurance should
be considered for Marion’s mother.

The Effect of Human Capital on Asset Allocation

Policy

The subcomponents of an individual’s total economic
wealth affect the portfolio construction in two primary
ways: (1) asset allocation which involves overall
allocation to risky assets; (2) underlying asset classes, i.e.
stocks and bonds, selected by the individual. This implies
that an individual whose job (earnings) has high
correlation with the stock market, should first choose a
less aggressive (less allocation to risky assets) portfolio
and then select less risky individual stocks and bonds (or
asset classes).
The human capital of a less mobile household
will have a lower present value and greater
volatility.
If human capital is very employer-specific
(difficult to earn the same wage from a
different employer), then it is also less valuable
and more risky.
A household with a nonworking spouse tends
to be in a less vulnerable position than a singleperson household if the non-working spouse
can exercise the option to rejoin the
workforce.
Younger investors should allocate more of their
investment portfolio to stocks because the
value of human capital (which is bond-like) is
highest early in the life cycle.
Older investors should allocate more of their
wealth toward bonds because their bond-like
human capital is gradually depleted as they

approach retirement.
Since human capital is illiquid, assets in
financial portfolio should be liquid (i.e.
marketable securities) so that they help
optimizing overall risk characteristics of an
individual’s total wealth.
The overall volatility of one’s economic
balance sheet can be reduced by selecting
assets that correlate weakly (or even
negatively) with human capital.

Practice: Example 14, 15 & 16,
Volume 2, Reading 12.


Reading 12

5.4

Risk Management for Individuals

Asset Allocation and Risk Reduction

Investment risk, property risk, and human capital risk can
be either idiosyncratic or systematic. Idiosyncratic risks
include the risks of a specific occupation, the risk of living
a very long life or experiencing a long-term illness, and
the risk of premature death or loss of property.
•

•

Idiosyncratic human capital risks can be reduced
through investment portfolio strategies and/or
through insurance (or annuity) products.
Life insurance and disability insurance
provides protection against human capital
risk.
Medical malpractice insurance provides
protection against idiosyncratic liability risk.
Annuities provides protection against risk of
outliving one’s assets.
Systematic risks affect all households by affecting
the earnings through a recession or slow economic
growth.

Practice: Example 17,
Volume 2, Reading 12.

End of Reading Practice Problems:
Practice all the questions given at
the end of Reading.

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